Delisting Deals: The Worst Investment Idea in Response to Chinese Company Scandals

 |  Includes: FOSUF, HRBN
by: Peter Fuhrman

Wagering big sums and buying all the shares of a Chinese company trading in the U.S. stock market, taking it private, then trying to re-list the company in China, hands down, is probably the worst investment idea in response to the scandal surrounding some Chinese companies listed in the U.S. Several such deals have already been hatched, including one by giant private equity firm Bain Capital that's now in the early stages, the planned buyout of NASDAQ-quoted Harbin Electric (NASDAQ:HRBN) (with PE financing provided by Abax Capital) and a takeover completed by Chinese conglomerate Fosun (OTCPK:FOSUF).

While the superficial appeal of such deals is clear, the risks are enormous, unmanageable and have the potential to mortally wound any PE firm or hedge fund reckless enough to try.

A bad investment idea often starts from some simple math. In this case, it's the fact there are several hundred Chinese companies quoted in the U.S. on the OTCBB or AMEX, with stunningly low valuations, often just three to four times their earnings. That means an investor can buy all the traded shares at a low overall price, and then, in partnership with the controlling shareholders, move the company to a more friendly stock market, where valuations of companies of a similar size trade at 20-30 times profits.

Sounds easy, doesn't it? It's anything but. Start with the fact that those low valuations in the U.S. may not only be the result of unappreciative or uncomprehending American investors. Any Chinese company foolish enough to list on the OTCBB, or do any other sort of reverse merger, is probably suffering other less obvious afflictions. One certainty: the boss had little knowledge of capital markets and took few sensible precautions before pulling the trigger on the U.S. backdoor listing, which among its other curses, likely cost the Chinese company at least one million dollars to complete, including subsequent listing and compliance costs.

Why would any PE firm, investing as a fiduciary, want to go in business with a boss like this? An "undervalued asset" in the control of a guy misguided enough to go public on the OTCBB may not be in any way undervalued.

Next, the complexities of taking a company private in the U.S. It's not a simple matter of tendering for the shares at a price high enough to induce shareholders to sell. The legal burden, and legal costs, are fearsome. Worse, lots can – and often will – go wrong in ways that no PE firm or hedge fund can predict or control. The most obvious one here is that the investor, along with the Chinese company, gets targeted by a class action lawsuit.

These are common enough in any kind of M&A deal in the U.S. When the deal involves a cash-rich PE firm or hedge fund and a Chinese company with questionable management abilities, it becomes a high likelihood event. Contingency law firms will be salivating. They know the PE firm has the cash to pay a rich settlement, even if the Chinese company is a total dog. Legal fees to defend a class action lawsuit can run into tens of millions of dollars. Settling costs less but targets you for other opportunistic lawsuits that keep the legal bills piling up.

Bain Capital may be able to scare off or fight off the tort lawyers. But other PE firms and hedge funds, without Bain's experience, capital and in-house lawyers in the U.S., will not be so fortunate. Instead, think lambs to slaughter.

Also waiting to explode, the possibility of a SEC investigation or maybe jail time. Will the PE firm really be able to control the Chinese company's boss from tipping off friends who then begin insider trading? The whole process of "bringing private" requires the PE firm or hedge fund to conspire together, in secret, with the boss of the U.S.-quoted Chinese company to tender later for shares at a premium to current price. That boss, almost certainly a Chinese citizen, can work out pretty quickly that even if he breaks SEC insider trading rules by talking up the deal before it's publicly disclosed, there's no risk of him being extradited to the US. In other words, lucrative crime without punishment.

The PE firm's partners, on the other hand, are not likely immune. Some will likely be U.S. passport or green card holders. Or, as likely, they have raised money from U.S. institutions. In either case, they will have a much harder time evading the long arm of U.S. justice. Even if they do, the publicity will likely render them "persona non grata" in the U.S., and so unable to raise additional funds there.

This existential risk, that the PE firm will be so disgraced by the transaction with the U.S.-quoted Chinese company that they'll be unable in the future to raise funds in the U.S., is both large and uncontrollable. The potential returns for doing these "delist-relist" deals aren't anywhere close to commensurate with that risk. Leaving aside the likelihood of expensive lawsuits or SEC action, there is a fundamental flaw in these plans.

It is far from certain that these Chinese companies, once taken private, will be able to relist in China. Without this "exit," the economics of the deal are, at best, weak. Yes, the Chinese company can promise the PE firm to buy back their shares if there is no successful IPO. But that will hardly compensate them for the risks and likely costs.

Any proposed domestic IPO in China must gain the approval of China's version of the U.S. SEC, the CSRC. Even strong companies, without the legacy of a failed U.S. listing, have a low percentage chance of getting approval. No one knows the exact numbers but it's likely last year and this, over 2,000 companies applied for a domestic IPO in China. About 10%-15% of these will succeed. The slightest taint is usually enough to convince the CSRC to reject an application. The taint on these "delisted" Chinese companies will be more than slight. If there's no certain China IPO, then the whole economic rationale of these "delist-relist" deals is very suspect. The Chinese company will be then be delisted in the U.S., and un-listable in China. This will give new meaning to the term "financial purgatory," privatized Chinese companies without a prayer of ever having tradeable shares again.

Plus, even if they did manage to get CSRC approval, will Chinese retail investors really stampede to buy, at a huge markup, shares of a company that U.S. investors disparaged? I doubt it. How about Hong Kong? It's not likely their investors will be much more keen on this shopworn U.S. merchandise. Plus, these days, most Chinese companies looking for a Hong Kong IPO need net profits of $50mn and up. These OTCBB and reverse merger victims will rarely, if ever, be that large, even after a few years of spending PE money to expand.

Against all these very real risks, the PE firms and hedge funds can point to what? That valuations are much lower for these OTCBB and reverse merger companies in the U.S. than comparables in China. True. For good reason. The China-quoted comps don't have bosses foolish or reckless enough to waste a million bucks to do a backdoor listing in the U.S., and then end up with shares that barely trade, even at a pathetic valuation. Who would you rather trust your money to?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.