Sinned against or sinner?

Chinese companies are no strangers to bad press overseas, whether it is accusations of operating by government fiat or concerns about corporate governance. In September it was the turn of small- to mid-cap Chinese firms that have found their way on to Western stock exchanges via reverse mergers.
 
An article run by Barron’s uncompromisingly took the companies to task, painting a picture of rampant misreporting of financials. It went so far as to brand some operations sham companies set up for the purpose of duping Western investors. The authors implicated people at every level of the supply chain, from brokers and bankers to auditors and individual company chairmen.
 
Needless to say, the piece dropped like a bombshell on the private investment in public equity (PIPE) industry.
 
Such a scathing piece is sure to generate buzz, but it misses the mark. Powerful forces – the world’s fastest growing economy and the largest financial markets – have driven more than 350 Chinese companies to the US in search of capital, and have no doubt attracted scoundrels looking to make a fast buck. But China will continue to produce strong private companies, so investors shouldn’t write off this class of investment because of a sensational story.
 
To be fair, there is a degree of substance to the accusations. China’s exposure to capitalism is scarcely more than 30 years in the making, and the culture of private enterprise is still a work in progress here. The need for capital has, in some places, outpaced the community’s ability to produce an adequate supply of ethical businessmen with the experience and discipline to operate companies on a global stage.
 
I have visited more than one company whose "books" were little more than sporadic hand-written notes in dusty ledgers. With profits rising fast, management has been too busy meeting market demand to worry about acquiring "Western" accounting skills.
 
Deliberate offenders
 
In a small number of cases, lack of expertise has been confounded by intent to deceive. Many Chinese businessmen began their careers in an era when the state controlled all commercial activity (for two-thirds of the economy, it still does). Having made the transition from state employees to private entrepreneurs, they know how to hide profits from local tax collectors, but not how to properly produce financials for the international capital markets.
 
This creates ample opportunity for financial advisors – from East and West – to fabricate financials meant to appeal to Western investors, but that are not representative of the truth.
 
Because China’s financial markets are as nascent as the country’s exposure to capitalism, the community of local financial service providers has similar characteristics. It is not difficult for a company to find "cooperative" local auditors. The chairman of one company with whom we were negotiating a term sheet wanted the right to choose another auditor if he was not satisfied with the results of the first audit (being done by a US, GAAP-qualified auditor).
 
Objectivity required
 
It is easy, therefore, to paint Chinese involvement with a broad brush, covering scandalous cases in detail and neglecting to mention that these are the exception, not the norm.
 
In fact, there have been some great success stories that have come out of China via the reverse merger model. Take Henan Zhongpin (HOGS.NASDAQ) for example, which debuted on the over-the-counter (OTC) bulletin board in February 2006 at about US$5 per share. Its reverse merger was accompanied with a US$27 million PIPE, which was followed by another US$50 million before upgrading to NASDAQ. Zhongpin performed well through the financial crisis and, at time of writing, was trading at US$20.70. Not a bad return for the original PIPE investors, or those that followed.
 
Focusing on some of the more prominent failures also involves selective sampling of representative brokers and portfolios. For every miscreant there is at least one group like Tri Point – or, for that matter, my own employer, SRG – which has realized very good returns over a sustained period (more than five years) investing in Chinese firms.
 
Another shortcoming of the Barron’s article is that it lumped together OTC and main board companies, which doesn’t allow for fair comparison (between companies or against indexes).
 
Many in the Chinese financial community will be quick to point out that the underhanded practices present in US markets were certainly not invented in China. In some cases, the Chinese company has been the victim. Many have been lured West by brokers with promises of capital investment, only to be left high and dry after completing a reverse merger. The broker sells his commission shares into the market and disappears, leaving the Chinese company to languish with no capital to grow.
 
There is no denying that China’s private sector, and more specifically the community of financial service providers that support private industry in the country, are far from mature. While many Western investors are eager to jump into the world’s fastest-growing economy, I wonder how well they really understand the dynamics of its evolution. In any case, as long as China’s economy continues its blistering growth, and as long as local capital markets remain out of reach of most companies, foreign investors will find investment opportunities in Chinese companies looking to list overseas.
 
But just like any other situation, investors should do their homework and look beyond the brokers’ marketing materials.