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Thoughts from the 2011 Wall Street China Forum

On May 6, 2011, I attended the 2011 The Wall Street China Forum in New York City on behalf of Seeking Alpha. Discussions at the forum primarily concerned the differing accounting standards between the U.S. and China, and the general disarray that U.S. listed Chinese stocks in the wake of several recent fraud scandals and concerns over RTO practices.

RTOs Can Be Bad, But Are Not Always Bad

For those that aren’t familiar, RTOs are reverse take-overs. RTOs are used by private companies to become publicly traded without filing for an initial public offering (NYSEARCA:IPO). To perform an RTO, the private company buys a controlling stake in a publicly traded company and uses their shares in the private company to exchange for shares in the public company. In an RTO, the private company does not need to pay the expenses and fees associated with an IPO, but they also will not acquire any additional funds. As acquiring funds is a large part of the basis for most companies going public, many do not consider it. 

For those companies who do not need to dilute the value of their company, an RTO may be a strong alternative. The setup is far simpler than an IPO, and the regulatory hurdles are insubstantial in comparison. And while it may be true that it is a mechanism more and more frequently used by questionable companies, it should also be noted that Berkshire Hathaway (NYSE:BRK.A) was also the subject of a RTO when Warren Buffet took it over. Sometimes, it is simply a sensible option for going public.

Another concern, here, is that some potentially legitimate Chinese companies may end up getting sold on the idea of an RTO by investment bankers. A businessman will usually prefer the less invasive, simpler and faster option, and an RTO is all of these when compared to an IPO.  It must at least occasionally occur that an otherwise capable business is sold on some fast-track plan pushed by an investment banker.

Chinese Versus American Accounting & Business Standards

A primary source of concern in the realm of Chinese RTOs and IPOs is the issue of differing accounting standards. Different systems have different rules, which can affect at what point revenue is accounted for and other issues. The differences in such standards are often the cause of significant concern.

This problem is magnified by the fact that most businessmen are aggressive risk takers and salespeople, not risk-averse lawyers and accountants. As a result, statements made by such new and fast growing companies often contain puffery and an overly rosy outlook for the future. This is not a China-specific issue, as there are certainly countless examples of U.S. companies overstating current results and/or future prospects.

Where the Market Discounts, Private Equity May Step In

At present multiples, many RTOs are trading at values far below traditional market metrics. As such, many may try to take themselves private either by buying themselves back from the market or seeking out a private equity buyer. While there has not yet been a frenzy of such privatization activity, some companies have already proposed such ideas.  Private equity firms may currently be doing their own due diligence on these companies, scouring the market for legitimate businesses that are being taken down due to the present uncertainty.

If private equity managers were to bless a few of these companies, it would certainly help remove some of the uncertainty overhanging so many recent RTOs and IPOs. Such companies tend to do far more research than public investors, and their concluding that at least some of the depressed recent comers are legitimate could help the industry as a whole.

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