China reverse mergers: In through the out door

Beijing Digital Horizon Technology, a mobile social networking provider, originally intended to list in Hong Kong. The company set up a subsidiary - the rather delightfully named E.T. Holding - in the territory five years ago as it plotted its move. Offshore funding poured into the new vehicle from Sequoia Capital, Lightspeed China and Infinity Group. 

Digital Horizon pulled the plug on its Hong Kong IPO last year and switched focus to a domestic listing. This plan also came to nothing as the Chinese regulators kept the door shut to new listings.

Earlier this year, Digital Horizon unveiled another scheme: it would go public on the domestic markets via a reverse merger with Shanghai-listed Jiangsu Sanfangxiang Industry. Another obstacle emerged as the parties couldn't agree on terms for the asset swap.

However, Digital Horizon got the terms it wanted with another shell in Shenzhen and two weeks ago announced plans to merge with Hangzhou New Century Information Technology.

After the Chinese Securities Regulatory Commission (CSRC) officially ended the 14-month embargo on new share offerings, 43 companies went public in January and five in February. There have been none since then, which means more than 600 companies remain on the waiting list.

Digital Horizon is one example of a number of private equity-backed companies that have sought to bypass the gridlock through a reverse merger on the A-share market. AVCJ Research records a total of 10 cases last year and three more so far this year.

"Shell listings are subject to a different approval process from traditional IPOs," says Leo Lou, a Shanghai-based partner at law firm Fangda Partners. "There are two listings review committees within the CSRC - one for new shares issuance and the other for listed asset restructuring. A reverse merger goes through the asset restructuring committee and takes 6-12 months to complete. I can't see a proper IPO getting done in two years with so many applicants waiting."

It begs the question whether what is generally considered to be a non-reputable route to market will catch on as a shortcut for private equity exits. Reverse mergers don't come without risks, but in the current environment they might be deemed worth it.

The CSRC has already moved to stop the trend becoming a craze. In November, it stipulated that all reverse merger candidates must meet the requirements set down for full IPOs, arguing this would restrict speculation on poorly performing listed companies. The regulator also banned prospective candidates from acquiring listed shells on ChiNext.

Previously, companies targeting reverse mergers needed to have been in operation for at least three consecutive years of operation and posted cumulative net profit of more than RMB20 million over the past two years. An IPO requires three consecutive years of profitability.

At least three companies - Wuhu Shunrong Auto Parts, Zhejiang Hangzhou Xinfu Pharmaceutical, and Xinjiang Korla Pear - have seen their reverse merger applications rejected following the CSRC's review.

Invisible risks

These kinds of transactions often get aborted over suspicions of insider trading.

In the past relatives of management team members involved in deals have bought shares in listed shells prior to official announcements and then cashed out when the stocks subsequently jumped. These situations usually end with regulatory inspections, which can put paid tot the reverse merger as well.

There is also some skepticism about the availability of high-quality listed assets to serve as shells, especially now the regulator wants to encourage low-trading stocks to delist.

"Whether the target company is a ‘clean shell' or not matters," explains one Chinese investment banker. "Debt-ridden assets might not be easy to identify before the transaction is conducted. It happens when the listed shells aren't transparent enough to disclose their financial documents. This be a problem when the company later wants to raise money from the public."

Fees are expensive for reverse mergers in China can also be unacceptably high, anything from RMB10 million to RMB100 million. On top of compensating existing shareholders in the listed shell, candidates must purchase publicly-traded stocks based on the market price. For PE investors, the returns are inevitably lower than those from an IPO.

"Of course, the best scenario is when a private equity investor exits at a high price," says Frank Han, executive director of Bohai Industrial Investment Fund Management. "However, sometimes it's more important for PE investors to exit rather than sitting on the investment, regardless of a lower return. Backdoor listings are one of the exit routes. It will remain active."

Domestic reverse mergers are most common among renminbi-denominated fund managers. The process is simply too difficult and time-consuming for US dollar funds, which are treated as foreign investors.

Under Chinese law, a foreign investor is allowed to invest in A-share market through an asset swap - injecting their equity interest in a Chinese company into a listed entity in order to exchange it for public traded shares. However, as the equity is held onshore, the transaction must receive approval from the Ministry of Commerce (MofCom) and the CSRC.

Applicants must meet the requirements to be classified "foreign strategic investors" and then they must buy at least 10% of the total shares of the listed company and are subject to a 36-month locked-up on their holding after listing. The lock-up period is the same for renminbi fund mangers if they are controlling shareholders; if they are minority investors, it is just 12 months.

There have been cases of reverse mergers overseas. A recent high-profile example was CITIC Group, one of China's largest state-owned companies, announcing plans to list through an asset injection into Its Hong Kong unit, CITIC Pacific. As such the company no longer needs to go ahead with the $10 billion Hong Kong IPO that has been mooted for years.

Passing fad

However, CITIC is an exception to the rule, not a precursor to a wave of Hong Kong reverse mergers by PE-backed Chinese companies.

"High-quality shell companies in Hong Kong are even more expensive than in China," the investment banker says. "Financial requirements are equivalent to a public listing and reverse mergers are highly regulated by Hong Kong exchange. If a company is generating substantial profits, why wouldn't it do a new share issuance?"

A-share reverse mergers will inevitably drop off once the regulators manage to work through the IPO waiting list and the listing process becomes more predictable in terms of how long it takes. In January, the CSRC announced a registration-based system for IPOs to replace the current approval-based system - which is expected to improve transparency - although details of the plan have yet to be announced.

Furthermore, investors do have another liquidity option, the over-the-counter (OTC) market for trading shares in non-public companies. This bourse is intended for smaller companies that don't meet the criteria for a full IPO and so the requirements are lower than the main boards. There is also the possibility of transferring to the main board at some point in the future, regulations permitting.

"Reverse mergers will not become a prevalent trend for companies to list given the costs. Moreover, the CSRC chairman said his agency would release the draft documents on the new IPO system by the end of the year, which will make new shares issuance easier," Fangda's Lou says.

"But it will happen only if they make their words work. Otherwise, shell listings will be still active in the market in order to get quick access to liquidity."

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• Topics
• Buyouts
• Greater China
• Venture
• Regulation
• CSRC
• IPO
• buyout
• China
• Bohai Industrial Investment Fund Management