China MBOs: The problem with privatizations

Harbin Electric's stock closed at $23 on October 21, its highest level in a year. Yet the price was still short of the $24 that Tianfu Yang, the company's chairman and CEO, and Abax Global Capital have offered to take Harbin Electric private. The bid - worth $463.8 million - received board approval in June and a few days later shareholders voted in agreement.

Multiple cases of fraud in the last year or so have made investors highly sensitized to the risks associated with Chinese companies listed in the US, particularly those that went public through reverse takeovers. As valuations plummeted, the chairman and CEOs of these companies began to consider privatization. Private equity players, sensing valuation arbitrage, stepped up to provide the capital.

As it stands, though, only eight take-private deals have been completed. Two of those were strategic acquisitions and, of the six management buyouts, three were supported by private equity.

Six more management buyouts are either under board review or pending shareholder approval. Abax is participating in two of these deals - Harbin Electric and a $439 offer for bimetallic products manufacturer Fushi Copperweld - while Bain Capital is expected to complete the privatization of China Fire & Security by the end of the year. Donald Yang, managing partner of Abax, told AVCJ in June that his team was in talks several companies about take-privates.

"There are quite a few private equity firms looking at the possibility of securing a go-private transaction in the US and then taking the company public again in Hong Kong," says Maurice Hoo, the Hong Kong-based co-head of Orrick's private equity practice. "But once we start working on these deals, people realize that it's not always as easy as they had assumed."

Faced with a daunting web of multi jurisdiction regulations and cross-border tax considerations, he estimates that less than one in 10 chairmen who start the privatization process actually make it to the end.

Trading at a low

There is little argument that the stocks in question are undervalued. Roth Capital Partners recently identified 32 US-listed Chinese companies with price-to-net cash ratios below 1.3x, ranging from China Biotic Pharmaceutical, which has a market capitalization of $30.5 million, to $809.7 million Giant Interactive Group. Only eight are reverse takeover stocks and over half are audited by one of the Big Four accounting firms. In 15 cases, company management directly or indirectly holds over 25% of the outstanding shares, making a potential privatization considerably easier.

"We believe the dramatic sell-off within the US-listed China sector over the past 15 months became increasingly indiscriminate with many companies trading at deeply depressed valuations, including some companies trading near or below net cash levels," Mark Tobin, co-director of research at Roth Capital, concluded. "We believe private equity interest in the sector remains high and anticipate additional privatization announcements, particularly as China's credit environment improves."

Morgan Stanley Private Equity Asia (MSPEA) has invested in two US-listed Chinese companies in the last five months, although as PIPE deals instead of management buyouts. The private equity firm committed $50 million to agricultural nutrients producer Yongye International in June and followed this up with a $100 million commitment to auto industry supplier China XD Plastics in August.

Yongye's share price had halved since January but spiked 42% on news of MSPEA's investment. The stock more or less maintained its value through October. XD Plastics is also close to sustaining the 45% jump in its share price that came in response to MSPEA's involvement. The stock had previously fallen 57% from its February peak.

"It's a very attractive pricing environment right now," Homer Sun, a partner at MSPEA, tells AVCJ. "The challenge is more about finding the right company."

Sun adds that MSPEA opted for structured PIPEs rather than a management buyout because it made the most sense in the company-specific context of a number of factors that go into determining suitability for a take-private. Other industry participants note that PIPE deals are comparatively easier to pull off. Even if a take-private is successful, the company can't be sure when it will be able to re-list. This could have serious implications for capital-raising activities.

In this context, differences between the US and Hong Kong listings systems are significant. While the US Securities and Exchange Commission operates on a disclosure basis - a company can be unprofitable and have material weaknesses in its financial as long as it informs the investing public of these facts - listing applicants in Hong Kong are subject to a merit review. They must meet various requirements including a reported profit of at least HK$20 million in each of the two preceding years.

Chinese online video sites Youku and Tudou, which raised $203 million and $174 million, respectively, on NASDAQ earlier in the year, would not have been able to go public in Hong Kong because they have yet to turn a profit.

Second, the Hong Kong Stock Exchange is highly selective about the jurisdictions with which it will do business. Until late 2006, only companies domiciled in Hong Kong, mainland China, Bermuda and Cayman Islands were eligible to list in the territory. Although the exchange has since broadened its parameters, the likes of Nevada, Wyoming and Delaware - jurisdictions of choice for many Chinese companies listed in the US - are not accepted. Special dispensation is available, but it isn't easily obtained.

