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Can Private Equity Save Chinese Stocks?

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It's been a fascinating and volatile time to be investing in Chinese stocks for the past 24 months, but last week showed definitively the challenges and opportunities in the sector. On the challenges side, there was the now well-known story of Longtop Financial (NYSE: LFT  ) , a Chinese financial software company that was once valued at more than $2 billion and owned by several high-profile investors. It said that its Big Four auditor, Deloitte, and its CFO were both resigning and that the Securities and Exchange Commission was beginning a probe into the company's accounting. This revelation comes after several short-sellers publicly called the company's numbers into question -- and were right.

Longtop is likely headed for delisting, a plight that has befallen several other Chinese companies that were revealed as alleged frauds thanks to sound short-side research.

It's not all bad
On the flip side, there was the announcement from China Fire & Security (Nasdaq: CFSG  ) that it would be acquired by Bain Capital Partners, a reputable firm no doubt, for $9 per share -- a better than 20% premium to where the stock had been trading. Yet our Global Gains team knows a thing or two about China Fire, having recommended the stock at $7 in June 2009 after it was publicly shorted by Mark Cuban's Sharesleuth website. We later sold for $14.50.

In its history as a listed company, China Fire ran from $3 to $16 back to $3 to $18 back to $5 and is now being acquired for $9. That wild ride reflects the massive changes in investor sentiment that have moved Chinese stocks for the past few years.

And this week we had the case of Yongye International (Nasdaq: YONG  ) , an active Global Gains pick that was down more than 50% of the year due to allegations of impropriety, but that was up almost 50% on Tuesday after Morgan Stanley Private Equity Asia announced it would be investing $50 million in the company via preferred shares. Apparently, the investing world trusts Morgan Stanley to do good research.

A new golden age?
But China Fire and Yongye aren't the only Chinese stocks beaten down by investor fears of weak corporate government and numbers that can't be trusted. In fact, there are more than 100 Chinese companies listed on the U.S. exchanges trading for less than 10 times earnings. Should we be placing small bets on all of them and hoping private equity rides to the rescue of at least some of them?

The answer to that question is clearly "no." Deals like Bain's buyout of China Fire and Morgan Stanley's investment in Yongye will be the exception, not the rule. First and foremost, that's because there are a lot of things wrong with U.S.-listed Chinese companies that would make it impossible for major private equity firms to ever get comfortable with them. Furthermore, as The Wall Street Journal recently reported, private equity firms seem to be more interested in divesting stakes in Chinese companies at this point -- likely because of macroeconomic fears -- rather than acquiring them. Finally, these deals aren't all created equal, and I suspect the track record for closing them will ultimately become as suspicious as the numbers of many of the companies themselves.

Deals gone wrong ... maybe
Consider China Security & Surveillance (NYSE: CSR  ) . The company has been hinting to investors about a buyout or dual-listing in Hong Kong since before this time last year, and first announced a "going private" proposal back in January. That process has dragged on for months and despite an apparent offer on the table to take the company private at $6.50 per share, the stock currently trades for $4.90. That's a massive arbitrage opportunity, but the market is skeptical that anything ever gets done.

That's also the case at Puda Coal (NYSE: PUDA  ) , where the chairman apparently thinks he will take the company private for $12 per share once he just lines up some external financing (the stock is currently at $6), and Harbin Electric (Nasdaq: HRBN  ) , where the chairman's plan to take the company private last October at $24 also lacks money behind it. Obviously, with no financing, there is no plan.

Similarly, John Hempton of Bronte Capital has raised some interesting questions about China Fire's business and what Bain actually sees in the company. His observations, particularly concerning the company's generous financing terms to customers, are acute, and what prompted us to sell the stock way back at $14 as the difference between the company's earnings and cash flows continued to rise. We suspected that one of the reasons China Fire was getting so much business from state-owned companies in China was because of the company's connections. But back in January 2009, the company lost a key government contact when Mr. Guo Tienan, brother of former board member Ms. Guo Tieying, went from being the head of China's Fire Security Bureau to head of Border Control Management. The company's founder also recently passed away. In a country where guangxi, or connections, are vital to business, this can't be good for the company.

Does Bain know all of this? Perhaps not. The deal is not expected to close until November, suggesting that Bain may still have some due diligence to perform. Morgan Stanley's investment in Yongye, on the other hand, is to be consummated on June 10, suggesting that this may be one of the few cases where private equity really will save the day.

Tim Hanson is co-advisor of Motley Fool Global Gains. He owns shares of Yongye International. The Fool owns shares of Yongye International. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (6) | Recommend This Article (10)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 02, 2011, at 1:03 PM, anopenmind wrote:

    "The Wall Street Journal recently reported, private equity firms seem to be more interested in divesting stakes in Chinese companies at this point -- likely because of macroeconomic fears -- rather than acquiring them.".....

    June 2 WSJ page C14 "Private-Equity Bulls in China Swap"....."Could accounting shenanigans prove a godsend for private equity? Some China-focused funds seem to think so.....private-equity funds see value emerging....A few rotten apples, even a lot of rotten apples, don't mean every Chinese small-cap firm listed in the U.S. is worthless."

  • Report this Comment On June 02, 2011, at 1:25 PM, ElCid16 wrote:

    CBPO is currently in the portfolio of IDG Ventures - China. It has fallen from $16 to $11.50 in a matter of 2 days. Someone exchanged 240K shares late on Monday, though. I'm not sure what the possibility is that those were the shares IDG were currently holding. Kudos to ETFsRule for bringing IDG to the CAPS Blog.

  • Report this Comment On June 03, 2011, at 10:10 PM, WayneGorsek wrote:

    Anyone buying Chinese stocks or investing in operations in China will have a rude awakening one day when they wake up and find the communist Chinese government has nationalized their company or assets. China is pure evil, they support our enemies and they are an enemy and a clear and present danger to the USA. We have lost eight million manufacturing jobs because of our Govt (city, county, state and federal) taxing, regulating, fees and fines on USA based companies and most have went to China. Also I have witnessed first hand how China will lower prices to well below cost to put the competition out of business and than later raise the prices to double what they cost before the Chinese entered the market and our inept USA govt does nothing about it.

    Wayne Gorsek

  • Report this Comment On June 03, 2011, at 10:26 PM, ETFsRule wrote:

    ElCid16: Thanks! You just reminded me, I need to make one more post in that blog about IDG.

  • Report this Comment On June 08, 2011, at 4:28 PM, MegaEurope wrote:

    "His observations, particularly concerning the company's generous financing terms to customers, are acute..."

    You mean astute.

  • Report this Comment On February 05, 2012, at 1:49 AM, jennytabassum wrote:

    You are posting a business improvement article. It's most important for any businessman.


    Jenny Tabassum

    <a href=>

    "Private equity Bahamas"</a>

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