Chinese Deja Vu – Chinese Based Companies Look Again to U.S. Capital MarketsChina Practice, Financing
This article was first published in the Winter/Spring 2017 edition of the MicroCap Review. It is being republished here with the permission of the editor. The original article can be viewed here.
According to Law 360, by late 2011 over 150 Chinese companies had gone public in the U.S. through reverse merger transactions with public shell companies. U.S. hedge funds, family offices and other investors were clamoring to buy securities of these companies in private placement, or PIPE, transactions that closed simultaneously with the closing of the reverse merger. Many of these hedge funds and family offices enjoyed significant returns on their investments while others who came to the party later did not do so well. In 2010 short sellers began putting out short reports on some of the China based public companies. These short sellers would first sell the company’s stock short and then issue an investigative report that identified various irregularities from fraud to undisclosed related party transactions. As the stock of many China based companies began to tank the short sellers would reap significant rewards. As a result of these short reports, announced audit committee investigations and SEC enforcement actions involving China based public companies, investors lost interest and many of the companies that remained listed on an exchange in the U.S. or quoted on the over-the-counter market began to go private or go dark.
From 2011 until today it remains very difficult for China based public companies to raise capital in the U.S. from U.S. investors. Only the biggest China based companies like Alibaba ($25 billion) or ZTO Express ($1.4 billion) are able to raise any significant amount of capital from U.S. investors. Even though the U.S. capital markets seem closed to China based companies, it seems that these companies have continued to go public in the U.S., however, they are now doing so through the front door in the form of a traditional IPO instead of the back door through a reverse merger with a public shell company. In 2014 and 2015, more than 20 China based companies listed in the U.S. through IPOs and they raised a total of approximately $29.5 billion. This year there have been six Chinese companies that either completed or are in the process of completing IPOs in the U.S., raising a total of approximately $2 billion. Unlike during the reverse merger heyday, where most companies were in the manufacturing sector, these companies are mainly operating in thee-commerce, TMT (technology, media, and telecom) and logistics industries.
Chinese technology companies in particular are interested in listing in the U.S. as the U.S. markets represent not only a securities market but a potentially significant commercial market. More and more Chinese intellectual property is being exported to the U.S. Of note is the fact that the Shenzhen market only recently opened up to Hong Kong investors (and by extension U.S. investors with accounts at Hong Kong investment banks) on December 5, 2016. Hong Kong investors are now able to trade the securities listed on the tech heavy Shenzhen Stock Exchange through an equity trading link between the mainland and Hong Kong. It will be interesting to watch the level of demand for Shenzhen traded securities and see if that demand correlates with demand for China based companies listing in the U.S.
WHO IS INVESTING IN THESE IPOs?
For the most part, it appears that the Chinese companies are bringing the investors with them from China. Most of the investors in these IPOs, in particular the smaller IPOs, are Chinese funds, banks and individuals. Even though the money is coming from China, these Chinese companies prefer listing in the U.S. because of the prestige associated with a U.S. listing and the ability to raise capital in the U.S. markets is secondary. Another reason that these companies are listing in the U.S.is that the timeline associated with a U.S. listing is significantly shorter than that for listing on the Shanghai or Shenzhen stock exchanges or even listing in Hong Kong and the costs associated with a U.S. listing are similarly less than a local listing. The approval-based IPO system in China has built up a queue of more than 800 companies that are currently waiting for approvals, which could take years for the China Securities Regulatory Commission to review. In contrast, it takes about four months to list in Hong Kong where as a U. S. listing can be done in as little as three months. In addition, it is generally believed that there is no significant difference in terms of associated fees for Chinese companies to list in China, Hong Kong or U.S. So, it seems that even though the U.S. capital markets may be closed for Chinese companies at the present time, cost, efficiency and prestige make it worthwhile to list in the U.S. For instance, according to the chief financial officer of Yintech Investment Holdings Limited, a large Chinese commodities brokerage that raised$101 million through an IPO in U.S. in April 2016, the company chose listing in the U.S. because of China’s huge backlog of IPO applications. “The purpose of the IPO is to further enhance our corporate brand and credibility.”1
SHOULD U.S. INVESTORS RECONSIDER MAKING INVESTMENTS IN CHINESE COMPANIES?
In the reverse merger days, Chinese companies were able to go public without the scrutiny of an underwriter or a national securities exchange and the SEC review only occurred after the company closed its reverse merger and PIPE financing in connection with the review of the company’s super 8-K or resale registration statement. Given that the new generation of Chinese companies are subjecting themselves to added under-writer, SEC and exchange vetting prior to the sale of securities, perhaps U.S. investors should take another look. Another helpful factor is that most of the money is coming from China and the Chinese investors are better able to do their own due diligence on Chinese companies than U.S. investors and in a significantly better position to enforce remedies. Given the common language and location, these Chinese investors may be able to identify red flags that U.S. investors cannot and if a problem does arise, these Chinese investors can take swift action in Chinese courts and do not need to rely only on U.S. courts. According to Eddie Wong a partner of top 40 accounting firm Friedman LLP and a leader of Friedman’s China practice, “As the Chinese public companies become more mature and sophisticated, unlike those that went public in the reverse merger days, they are becoming higher quality issuers. They are aware of their obligations to the U.S. regulators, investors and auditors, and are more concerned with transparency than ever before.
“In addition to the upfront vetting that Chinese companies are subject to in an IPO as compared to a reverse merger, underwriters like ViewTrade Securities, which has underwritten several Chinese IPOs and has significant connections throughout Asia, are using structural mechanisms to help protect investors. For example, in ViewTrade’s recent China Customer Service IPO offering, it required the Chinese company to keep $500,000 in an escrow account for 24 months as an indemnification fund to be used if shareholder or other litigation arises as a result of the offering and the issuer does not honor the indemnification clause in the underwriting agreement. According to Doug Aguililla, Director of Investment Banking at View Trade, “We believe that this mechanism serves to increase market integrity and investor confidence.” These structural mechanisms are another reason for investors to reconsider making investments in Chinese public companies.
The jury is out on whether investors should reconsider investments in Chinese companies. A wait and see approach may be most prudent. However, given the potential for significant returns, U.S. investor may want to begin testing the waters with this new breed of Chinese issuer.
By Louis A. Bevilacqua, Esq. and Kevin (Qixiang) Sun, Esq.