"If you are a Nevada company and you want to list in Hong Kong you might decide to re-domicile from Nevada to Cayman, but it could trigger tax consequences at national or even at state level," Orrick's Hoo says. "This might mean the whole process is no longer economically viable."

Regional differentiation

State-level bureaucracy doesn't stop at taxation. Certain US states have emerged as popular jurisdictions for company incorporations because they offer a combination of tax incentives, privacy and control for the major shareholders. However, this can also work against the company.

Abax only got involved with Harbin Electric after Baring Private Equity Asia pulled out last November, having initially agreed to work exclusively with Yang, the chairman, on a buyout deal. According to a source familiar with the situation, Baring's departure was in part driven by regulations governing the transaction.

Harbin Electric is incorporated in Nevada where anti-takeover laws make it difficult for an "interested stockholder" - i.e. a party that, together with associates, owns 10% or more of a company, or has owned such a stake in the last three years - to increase its holding. By aligning itself with Yang, who owned around 30% of the company, Baring pushed its ultimate goal of crossing the 10% threshold further away, the source says.

The other obstacle is a successful management buyout is that investors' worst fears might be realized and the company exposed as a fraud. "When you start looking at these reverse takeover companies, you have to assume they all have problems," says one China-based fund manager. "Everything listed outside of Hong Kong and China is worse. Whatever you might feel about it, Hong Kong has a listings committee and they have a process."

While the fund manager accepts that few of the successful privatizations have a whiff of fraud about them, he suggests that some processes get a long way down the track because, at worst, people are taking bribes, and at best, the PE investors are tied to a structure whereby they sacrifice all their fees if the deal doesn't close.

Fraud claims were leveled at Yongye International well after MSPEA had begun its due diligence on the company. Just over a week before the PIPE deal was announced, Absaroka Capital Management, a Wyoming-based hedge fund, accused Yongye of manipulating its earnings. It questioned the company's relationships with major suppliers and customers and the level of compensation awarded to management compared to industry peers; challenged claims that Yongye's main fertilizer product was developed by scientists at Stanford University; and said that a recent acquisition was nothing more than a means of siphoning cash of the books.

Yongye disputed the claims and MSPEA stands by its investment thesis that the company is a leading player in an underpenetrated market. As part of the deal, Sun joined Yongye's board of directors.

Short-sellers attack

Short-seller scrutiny of Yongye pales in comparison to that directed at Harbin Electric. Citron Research describes the company as "a money pit with hidden liabilities that are consuming its cash." It has questioned the veracity of the Harbin Electric's US regulatory filings, claiming that revenues from major customers have been grossly overstated; challenged the most recent audit, which was conducted by a firm that has been reprimanded by regulators; and produced documents which suggest that Yang admitted to guilt in a 2004 loan fraud case.

Further questions were asked of the $400 million loan facility that Yang's Cayman-incorporated acquisition vehicle has secured from China Development Bank's Hong Kong branch to finance the transaction. Abax's commitment extends to $38.8 million in equity financing and $25 million in mezzanine financing.

After reaching $23.20 when the deal was first announced, Harbin Electric's stock sunk to 70% below the buyout offer price in mid-June. Although the value has rebounded, the fact that it still trails the offer price suggests investors remain skeptical about the deal going through.

China Fire & Security is trading at a marginal deficit to the offer price, having jumped 12% on the initial announcement in a March and a further 16% on confirmation of Bain's involvement in May. Fushi Copperweld is down 46% on its offer price, which was announced nearly a year ago.

Limited liquidity may have some impact on the trading levels of these stocks but, as Abax's Donald Yang noted to AVCJ in June, few companies have so far been privatized and those that have are still to list in Hong Kong, which means the strategy as a whole is unproven. Uncertainties abound, from the quality of the company or the fact that the Hong Kong Stock Exchange's merit-based assessments are subjective.

"The interesting thing about these deals is that they involve Hong Kong listing rules, US securities law, Chinese law and the corporate law of the jurisdiction in which the firm is incorporated. We have to pull everything together," says Hoo. "Despite the potential, there haven't been enough deals to suggest that private equity firms have a track record moving companies from one jurisdiction and relisting in another as a means of adding value.

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• Topics
• Greater China
• Buyouts
• North America
• China
• USA
• buyout
• regulation
• professional services
• Abax Global Capital
• Morgan Stanley Private Equity Asia