By Drew Bernstein and Crocker Coulson
Since the beginning of 2015, over 20 Chinese companies have announced their intention to abandon NASDAQ and the NYSE for greener pastures at home on China's Shenzhen and Shanghai stock exchanges. The go-private concept was straightforward: Buy out American public investors at a modest premium, and then relist the shares at a valuation 2-3 times higher on the A-share market.
This trend was hardly comforting news for the U.S. exchanges, which have counted on China as a rare source of growth. It was also troubling for the investment banks that sponsor these overseas listings, many of which have already slashed their China equity desks in recent years.
The recent mayhem in China's A-share markets should cause these companies to rethink the wisdom of their delisting strategy, and perhaps gain a new appreciation for the virtues of more mature and well-regulated equity markets.
Dotcom Mania, Beijing Style
Just a month ago, China's domestic stock markets were experiencing a full-blown bubble, the likes of which the U.S. last experienced in 1999. The Shanghai stock market had gone up 135% in 12 months. Technology stocks were trading at over 100 times earnings. And every IPO was a moon shot, with some rallying 4000% above the offer price.
Not surprisingly, these sorts of valuations had CEOs salivating. Consider that a market leader like Alibaba (NYSE:BABA) listed on the NYSE is trading at "only" 50 times earnings, while relatively obscure companies trade for twice as much at home. Why not make the switch? After all, management has a duty to maximize the value for shareholders, and companies that can access cheaper capital have an enormous competitive advantage.
But the delist-relist strategy only works if the A-share market's towering valuations are sustained for several years, a prospect that now seems dubious.
Going private is a complex and time-consuming process, which can take anywhere from six to 18 months. There are special committees to be formed, fairness opinions to be written, and proxy statements to be drafted, circulated and voted upon. Inevitably shareholder lawsuits challenge the price being offered by insiders to buy out less informed outside owners. Once the company has gone private, then the company begins the arduous approval process for a Chinese IPO, which can take one to five years.
In recent weeks, the fragile foundation of the A-share equity edifice has been fully exposed. Stocks lost over a third of their value in a dizzying descent, before massive government intervention managed to put a temporary floor under the stock market. What just a few months ago looked to be exceptional strengths of the Chinese model, have now been revealed as serious flaws.
There are no investors in China, only speculators and state actors.
A mature market is made up of both speculators, who trade on news and sentiment, and value investors, who carefully analyze cash flows and balance sheets. When the market gets frothy, value investors tend to sell down their positions. But when sentiment becomes overly bearish, value investors will tend to step in to scoop up cheap shares. China is primarily a retail-driven market, where even institutional investors pay more attention to government policy statements than to business fundamentals.
The recent China bubble was fueled by tens of millions of new stock accounts opened by neophyte investors. Two-thirds of these fledgling stock pickers left school before the age of 15 and 6% are illiterate. Chinese investors responded strongly to bull market cheerleading in the official media and largely ignored corporate fundamentals, which explains why stocks staged such an explosive rally in the face of declining growth and squeezed profits.
When sentiment finally turned negative in July, every investor wanted to leap off the elevator at once, and there were no value investors to cushion the fall. As a result, the Chinese government was forced to become the buyer of last resort. This explains why China's stock market will continue to be structurally unstable for many years to come.
Drastic intervention has undermined market quality.
When panic selling was at it's height, China's state media spoke of a "war on stocks" necessary to reverse declining prices. The Chinese government brought heavy artillery to this battle. Their interventions may have scared away sellers, but it may also have done long-term damage to the health of the A-share markets.
The two most important functions of any market are liquidity and price discovery. When the bubble burst, China suspended trading in over half of the public companies was suspended. A recent analysis by the Wall Street Journal showed that on the worst days, only 3% of listed companies were freely tradable because so many names hit 10% decline floors. Price discovery, which is absolutely critical to efficient allocation of capital, has been compromised, and investors cannot accurately mark their holdings to market.
Today, a substantial number of stocks remain frozen, funds that own 5% or more of a company's shares are prohibited from selling, and brokers who facilitate aggressive selling are under the threat of criminal prosecution. This is what institutional investors fear most, when a market becomes a "roach motel" where you can check in but you can't check out.
Access to equity financing is the exception in China, not the norm.
In China, the government also exerts a heavy hand over which companies can raise equity capital.
