China forestry assets: A due diligence nightmare

Since the start of 2011, two of China's largest listed forestry companies have fielded accusations of fraud, the CEOs of the firms have departed and two high-profile foreign investors have suffered as a result.

The experiences of China Forestry and Sino-Forest emphasize the challenges of pre-deal due diligence and ongoing oversight in China, particularly when dealing with plantation assets - hard assets turned intangible by a web of government regulation, opaque processes and companies under pressure to expand.

Several industry participants tell AVCJ they have looked at and passed on opportunities to invest in forestry assets, although they admit it is a potentially lucrative area. For some, however, the potential didn't outweigh the risk. "We looked at a number of these deals as coinvestments, didn't feel comfortable about the cashless nature and stayed away from them," says Vincent Huang, a partner at Pantheon.

China Forestry received $55 million from Carlyle Asia Growth Partners III in two transactions from January 2008 and the fund held a 10.96% stake at the end of 2010. Partners Group invested $30 million alongside Carlyle and holds 5.4% of the company.

The auditor flagged up financial irregularities in January and the stock was suspended from trading. A probe by the Hong Kong Securities and Futures Commission led to a judge freezing HK$398.2 million ($51.2 million) in assets held by Li Han Chun, China Forestry's CEO. He was later detained by the Chinese authorities for the alleged embezzlement of RMB30 million ($4.7 million).

Explaining a fraud

An investigation by an independent board committee found that Li and his team had been using the sales proceeds from China Forestry's primary mainland subsidiary to buy forest assets from farmers and to cover operating expenses related to harvesting activities. They falsified all the records and bank documents in order to deceive the auditor.

"If you are having trouble acquiring land and the stock market is pushing for good performance, you have to do something to keep the price up," explains one industry participant. "They went to the farmers who own the land certificates and said, ‘You sell us the certificates and keep the timber.' Then they used the certificates as evidence of land purchases. It's so hard to validate."

This pressure to build up assets appears to be borne out by the numbers. China Forestry reported that its net assets rose from RMB1.4 billion to in 2007 to RMB7.4 billion in 2008 as net profit jumped sevenfold to RMB5.8 billion. A year later it listed in Hong Kong, raising $216 million. Net assets peaked at RMB9.6 billion in 2009 but Li's activities led to a RMB2 billion write down the following year as the company posted a RMB2.7 billion loss.

The situation isn't helped by a lack of clarity over land ownership. According to industry sources, several years ago China's forestry bureaus embarked wanted to raise funds and this resulted in land use rights being sold off relatively cheaply. This brief window of opportunity has distorted the forestry business model. At the same time, the process is opaque and there are inevitably reports of corruption and backhanders. There is no central land registry with details of who owns what.

In approaching individual farmers, Li and his team appear to have targeted another ownership class: Individuals who were awarded land use rights as part of a government privatization drive.

A China-based fund manager whose portfolio includes an unlisted forestry company, recalls looking at companies with holdings that amounted to nothing more than a collection of memoranda of understanding. "There is usually a guy with a military background who they say can get the land. Common sense should tell you it's not worth the risk. In one case, we sent in an operations guy from our own forestry company and he just threw up his hands and said the whole thing was a sham."

Not looking good

In this context, the prospects for Sino-Forest don't look promising. The company, which listed in Toronto in 1995 through a reverse takeover (RTO), has also aggressively built out its asset base. Total assets stood at $895 million in 2005. Three years later, the figure was $2.6 billion and by 2010 it had reached $5.7 billion. Net profit increased more than 70% over that two-year period to $395 million.

In June, short-seller research firm Muddy Waters went on the offensive, denouncing Sino-Forest as the "granddaddy of China RTO frauds." It issued a report accusing the company of routing funds off the books through a web of intermediaries in order to fabricate sales transactions. The report challenged Sino-Forest's claim that it had purchased $2.9 billion in standing timber under master agreements since 2006, saying asset purchases had been overstated by more than $800 million.

The company denied any wrongdoing and asked an independent committee to investigate. Towards the end of August, Sino-Forest's chairman and CEO resigned and three employees were suspended after the Ontario Securities Commission said the company may have misrepresented its revenue statements and exaggerated its timber holdings. It added that Sino-Forest "appears to have engaged in significant non-arm's-length transactions."

Paulson & Co. didn't wait around the denouement. Two months earlier, with Sino-Forest's stock down 80% since the publication of the Muddy Waters report, the US hedge fund exited its holding in the company, supposedly incurring a loss of more than $500 million.

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