First U.S.-Listed Chinese Firm Plans Switch to China; The curious case of a backdoor listing in Shanghai; Reverse A-share mergers

August 6, 2013, 7:56 AM

First U.S.-Listed Chinese Firm Plans Switch to China

A wave of Chinese companies have left the Nasdaq and NYSE in recent years, with their founders vowing to relist somewhere they’re more appreciated. Finally one company has announced plans to relist – but using the same reverse merger technique that got U.S. investors riled up when the same firms went to trade in the U.S. in the first place. China Security & Surveillance Technology, Inc., a Shenzhen-based firm that delisted from the NYSE in 2011, wants to list one of its subsidiaries, China Security & Fire, on the Shanghai stock exchange. According to a public filing, it plans to list part of itself via a sale to Shanghai Feilo Co.600654.SH -0.25% Ltd., a manufacturer of electronic parts for cars already trading on the Shanghai market.The owner of China Security, Chairman Tu Guoshen, will buy up shares of Shanghai Feilo, so that he would own 62.9% of the merged company, the filing said. Shanghai Feilo is also buying stock in China Security, allowing Mr. Tu to back his firm’s assets into the listed company.

If the reverse merger goes through, China Security would be the first example of a successful shift of Chinese assets once listed in the U.S. to a mainland China exchange. The potential relisting comes after U.S. investors started to turn against Chinese companies listed on U.S. exchanges in 2010. Dozens of the Chinese companies were accused by their auditors and short sellers of having lied to their investors and misrepresented the true extent of their businesses.

As stock prices plunged, the Chinese management of many firms raised funds from private equity investors and banks like China Development Bank to help buyout the U.S.-listed shares and take their companies private, with the intention of relisting after a few years in Hong Kong or mainland China, where presumably investors would better understand Chinese businesses and give them higher valuations.

China Security, which makes surveillance and safety equipment, was valued at $580.4 million when Mr. Tu bought it two years ago. Shanghai Feilo is paying 4.5 billion yuan ($730 million) in stock for China Security shares.

“The valuation [that China Security is getting from the buyer] is off the charts,” says Mark Tobin, founder of consultancy Tobin Tao & Company, which tracks Chinese companies listed on U.S. exchanges. The buyer is paying more than 41 times 2012 earnings for China Security’s subsidiaries, a huge jump from the 6 times trailing earnings that the chairman bought out China Security for, according to calculations by the firm.

The Chinese regulator still needs to sign off on the reverse merger, although the route should let China Security list its assets more quickly than through trying to go public as a new company. China’s government put initial public offerings on hold last October because it didn’t think investors could handle a flood of new shares amid weak market conditions, say analysts. The moratorium has resulted in a queue of nearly 750 companies waiting for IPO approval. Even if the regulator opens the door for new listings this year, companies may need to wait years before actually listing, say analysts.

Still, even if China Security manages to wrangle a listing, it might not be able to raise money. A reverse merger allows a company to obtain a stock market listing by taking over the shell of listed company that no longer has any operations, a process that is a lot less transparent than a traditional initial public offering. But unlike an IPO, the process doesn’t involve new fundraising, and usually companies will issue new shares soon after in order to tap fresh capital. In China that requires government approval, and regulators might be wary of encouraging such an explicit attempt to get around its IPO moratorium.

Also, the China Security deal differs a little from a traditional reverse merger in that Shanghai Feilo is not a shell company. In fact Shanghai Feilo’s revenue for 2012 was more than 2 billion yuan in sales, larger than the 1.16 billion yuan posted by China Security. Still, Shanghai Feilo says that after the merger it will not continue its automotive business, switching its operations entirely to security and surveillance, according to its public filing. The firm doesn’t explain why it will shed its core business, saying only that the acquisition will enhance its profitability.

A Shanghai Feilo representative could not be reached for comment. A spokesperson for China Security declined comment.

More re-listings of U.S. listed Chinese firms could follow suit, say lawyers and private equity investors that have been involved in the buyouts of such firms.

“The most favorable destination is the Hong Kong stock market because the firms wouldn’t have to unwind the complicated legal structures they set up in order to be allowed to list overseas,” says Joseph Chan, a lawyer at Sidley Austin. The reverse merger model is a possibility for some of these firms, although “the same level of skepticism with which U.S. investors viewed Chinese reverse merger companies there should apply to mainland investors,” he adds.

