Debunking the Delist-Relist Approach as a Plausible Rescue for Chinese RTOs

by: Peter Fuhrman

Who will end up losing more, the investors who put their money into Chinese companies that did RTOs and then watched the price plummet? Or the private equity and hedge funds that are now looking to take these companies private?

Making a failed investment is usually permissible in the private equity and hedge fund business. Making a negligent investment is not. The PE and hedge firms now considering the “delist-relist” transactions I wrote about last time (click here to read) are jeopardizing not only their investors’ money, but the firm’s own survival. The risks in these deals are both so large and so uncontrollable that if a deal were to go wrong, the PE and hedge funds would be vulnerable to a lawsuit by its Limited Partners (“LPs”) for breach of fiduciary duty.

Such a lawsuit, or even the credible threat of one, would likely put the firms out of business by making it impossible for them to raise money from LPs again. In other words, PE and hedge funds that do “delist-relist” are taking existential risk. To this old guy, that is just plain dumb.

Before making any investment, a PE firm, to fulfill its fiduciary duty, will do extensive, often forensic, due diligence. The DD acts as a kind of inoculation, protecting the PE firm in the event something later goes wrong with the investment. As long as the DD was done properly, meaning no obvious risks were ignored, then a PE firm can’t easily be attacked in court for investing in a failed deal.

With the “delist-relist” deals however, there is no way for the DD process to fully determine the scale of the largest risks, nor can the PE firm do much to hedge, manage or alleviate them. This is because the largest risks are inherent in the deal structure.

The two main ones are the risk of shareholder lawsuits and the risk that the company, after being taken private, will fail to win approval for an IPO on a different stock market. If either occur, they will drain away any potential profit. Both risks are fully outside the control of the PE firm or hedge fund. This makes these deals a blindfolded and naked crawl through a minefield.

Why, then, are PE and hedge funds considering these deals? From my discussions, one reason is that they appear easy. The target company is usually already trading on the US stock market, and so has a lot of SEC disclosure materials available. All one needs to do is download the documents from the SEC’s Edgar website. Investing in private Chinese companies, by contrast, is almost always a long, arduous and costly slog – it involves getting materials, like an audit, and then making sure everything else provided by the company is genuine and accurate.

Another reason is ignorance of or indifference to the legal risks: many of the PE firms I’ve talked to that are considering these “delist-relist” deals are based in China, and so have little direct experience operating in the US capital markets. Instead, the firm’s focus on what they perceive to be the “undervaluation” of the Chinese companies quoted in the US. One PE guy I know in Hong Kong described the Chinese companies as “miss-killed”, meaning they are, to his way of thinking, basically solid businesses that are being unfairly scorned by US investors.

There may well be some good ones foundering on US stock markets. But, finding them and putting the many pieces together of a highly-complex “delist-relist” deal is outside the circle of competence and experience of most PE firms and hedge funds from China.

This investment approach, of looking for mispriced or distressed assets on the stock market, is a strategy following by many portfolio managers, distress investors and hedge funds. PE firms operating in China, however, are a different breed, and raised money from their LPs, in most cases, by promising to do different sorts of deals, with longer time horizons and a focus on outstanding private companies short of growth capital. The PE firm acts as supportive rich uncle, not as a crisis counselor.

Abandoning that focus on strong private companies, to pursue these highly risky “delist-relist” deals seems not only misguided, but potentially reckless. Virtually every working day, private Chinese companies go public and earn their PE investors returns of 400% or more. There is no shortage of great private companies looking for PE in China. Just the opposite. Finding them takes more work than compiling a spreadsheet with the p/e multiples of Chinese companies traded in the US. But, in most cases, the hard work of finding and investing in private companies is what LPs agreed to fund, and where the best risk-adjusted profits are to be made. How will LPs respond if a PE firm or hedge fund does a “delist-relist” deal and then it goes sour? This, too, is a suicidal risk the PE and hedge funds are taking.

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