Prices for IPOs are set artificially low, ensuring a rich return for insiders and those allocated shares, but depressing IPO proceeds for the company. Follow-on offerings are the exception, rather than the rule. And when the market tanks, regulators simply shut down new offerings for years at a time to restrict the supply of new shares in the hopes of propping up the market.
So companies planning to re-list on A-share market risk being locked out from public equity financing for a long time. By contrast, companies listed in the U.S. that perform well can access sizable amounts of new equity and debt overnight should they have a compelling use for it.
Listing standards have deteriorated.
In the past 18 months China has seen an explosion of speculative listings on the alternative ChiNext exchange and its new over-the-counter (OTC) markets, where thousands of new companies have listed in the past few years.
This OTC market, known as the National Equities Exchange and Quotations (NEEQ), has far lower disclosure standards and a reputation for aggressive stock promotion and price manipulation, with one speculative biotech running up to $16,000 a share a few months ago, before collapsing.
What's more, the A-share market now also offers the potential to execute a "reverse merger" in which the overseas company is acquired by a smaller, underperforming public company in China.
This technique was recently adopted by U.S. refugee Focus Media, which is in the process of a back door listing via a small rubber company, Jiangsu Hongda New Material, on the Shenzhen Exchange. These plans hit a snag when the rubber company's chairman, Zhu Dehong, resigned on June 23rd amidst an investigation of securities law violations.
In sum, China has now managed to import many of the worst excesses of America's Chinese reverse merger boom back in the 2005 to 2009 era.
When the party is in full swing, no one wants to know what's in the punch. But it is likely that Chinese investors will be in for a very long and painful hangover.
When Going Private is the Best Available Option
Looking at the list of companies that have announced going private plans, there is one sizable company, Qihoo360, valued at $10 billion, and a few mid-sized, well-respected names such as Homeinns Hotel Group (NASDAQ:HMIN), Mindray (NYSE:MR), YY.com (NASDAQ:YY) and Wuxi PharmaTech (NYSE:WX).
But many of the others are either relatively small, have come under criticism (deserved or not) by U.S. short-sellers, or have failed to deliver promised financial results. Half of them traded under $10 prior to their announcements.
For these companies, a strategic retreat back to China may be their best option. Several have business models that cannot easily be appreciated or evaluated by overseas investors. What's more, their management teams may never have been fully comfortable with the transparency and access that overseas investors typically demand of their investee companies.
But delisting primarily to capture the inflated valuations on the A-share market is like an American Internet company assuming that it will always be 1999.
Prepare for a Wild Ride Ahead
While the government has slowed down the market slide for now, there are a number of reasons to believe that there will be further drama to come.
First, the bull market was fueled by an exceptional amount of margin buying and leverage.
At the peak there was $370 billion in margin financing by securities companies alone. But this was really just the tip of the iceberg. Speculators were making levered bets using umbrella trusts and a wide range of non-traditional financing channels. Companies were betting on stocks using bank loans and their working capital. To prop up the market, Chinese regulators have pumped additional margin financing into the system and now even allow investors to use their homes as collateral to buy stocks on margin.
If the market declines again, the cycle of forced liquidations will accelerate.
Second, stocks listed on the A-share market are far from cheap, and have yet to find a clearing price based on fundamentals.
While valuations of the blue-chip A-share stocks have declined, they are still over 50% higher than comparable companies trading on the Hong Kong Stock Exchange. Meanwhile, stocks listed on the speculative ChiNext exchange trade at over 80 times earnings.
Third, the bull market and the retreat have further destabilized the overall financial system.
The shares of large SOEs are now being supported by heavy buying from government financial entities and state-owned financial institutions. Loading up these balance sheets of the banks and insurance companies with inflated shares will inevitably de-stabilize them if and when the market eventually moves to fair value.
It will take a number of quarters before we know just how much damage was inflicted on corporate balance sheets by the recent market mania. But the follow on shocks from deteriorating asset quality could be very significant.
Just a few months ago, China seemed to be well on the way to gaining acceptance for China's financial markets as mature and lucrative place for international capital to invest. This spring the media touted that China's A-share market was on track to be added to the MSCI global emerging markets index, which would have automatically brought billions of fresh investment into the market.
When MSCI decided in mid-June to delay this addition, it set off the first tremors of what became a market meltdown. Today, China's stock markets appear to be a long way from meeting global standards. As such, U.S.-listed Chinese companies may want to take a hard look before they leap.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.