Accounting Scandals Driving Chinese Companies From IPOs to Private Equity

The word is out - and it isnt pretty. American and European investors thought they could grab a piece of the Chinese economy's exponential growth on the cheap by taking small companies public on western exchanges. Chinese business people thought they could gain access to western markets and money by doing the same. It was a match not exactly made in heaven.

Both sides chose to overlook cultural, financial and regulatory differences because, hey, what could go wrong? Expensive lawyers and steely, experienced regulators would catch any 'irregularities.' Except that in a recessionary economy, US law and accounting firm revenues had tanked. Those still working recognized that survival depended on doing deals, not stopping them. Western securities regulators faced shrinking budgets and relentless pressure to accomodate from politicians, the bulk of whose campaign funding came from financial services. The Chinese meanwhile, with their historic distrust of regulatory mandarins, kept much of their management in the family and treated business as an extension of personal finances.

Eventually, multiplying reporting problems and resultant business failures exposed the accounting problems. The result has been wholesale investor flight from small public Chinese companies. The good news is that deep-pocketed western private equity firms, with the wisdom of other people's problems to build on, see an opportunity to finance some of these businesses at more advantageous, risk-adjusted terms. The market has cleared. Whether the lessons learned will stick is another matter. JL

Dinny McMahon reports in the Wall Street Journal:

Hundreds of small Chinese companies flocked to U.S. exchanges in recent years, and investors eagerly greeted them as bets on China's surging economy. That love affair has soured.

After a spate of recent scandals—and amid growing investor skepticism—a flurry of those companies are in talks to be taken private.
In some cases, the companies plan to relist in two or three years in Hong Kong or mainland China, where valuations for such companies are now higher than in the U.S.

Shareholders saw billions of dollars in paper losses over the last year after a wave of accounting irregularities surfaced at dozens of U.S.-listed Chinese firms, prompting exchanges to delist several companies. The Securities and Exchange Commission also set up a group to investigate problems at Chinese companies listed in the U.S. As a result, investors have turned their backs on virtually the entire category, even though the vast majority of companies haven't been accused of wrongdoing.

The investor retreat has caught the attention of private equity groups. A number of them are working with the heads of Chinese companies to buy out outside shareholders, according to the companies' filings with the SEC. At least seven Chinese companies have initiated procedures for such buyouts or announced plans to, the filings show.

The deals can be dicey. Existing shareholders are sometimes dissatisfied with the prices they are offered and investor lawsuits are common, says Donald Yang, chief investment officer at Abax Global Capital, a hedge fund that is helping two Chinese companies go private. And critics, including hedge funds that short stocks, warn that some firms may be going private primarily to avoid scrutiny.

But some private-equity investors say they see an opportunity to snap up companies with experience dealing with the demands of international investors at what could be bargain prices.

"It's a perfect storm to be doing these deals...[and] there's a lot of people in the hunt," said Josh Kurtzig, a partner at Tangram Capital Partners, which is helping assemble a couple of privatization deals. "Some CEOs say that going IPO in the U.S. was the worst decision they'd ever made."

Many of these companies came to the U.S. because they were too small and lacked the influence to win a listing on China's state-run exchanges. Plus, there was ample demand from U.S. investors. Most listed through so-called "reverse mergers," which are backdoor processes that entail less regulatory scrutiny than traditional initial public offerings.

Joseph Chan, a partner at law firm Sidley Austin LLP in Shanghai, said interest in doing privatization deals started to pick up around the time the SEC started investigating allegations of fraud at Chinese firms toward the end of last year. The Bloomberg Chinese Reverse Mergers Index has fallen about 60% since mid-November, when sentiment started turning against the sector amid widening allegations of misconduct.

Among the deals in the works, Bain Capital is buying outstanding shares in Nasdaq-listed China Fire & Security Inc. for $9.00 each. That is almost 50% higher than the $6.26 closing price on March 7, when the company announced that a then-unnamed private equity fund was looking to buy it out. At that time the company's share price was 60% lower than a year earlier, despite not being implicated in the investigations or allegations swirling around the sector. It closed at $8.47 Wednesday, and currently has a market capitalization of about $240 million.

More recently, shareholders of specialty chemical maker Chemspec International Ltd. agreed in mid-August to accept an offer from the company's chairman and a private-equity fund headed by Fred Hu, former Greater China chairman for Goldman Sachs, to take the company private. The price of $8.10 per American depository share was 10% below its initial public offering price two years ago. The company delisted from the New York Stock Exchange at the end of last month.

Mr. Hu, whose fund Primavera Capital Group is paying $139 million for Chemspec's outstanding shares, says he decided on the deal before market sentiment began souring on Chinese stocks, but the slump "enhanced our case."

Still, he advises caution. "There's been a lot of talk (of doing these deals) in the wake of the massive sell off of Chinese public companies, but not everyone can do it," he says, pointing to the need for "in-depth due diligence to be sure of what you're getting into."

Skeptics say that at least some of these potential deals may not be all they are cracked up to be. Andrew Left, who runs Citron Research, a short-seller that publishes bearish reports on stocks, says some companies may just be floating privatization plans to buoy their share prices.

Mr. Left has specifically made that allegation against Nasdaq-listed Harbin Electric Inc., which makes electric motors, and is pursuing plans to go private with the help of Abax Global Capital. Mr. Left says Harbin Electric overstated its export revenue and committed securities violations, accusations the company denies. On June 9 he wrote on his website that Harbin Electric is a "struggling company doing whatever they have to do in order to keep that share price high enough."

Harbin Electric declined to comment. But on August 3, Chairman Yang Tianfu said in a statement that Citron's most recent report, posted that day, was "a patchwork of fabricated evidence, falsehoods, selective use of information, and clearly biased and dishonest reporting, showing that the authors' only intention is to drive our stock price down."

Harbin Electric's stock is trading at a discount of about 25% to Abax's proposed buyout price, indicating investor concerns that the deal might not happen. As of Aug. 15, more than seven million shares had been borrowed for short selling, representing almost a quarter of shares available for trading.