My fellow Fool Rich Smith was fired up about the announcement from Yongye International (Nasdaq: YONG ) earlier this week, as were investors -- they sent shares soaring 42% on Tuesday.
As I covered in brief, the ecstatic reaction was due to the dual announcements of Morgan Stanley's (NYSE: MS ) Asia private-equity unit investing $50 million in the company and the company's CEO, Zishen Wu, pledging to buy up to $3 million in stock on the open market.
Given that Chinese reverse-merger stocks have been a very polarizing topic, I fully understand that by trying to take a sober look at the situation at Yongye it's very likely that I'll be simultaneously labeled a short by the longs and a dupe by the shorts. But try I must.
If the news could be summed up in a word, it's "credibility."
For those who haven't followed closely, the world of Chinese small caps has been rocked by fraud accusations, spanning from collapses of stocks like RINO International and China MediaExpress, to the ongoing trading halts at Wonder Auto Technology (Nasdaq: WATG ) , China Integrated Energy (Nasdaq: CBEH ) , and Shengdatech (Nasdaq: SDTH ) , and, of course, the ground-shaking fraud at not-so-small-cap Longtop Financial (NYSE: LFT ) .
Investors have been hoping for some sign they could trust that -- unlike the companies above and in spite of short-seller reports attacking the company -- the numbers and the business at Yongye are sound and reliable. Tuesday's news demonstrates that not only is a major, global financial firm willing to put its money into Yongye, but the CEO is putting his own personal money where his mouth is.
And to be sure, Morgan Stanley's Asia P/E arm is no piker that's throwing around money from afar. Its team has invested $1.8 billion in Asia investments over the past 15 years. Homer Sun, who is set to join Yongye's board, is a managing director and part of MS' China Management Committee, which is described as "the firm's senior business leaders within China." He already sits on the board of multiple other Chinese companies. To hear Sun say that MS has performed "extensive due diligence" should carry some serious weight with investors.
Yongye is also giving Sun significant power in the form of veto power that would allow him to block a variety of moves from related party transactions exceeding $100,000 to major acquisitions and asset sales.
There isn't a whole lot that is directly bad from these announcements, but we shouldn't overlook the fact that Morgan Stanley's investment isn't on the level with every other average Joe's investment. The preferred shares put MS above common shareholders and even though the dividends are being paid in the form of shares, that's still a return that holders of the common aren't getting (not to mention a dilutive cost to them).
Additionally, the initial conversion price of $8.80 has been highlighted as significant since it's well above today's $5 and change, but it's also notable that the initial liquidation preference on the preferred is also $8.80. That means that if anything goes wrong and it comes down to divvying up Yongye's assets, each preferred share needs to be paid out $8.80 before anything trickles down to the common.
Finally, the power that MS has been granted on the board cuts both ways. While the bright side is that MS can block potentially harmful actions, it can also block actions that might be great for holders of common shares, but not ideal for MS' preferred investment. They can, for instance, block both dividends and share buybacks.
The yet unknown
There have been a heck of a lot of surprises when it comes to fraud at Chinese companies. Major auditing firms have been fooled, global investment banks have vouched in IPOs, and supposedly savvy investors have been taken for a ride. The alleged fraud at Longtop has been particularly jaw-dropping as there were apparently bank tellers in on the grift and lying to auditors. So it's not a complete stretch to think that Morgan Stanley could be getting played here.
That said, to me at least, the fraud case against Yongye has been pretty weak as compared to the cases against many of the other companies. Many of the supposed fraud red flags that have been cited -- the coal mine purchase and the customer list acquisition for instance -- could just as easily be poor business or capital allocation decisions as evidence of fraud. Just because MS has determined that management isn't siphoning money out of the company doesn't mean that it isn't making poor decisions with shareholder money.
On a related note, the company reported nearly $45 million in cash on the books at the end of the first quarter and is also starting to show meaningful cash flow from operations. The $50 million from MS will give the company a very significant amount of dry powder and the ability to quickly squander shareholder value through large, overly ambitious expansion plans or acquisitions. MS will have a check on this through its veto power, but as noted above, its incentives aren't perfectly tied to common shareholders.
Follow along to China
I recently said I was throwing in the towel on going either way on Chinese small caps. Admittedly, my timing was pretty impeccable (sarcasm intended) with regard to the announcement from Yongye, but it doesn't change my overall view of the group -- shenanigans have been so widespread and nasty and individual investors are generally at such a large informational disadvantage that investing in these companies seems pretty Sisyphean.
However, there are ways to get around that informational disadvantage, and one is to travel to China and do some of your own on-the-ground due diligence. And if that's outside of your scope, you can also find a trusted source that'll do that on your behalf. Two of my fellow Fools from Motley Fool Global Gains are about to do just that -- head to China and do some first-hand tire-kicking. You can sign up to get free dispatches from their trip and keep up with what they uncover.