End of the line

“This is the Shanxi red sea apple. It only grows in this small area. It is the future of the beverage industry.”

It was 2008, and my first week on the job doing financial consulting for Chinese companies seeking foreign investors. I had been flown to Hohhot, the capital of Inner Mongolia, and then driven four hours through coal country to meet with a company on the Yellow River that grew crab apples, crushed them, added equal parts sugar, canned the stuff and marketed it as a branded health drink. It tasted as one would expect crab apple juice to taste. They wanted to do a reverse takeover (RTO).

For me, that taste of juice toasted the beginning of two years touring China, visiting factories churning out concrete, plastics, chemicals, shoes, agriculture, aquaculture, auto parts and pharmaceuticals. I met with managers at internet gaming companies, mines, telecom operators, discount card vendors, logistics operators, high stakes gambling organizers and even an operation that extracted protein from dead flies and put it into gel caps.

For lack of better options

All were interested in reverse mergers on the over-the-counter bulletin boards, with the aim of raising growth capital and eventually up-listing to NASDAQ. In the end, I worked with about a dozen companies that at some point or another executed a reverse merger.

 As anyone reading this issue probably knows, the words “reverse merger” are Wall Street poison these days. They weren’t always that way, but still the natural question to ask is why any Chinese entrepreneur in their right mind, after spending years building a multimillion-dollar asset, would decide to merge it with a failing company traded over the counter in the US?

The simple answer is that there really wasn’t a better option for most Chinese enterprises looking for a listing, and there is tremendous political pressure from the top down to increase not only foreign direct investment but also the net number of listed Chinese companies. Often the motivation for a foreign listing has more to do with increasing the standing of local politicians than it does with raising capital.

Let’s take a step back for some macroeconomic perspective: As emerging markets have outperformed over the past 10 years, there has been huge demand from investors for China exposure. Likewise, on the Chinese side, there are tens of thousands of companies with material earnings and breakneck growth histories that need capital to fund their expansion.

However, due to the regulatory environment, renminbi capital controls, lack of investment banking resources, and cultural and language hurdles, it can be very difficult to match the demand with supply.

Furthermore, domestic IPOs on the mainland are not an option for most companies; they are notoriously hard to come by and require years of waiting even if one has the relationships needed to get on the list. Investment banks get paid as a percentage of capital raised, so most of them aren’t interested in underwriting an IPO abroad or in China that is looking to raise less than US$80 million.

Left behind

That leaves a huge segment of the middle market with limited options for raising money. For example, the current poster child of the Chinese telecommunications equipment industry, Huawei, was once so short on funding channels it was forced to borrow from loan sharks in Hong Kong at exhorbitant rates to maintain growth.

And then there is the issue of exit for investors. There are dozens of hedge funds and institutional investors interested in small- and medium-sized companies in China. There’s lots of talk about how an IPO is only an option, not a requirement, but in fact most investors still require a structure in which they are comfortable investing. This is usually a tradable equity.

All of these factors came together around the turn of the century, when Chinese reverse mergers grew legs and took off. Entrepreneurs got their money and a listing, and institutional investors got China stock at deep discount in a US-listed equity that fit the bill of their investment charter. Everybody won. While it may seem odd from the outside, when I worked with a Chinese steel products manufacturer with nearly US$20 million in earnings that merged with a bulletin-board-quoted company whose principal business was the ownership of a few vending machines in New Jersey strip clubs, it was par for the course at the time.

After the boom years leading up to 2010, Chinese reverse mergers have imploded in a most spectacular fashion.  It seems that anybody with an internet connection can take a China stock down 20% by posting a negative article on seekingalpha.com from the comfort of their grandmother’s basement.

See ya, sucker

Should anyone be surprised? Not really: Reverse-merger stock promoters, “shell guys” and penny stock pushers are a notoriously shady lot. Most of them probably never dreamed of promoting companies that actually made money before the Chinese RTO phenomenon.

But this crew nevertheless managed to do plenty of damage to what were, in many cases, legitimate Chinese firms with real products, satisfied customers and no clue what they were getting into. Many  were “orphaned” by their backers, bankers and advisors after the transaction and didn’t have the resources or wherewithal to effectively prevent or defend against a short attack.

Other companies are indeed committing some degree of fraud and deserve to be exposed. To be sure, some of the fraud I’ve encountered in China has been stunning. I once met with a CEO in central China who illegally sold millions of dollars in private stock in a fake company to the local police pension fund and needed to get the company on the bulletin board before they found out.

As we’re seeing lately, some of this fraud has weaseled its way onto US exchanges. That said, most of the exchange-listed, reverse-merged China assets on the market have at some point filed registration statements, meaning that they have withstood the same amount of diligence and scrutiny from the Securities and Exchange Commission (SEC) that a full-fledged IPO would receive.

Small fry

In the grand scheme of things, Chinese reverse mergers a
re probably getting far more attention from regulators than they deserve. Your average private placement by these companies is usually around US$10 million, and is made by professional institutional investors who ostensibly know what they’re doing. Valuations are rock bottom (low single-digit price-to-earnings multiples) indicating that fraud risk is already priced into the deals.

Compare this to Renren.com, which just closed a traditional IPO offering of more than US$700 million at an astronomically bloated price-to-earnings multiple of 500.

The company is backed by brand-name venture capital and bulge-bracket investment bankers. Prior to the offering, the company revised the number of users claimed in its registration statement down by nearly 30%. That’s an astounding oversight for a supposedly top-shelf deal. The SEC, rather than investigating reverse-merger fraud, should be looking at how to treat China-based US-listed equities as a whole, addressing problems with disclosure and cross-border audit standards.

Short-sellers as well appear to be blatantly manipulating the market with impunity, deliberately issuing misleading “research” reports to destroy shareholder value for their own profit. They are not subject to regulatory scrutiny.

There’s no place like Shanxi

Taking an honest assessment, many Chinese companies should never gone public in the US to begin with. China has a business environment where tax evasion, bribery and obfuscation are often, but not always, the necessary evils of being competitive. Being listed in the US brings a set of responsibilities including timely financial reporting, investor communications, Sarbanes-Oxley and Foreign Corrupt Practices Act compliance, which many Chinese management teams are completely unprepared for.

These days, if you have a Chinese crab apple farm, it’s probably best to stay at home.