Such a model would also be challenging for firms operating in industries that the government restricts foreigners from investing in, such as internet and e-commerce, says Mr. Chan. Advertising firm Focus Media Holding Ltd., the largest Chinese firm listed in the U.S. to get bought out, used so-called variable interest entity contracts to open themselves up to foreign investment. Such contracts are complicated to unwind and some of Focus Media’s current owners, including foreign private equity firm Carlyle Group LP, would have difficulty buying shares of its business trading on China’s mainland stock market.

China Security was one of the first Chinese firms to list on the NYSE in 2007, also through a reverse merger. Mr. Tu has been the company’s chairman and chief executive since 2005, owning 20.9% of the company when it was trading in the U.S. before the buyout. He took the company private in 2011 with the help of a $500 million loan from China Development Bank.

Shanghai Felio is currently a state owned enterprise, with Chinese state-owned electronics manufacturer Inesa Electron Co. Ltd. controlling 17.8% as of the first quarter. After the merger, Inesa will own 6.6%.

The firm’s shares are up 53.1% since it announced the deal in June.

The curious case of a backdoor listing in Shanghai

Monday, August 5, 2013

Reverse A-share mergers

The term “sea turtle” has been applied to Chinese students returning to the motherland after years of studying abroad. This time the amphibious reptile coming home is a Chinese technology firm that was taken private off the New York Stock Exchange in 2011 for US$583.2 million.

A subsidiary of China Security & Surveillance Technology (CSST) has filed to list on the Shanghai Stock Exchange via a reverse merger, according to a Thursday note from consultancy Tobin Tao.

A reverse merger means the company will buy into a firm already listed in the mainland financial hub.

The company’s chief executive Tu Guoshen bought out CSST with backing from China Development Bank during the height of a wide-reaching fraud scandal that saw more than 150 Chinese firms struck from US exchanges.

CSST was one of only a handful of mainland companies listed in the US to attract private investment afterwhat came close to being a complete delisting of Chinese firms on New York exchanges. It’s also the first of these companies to relist – and in Shanghai of all places.

The security tech firm’s landing on the mainland should draw attention not just to turtles looking to come home, but to firms that are sneaking onto an exchange officially closed to newcomers.

To get onto a mainland exchange, the company has few other choices than to enter through the back door. The China Securities Regulatory Commission (CSRC) has suspended IPOs since last October, in the process directing a long list of Chinese companies into an IPO approval queue that numbered some 900 by May 2013.

The Shanghai Stock Exchange has been one of the world’s worst performing bourses during the past four years. Like Chinese companies in the US, a large number of its firms have been mired in accusations of misreporting their results and poor corporate governance. CSST’s decision to come back begs the question: Why Shanghai and not a better functioning bourse?

Actually, reverse mergers to circumvent the mainland’s IPO queue has become somewhat of a trend, especially for technology firms.

“[Reverse mergers] are popular nowadays,” said Heather Hsu, an A-shares analyst at Fortune CLSA Securities in Shanghai. “It makes perfect sense. We’ve seen a lot of technology A-shares trading at a huge premium compared to their peers in Hong Kong or the US.”

The CSI300, China’s main board, may look abysmal, but that can be misleading on the value of select China stocks, Hsu said. Investors should look at the country’s tech board, Shenzhen-based ChiNext, where stocks are trading at an average price-to-earnings ratio above 30.

CSST has certainly taken note of the P/E ratio at which China tech firms are trading. Take for example Zhejiang Dahua Technology, a security technology company based in Hangzhou. Shares on August 2 were trading at more than 50 times P/E.

The premiums sound good but oversight is still a major problem. The use of backdoor IPOs in the US allowed the shadiest of Chinese firms to sell in New York without proper oversight. Part of the CSRC’s intention in closing the market to new listings was to bolster regulation over firms seeking access to capital markets.

So far, there’s no clear indication that more of China’s US-listed firms that were privatized will follow suit with a mainland listing. However, if these sea turtles start washing up on shore, the use of reverse mergers for these companies, or any Chinese firms, should be met with some skepticism from investors.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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