Sunday, January 16, 2011

Avoiding Problems: How to identify quality China based companies listed on the U.S. Stock Exchanges

Article from NY Global Group

Some highlights:

Cultural Understanding is Critical to Successful Investing:

Peter Siris, a New York based Chinese-English bilingual money manager at Guerilla Capital who has invested in many U.S. listed China based companies, is perhaps one of the few people on Wall Street that have a good understanding of how to invest in small cap growth Chinese companies. He has put it very well in one of his media interviews:

"Most people who own these China stocks don't go to China, they don't know these companies, and they don't speak the language. And so they can be suckered in both long and short."

Due Diligence Process May Have Uncovered Some Problems Early On:

Some investors prefer public companies that have gone public through IPOs. But the reality is that it makes no difference whether the company went public through an IPO or a reverse merger – they go through the exact same level of SEC reviews when a financing related registration statement SEC Form S-1 is submitted to the SEC.

Problematic Chinese companies represent a very small percentage of all China based, U.S. listed companies. The majority of China based, U.S. stock exchange listed companies are compelling opportunities for investors to tap into the growth of China.

Structural changes however, should be made so that the investing public in the U.S. gets as much protection by investing in China names as they invest in U.S. companies. The following are some observations:

China Based Companies with VIE Structures Are the Single Biggest “Time Bombs” in the U.S. Markets:

In a VIE structure, the public shareholders do not own the underlying assets in the operating entity – the actual business that generates revenues and earnings for common shareholders. Instead, all of the sales and incomes reported by the public company and filed with the SEC are booked through contractual agreements whereby a company’s management and founders agree to transfer their rights to sales and incomes from the operating business to the public company. The original founders retain the ownerships of the underlying tangible hard assets such as cash, factories, land use rights, machinery, customers etc. In theory and in reality, company management and founders can choose to walk away and leave the public shareholders with no legal claims to the assets of an operating entity. Doesn’t this sound crazy? It certainly does.

RINO was a good example of a VIE structure. RINO’s market capitalization was at one time approaching $1 billion. Shareholders that bought shares in RINO apparently did not realize the inherent risks involved since they perhaps did not bother to read the company’s SEC filings which disclosed risks associated with a VIE deal structure.

A public company in the U.S. with a VIE structure poses the single biggest risk to U.S. investors. Alarmingly, companies with the VIE structure represent more than 20% of the entire universe of China based, U.S. listed companies listed on U.S. stock exchanges, including almost all of the high flying internet stocks. The vast majority of them have become public companies in the U.S. through IPOS.

In contrast, China’s own domestic stock exchanges do NOT permit listing of any company whose revenues are organized under a VIE structure. The VIE structure was created by global law firms in the early 2000s to intentionally circumvent legal requirements in China that prohibit foreigners from owning shares in China based internet companies. That law is still applicable in China today. However, the “creative” VIE structure has become a main stream listing process for China based companies – with almost all of them listed through IPOs in the U.S. markets. What do shareholders own by buying shares of a company organized under a VIE structure? Legal professionals may argue that shareholders get sufficient protection through those management contracts. The reality is, in today’s China, a VIE structure is nothing but a piece of paper evidencing certain “right” that is next to impossible to enforce under Chinese laws.

Companies with “Earnings Make Good Provisions” Pose Significant Risks to

The typical audience of early investors in U.S. listed China based companies are small hedge funds, those with less than $100 million under management and are never long term holders. The vast majority of them are unwilling to or are unable to perform much due diligence on the target companies in China. A popular mechanism that caters to these types of investors is created, by Wall Street bankers and lawyers and is given the fancy name of “earnings make good provisions.” In this approach, investors demand a company CEO make personal guarantees as well as on behalf of his company that certain minimum net income targets must be met by the company, typically for 3 years in a row from the date of the investment. If the company misses its earnings targets in a particular year, the CEO could lose the majority control of his company to the investors to “make good” on those earnings promises. This financing mechanism is worse than a weather forecast. Unless one can predict weather conditions precisely on a specific date, three years in a row, one may lose control of his company. Such mechanism not only stimulates management fraudulent behavior but also limits the investing public’s upside – earlier investors often sell short against their positions. This is one of the main reasons why many China based, U.S. listed high growth small cap companies trade at single digit current year multiples and are highly vulnerable to short seller attacks – they fight the short sellers on a daily basis as a result of their previously entered “earnings make good provisions” related financings. A lot of Chinese company CEOs complain about these “poison terms”, often sold to them by small investment banks. The willingness to do “all things possible” to achieve those earnings targets - a high risk endeavor for both the companies and the investing public.

Investors can follow some own criteria before investing in US-listed stocks:

“NYGG 10 Commandments” which they strictly follow during their client acceptance process:

1. Leader: A market leader in a high growth industry in a favorable market environment

2. Operator: • Managed by Company founders and industry experts, not capital markets personnel

• Founders/management must own majority of the Company

3. Profitable: • Minimum US$2 million in recent year net income (U.S. or International GAAP audited)

• Net income margins of at least 15%. Strong balance sheet, no long-term debt

4. Growth: • Minimum year over year growth of 50% in net income in the last two years

• Anticipate minimum YOY growth of 50% in net income in the next two years without

requiring significant additional investment capital

5. Ownership: Company must own 100% of the underlying business and related assets

(REJECT revenue recognition through VIE structure or “management contracts”)

6. Quality: Must exceed listing standards for the NASDAQ, NYSE or other stock exchanges

7. Commitment: • All Company insiders must sign share lock-up agreements

• Restrict personal share sales to the general public for minimum 3 years from the date of

Company’s initial listing on a stock exchange

8. Governance: • Strong corporate governance, strict compliance with all laws and regulations

• Quality legal representation and quality independent audit firm audits

9. Proactive: • Management team must have strong English communications skills

• Regular participation in deal or non-deal road shows through quality investment banks

10. Clean: Simple capital structure - no “poison” financings or “earnings make good” provisions

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