It’s hard being a China short seller

It’s a big, big China leveraged buyout — the biggest ever, in fact. Advertising company Focus Media, which is listed in the US, said it has received a $3.5bn takeover offer from its chief executive who is backed by a number of private equity groups, including Carlyle.

It’s gained attention in part because the offer (in the form of a non-binding proposal letter) of $27 per share is higher than the level the shares closed on the last day before the short seller Muddy Waters published the first of several reports criticising the company.

Muddy Waters, of course, had a big success with its trades and publications against the now-virtually-defunct Sino-Forest Corp, which it accused of fraud over its forestry assets and sales. Muddy published their first note on Focus Media on November 21, with the the Sino-Forest story still ringing in investors’ ears. So, while the Focus Media attack knocked almost 40 per cent off the share price at the time, most of that had been regained by February, by which time various finance types were quoted as saying Muddy Waters’ claims lacked a smoking gun element, weren’t really new, were disproved by independent surveys and so on. Here’s Bloomberg on the matter:

Market surveys conducted by Ipsos SA, a Paris-based polling company, and its unit Synovate in more than 100 cities showed that the number of LCD screens and poster frames reported by the Chinese company was more than 99 percent accurate, Focus Media said. While some of the company’s acquisitions haven’t been successful, assertions of fraud are “without foundation,” Focus Media said on Nov. 22.

Focus Media is “a legitimate business” and Block failed to provide new information on its acquisitions because the deals are publicly disclosed, said David Semple, director of international equity at the Van Eck Emerging Markets Fund in New York, which oversees $35 billion, including Focus Media shares.

“You are looking at the stuff in the past and people knew about it,” said Semple. “Why bring it up now? They didn’t even bother to check with the company to find it out.”

Now, it’s not like all US-listed Chinese stocks (particularly reverse takeovers) are now considered in aggregate to be perfectly standard investments. John Hempton of Bronte Capital, who has shorted the odd Chinese company himself, wrote about this in his widely read post on the “Chinese kleptocracy” last month, which confirmed that accusations of incidents of fraud had only lead to restrictions on accessing company filings.  Meanwhile, the Chinese Development Bank has been helping some US-listed Chinese companies to delist.

In fact, Muddy Waters might now be suffering from its own earlier success: one of the criticisms noted in the Bloomberg report quoted above is that the Sino-Forest debacle had dampened the shares of all Chinese and HK companies listed in the US, meaning there was less low-hanging fruit to be gained:

Ironfire’s Jackson says Block has helped weed out questionable Chinese companies listed in North America and tempered overly bullish investor sentiment. The chances of a repeat are limited because share prices are already depressed and the bigger companies have more resources to fight back, Jackson said.

What’s interesting about the Focus Media offer news is that it’s boosted some of the other China stocks that have been the subject of fraud allegations too:

Universal Travel Group (UTRA), whose financial statements and business model werequestioned by Glaucus Research Group last year, climbed 47 percent to $1, advancing 85 percent in 3 days. Duoyuan Global Water Inc. (DGWIY), rated a “strong sell” by Muddy Waterswhen it initiated coverage in April last year, rallied 11 percent to 30 cents.

What’s also interesting is that the exit strategy for private equity buying into Chinese companies relies on a little optimism. As the FT’s Henny Sender reports:

The challenge facing private equity firms taking Chinese companies private is how they eventually get their money back. Many have listed in the US in the first place because they have had trouble securing approvals for listings in China.

Securities regulators in China have vowed to make it easier for privately controlled companies to list on Chinese exchanges. So far, that shift has not been evident and most listings have involved state-owned enterprises. Hong Kong investors also have not been receptive to buying shares in privately controlled Chinese tech companies.

Then again, Carlyle apparently had (or has) a stake in China Agritech, which was the subject of criticism from Bronte Capital’s Hempton last year. And Carlyle in April was still confident that its 10.5 per cent stake in China Forestry Holdings was doing fine despite an independent audit stating that most of the company’s revenues between 2006 and 2009 weren’t verifiable.  So presumably it takes more than a bit of regulatory uncertainty and short-seller accusations to put them off.

And their partners on the offer can probably also provide some reassurance. From the FT again:

Other members of the group bidding for Focus include Fountainvest, a fund established by Frank Tang, formerly of Goldman Sachs, and Temasek, the Singapore government investment arm; Citic Capital, a Hong Kong-based investment fund that is part of Citic, the Chinese government-controlled financial group; CDH, a Beijing-based investment firm; and a unit of China’s Everbright financial conglomerate.

Related links:
The joys of auditing a China short target – FT Alphaville
Muddy Waters loses support in latest market calls – Bloomberg (February 2012)
West China Says Business Healthy After Short-Seller Note – Bloomberg