Making Chinese Entrepreneurs Drive in Reverse
A dysfunctional financial system at home backs them into dodgy deals in America.
By JOSEPH STERNBERG
Wall Street Journal
JANUARY 27, 2011
As if China Inc. didn't already have enough problems in America—think safety scares, currency wars, investment protectionism and Sen. Chuck Schumer—now comes the Securities and Exchange Commission. Regulators are investigating allegations of accounting irregularities at several Chinese companies whose shares are traded in America thanks to so-called reverse mergers. Regulators and not a few reporters worry American investors may have been victims of frauds perpetrated by shady foreign firms.
Allow us to posit a different view: Despite the inevitable bad apples, many of the firms involved in this type of deal are as much sinned against as sinning.
In a reverse merger, the company doing the deal injects itself into a dormant shell company, of which the injected company's management then takes control. In the China context, the deal often works like this: China Widget transfers all its assets into California Tallow Candle Inc., a dormant company with a vestigial penny-stock listing left over from when it was a real firm. China Widget's management simultaneously takes over CTC, which is now in the business of making widgets in China. And thanks to that listing, China Widget also is now listed in America, without having gone through a traditional initial public offering.
It's an odd deal. The goal of a traditional IPO is to extract cash from the global capital market, perhaps to fund further business expansion or to allow the founder to cash out. A reverse merger, in contrast, requires the Chinese company to expend capital to execute what is effectively a purchase of the shell company. The company then hopes it can turn to the market for cash at some point in the future via secondary offerings.
Sometimes this happens quickly, especially if the company can do a private placement of shares with hedge funds or the like. Other times it may never happen, since these transactions frequently leave the company listed on over-the-counter markets where institutional investors like mutual funds fear to tread, with little analyst coverage to spur demand. Meanwhile the company owes hundreds of thousands of dollars, or more, in annual tax liabilities and regulatory compliance costs for what is now technically an American enterprise.
Yet despite its evident economic inefficiencies, the technique has grown popular in recent years. Hundreds of Chinese companies are now listed in the U.S. via this arrangement, with a combined market capitalization of tens of billions of dollars. Some of those may be flim-flammers looking to make a deceitful buck. But by all accounts, many more are legitimate companies. Why do they do it?
One relatively easy explanation is that the Chinese companies have been taken advantage of by unscrupulous foreign banks and lawyers. In China's still-new economy with immature domestic financial markets, it's entirely plausible that a large class of first-generation entrepreneurs are relatively naïve about the art of capital raising but see a listing—any listing—as a point of pride and a useful marketing tool. There may be an element of truth here, judging by the reports from some law firms that they now receive calls from Chinese companies desperate to extract themselves from reverse mergers. (The news for them is rarely good.)
More interesting, however, is the systemic backdrop against which reverse mergers play out. Chinese entrepreneurs face enormous hurdles securing capital. A string of record-breaking IPOs for the likes of Agricultural Bank of China, plus hundred-million-dollar deals for companies like Internet search giant Baidu, show that Beijing has figured out how to use stock markets at home and abroad to get capital to large state-owned or well-connected private-sector firms. The black market can deliver capital to the smallest businesses, albeit at exorbitant interest rates of as much as 200% on an annual basis.
The weakness is with mid-sized private-sector companies. Bank lending is out of reach since loan officers favor large, state-owned enterprises. IPOs involve a three-year application process with an uncertain outcome since regulators carefully control the supply of new shares to ensure a buoyant market. Private equity is gaining in popularity but is still relatively new, and the uncertain IPO process deters some investors who would prefer greater clarity about their exit strategy. In this climate, it's not necessarily a surprise that some impatient Chinese entrepreneurs view the reverse merger, for all its pitfalls, as a viable shortcut.
So although the SEC investigation is likely to attract ample attention to the U.S. investor-protection aspect of this story, that is the least consequential angle. Rules (even bad ones) are rules. But these shares are generally held by sophisticated hedge fund managers and penny-stock day traders who ought to know that what they do is a form of glorified gambling.
Rather, consider the striking reality that some 30-odd years after starting its transformation to a form of capitalism, China still has not figured out one of capitalism's most important features: the allocation of capital from those who have it to those who need it. As corporate savings pile up at inefficient state-owned enterprises, potentially successful private companies find themselves with few outlets to finance expansion. If Beijing can't solve that problem quickly, a controversy over some penny stocks will be the least of anyone's problems.
Mr. Sternberg edits the Business Asia column.
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