Chinese companies facing low valuations on US stock exchanges have some options left on the table
When investors think a company’s market price is undervalued, they can buy the company’s shares. But when a company thinks itself to be undervalued by the market, it sometimes opts to buy out the investors.
Such is the case with Focus Media, a Nasdaq-listed company that operates ad displays in elevators, supermarkets and subways across China. The company announced in August that it was in talks with a group of investment funds to go private. The $3.5-billion deal is still pending, but if it goes through, it will be the biggest leveraged buyout ever of a China-based company.
Focus Media is one of a number of victims of short-seller attacks on US-listed Chinese firms over the past two years, based on reports of alleged fraudulent practices of various kinds. The assault on Focus Media followed a report in November of 2011 alleging the company had overpaid for acquisitions. It did not force a delisting, but its shares have languished for months at a low valuation, along with most other small- and medium-sized Chinese companies listed in the US. The buy-out announcement effectively signals that the big-name funds involved–including the Carlyle Group, FountainVest Partners, CITIC Capital Partners and Temasek–have concluded that the basic problem is not with the Chinese company, but with the US markets.
They are not alone. Focus Media is only the biggest of a growing number of Chinese companies looking to delist from the US, fed up with low valuations there.
“Some [Chinese] companies felt disappointed after listing in the US,” says Zhu Guofan, CEO of the Chinese foot massage chain Beijing Tailian Liangzi Health & Fitness.
Other Chinese companies are scrapping plans to list in the US. China’s technology firm Huawei recently told CNN that it had ‘no plans’ to list on an international exchange, largely due to negative reports about the company in the US.
Chinese companies already listed on American exchanges have various options to consider. For starters, they could look to try their luck on another exchange, as Focus Media seems to be looking to do. They can arrange cash to buy out investors and “go private.”
But another option for companies is to improve their systems, ensure compliance with market requirements, improve transparency and their public image to ward of short-seller attacks and low valuations. Some US-listed Chinese companies are doing just that and in the long run such reforms could pay off handsomely.
Good Old Days
“A couple of years ago, we would go to China and every company wanted to do a reverse merger in the US,” recalls Kevin Pollack, Managing Director at Paragon Capital, a fund that invests in US-listed Chinese companies. Reverse mergers–the process of buying out a company already listed in the US and inserting assets from the buyer–were a popular “backdoor” route to American markets for Chinese companies too small to afford an IPO.
That came to a sudden halt in 2011 due to a rash of short-seller attacks and financial accounting scandals among US-listed Chinese companies. The Bloomberg Chinese Reverse Mergers Index crashed by around 65% over the course of that year, and the Halter USX China Index–an index of US-listed companies that derive most of their revenue from China–fell by almost 30% over the same period.
The most famous, an attack by research outfit Muddy Waters on the Toronto-listed Chinese lumber firm Sino-Forest, eventually led to a fraud investigation and the humiliation of John Paulson, the manager of a multi-billion dollar hedge fund that had bet heavily on the stock.
Short-seller attacks have since become rare. But the stigma remains, and nearly every index of US-listed Chinese stocks continues to plumb new depths independent of the overall market direction. “Investor sentiment has not really improved,” says Pollack of Paragon Capital. “I know a lot of funds that got burned and have said they’ll never invest in another Chinese company again. It’s going to be very hard to bring those investors back in.”
Little wonder, then, that many US-listed Chinese companies have given up even trying, opting instead to delist from the American markets. In 2011, 10 Chinese companies worth a combined $3.5 billion delisted from US exchanges (up from zero in 2010), according to data from Roth Capital Partners. By contrast, new listings from Chinese companies fell by almost half to $2.2 billion in 2011, meaning US markets experienced a net outflow of Chinese equities.
Estimates of the number of Chinese firms that have or plan to delist this year vary, but Groves of DAC Management puts the outstanding figure at around two dozen.
Rebels Without a Cause
Delisting is not necessarily an easy course for frustrated US-listed Chinese firms. For one thing, they must reach agreement to buy out US investors, says Groves. Lawsuits are often involved.
In terms of re-listing, Hong Kong is an attractive option, but some Chinese companies are experimenting with smaller exchanges like Sydney, Frankfurt, Singapore or Seoul. China King-Highway Holdings Ltd., Global SM Tech Ltd and China Engine Group, for example, listed with Korean exchange KOSDAQ in 2009. But these bourses are much less liquid than the US, and generally offer even lower valuations.
Instead, many Chinese investment banks are now pitching US-listed China companies to re-list on the Shanghai or Shenzhen exchanges, says Groves. Bankers say these markets offer valuations several times higher than what companies are getting in the US.
That may be true but it misses the point, argues Li Wei, Professor of Economics and Emerging Market Finance at the Cheung Kong Graduate School of Business. Unlike regulators in the US, the China Securities and Regulatory Commission (CSRC) approves for listing only companies it thinks are surefire winners. Peter Fuhrman, chairman of the private equity fund China First Capital, has estimated about 10-15% of applicants were approved in 2010.
Because listing is so exclusive and Chinese investors have few other asset classes in which to invest, valuations on Chinese stock markets can be high. “If you’ve got a quota to be on the list [of approved IPOs] by the CSRC, it’s as if you’ve got a machine to print money,” says Li. But de-listing from the US without a guaranteed spot in China would be very risky.
The bottom line is that there’s no obvious substitute for the US markets.
“What is the right path?” asks Pollack of Paragon Capital. “Today it’s no longer clear, there is no right answer.”
For Chinese companies that do stick it out in the US, there are other ways to boost investor confidence and perhaps their valuation, says Pollack.
Many Chinese companies claim to have lots of cash on hand–something hard for investors to independently verify. They could demonstrate their bona fides through a big stock buy-back, which would double as a signal of management’s faith in the company. They might also consider giving the money back to investors via dividends.
US-listed Chinese companies could also upgrade their audit and legal service providers to big-name global brands (despite the issues many of these brands, especially auditors, have had in China). Finally, advises Pollack, hit the road: “Management teams still need to spend time in the US meeting with investors and sharing their story,” he says. At the very least, they might find someone willing to take them private.
Pollack points to two companies that have successfully pursued such strategies after being attacked by short-sellers. After its report on Sino-Forest, Muddy Waters hit Spectrum, a Chinese communications firm, in late June 2011. The firm “responded very well,” said Pollack, by addressing the allegations, buying back stock and issuing dividends to investors. Silvercorp Metals, a natural resource firm targeted by short-seller Alfred Little, pursued a similar strategy with success.
These are smart steps, but many–including Pollack–caution that the road back into investor graces is not an easy one. Small and medium-sized Chinese companies are often behind on their US financial filings, and all the buttering up in the world can’t undo the fact that should something go awry, US-based investors are now aware that it is very difficult getting at the underlying assets of Chinese companies.
“It’s funny–as we’re talking to [Chinese executives], all of a sudden the light bulb goes on and the Chinese company realizes that if they just take their company and leave, it’s very difficult for the foreign investors to get paid back,” he says. Smart US investors discount Chinese shares as insurance against such a possibility.
Here be Regulators
Tensions between American and Chinese regulators also impact the valuations of Chinese companies listed in the US. One dispute is over whether US financial regulators should be allowed to inspect the books of auditors overseeing US-listed Chinese companies (which China claims is a violation of its sovereignty). Negotiations have hardened over the past year, to the point that some speculate that all Chinese firms could be forced to de-list from US markets.
But despite all the obstacles, many investors expect small and medium-sized Chinese companies to eventually return in force to the US market and valuations to rise. “I’m still very bullish on China–there’s some good companies out there that are undervalued,” says Pollack of Paragon Capital.
(Image courtesy Flickr user Flodigrip’s world’s photostream)