As a well recognized market leader in China and on Wall Street in the China related middle market advisory space, our firm New York Global Group has been advising China based corporate clients with their strategic growth in the last 17 years. The foundation of our business success lies in our ability to truly understand China and China related transactions in the same cultural environment as Chinese CEOs do.
Despite a large deal flow, less than 2% of all China based companies reviewed by NYGG have passed the firm’s rigorous client acceptance process. NYGG’s local presence in China provides the firm with the latest intelligence on Chinese companies on an ongoing basis.
The fundamentals of a business and more importantly, the integrity of a management team determine its stock performance over the long run. Can lawyers and accountants give investors assessment on the integrity of a company’s management team? The answer is No. That’s part of what NYGG does – we bring to our clients the “human due diligence” in addition to extensive accounting and legal reviews on projects which we support.
Cultural Understanding is Critical to Successful Investing:
NYGG staff meets with several hundred Chinese companies each year across many sectors. Through these meetings, we often gain insightful knowledge in many industries by speaking directly to Chinese CEOs and other leaders. We speak to them in the same Chinese language and we truly understand them since we share the same Chinese culture. Therefore, we believe New York Global Group (NYGG) has the ability to read into the “minds and hearts” of a Chinese CEO and conduct “human” due diligence – far more real and extensive than any desktop accounting or legal reviews. It is all about getting to know the people involved.
Peter Siris, a New York based Chinese-English bilingual money manager at Guerilla Capital who has invested in many U.S. listed China based companies, is perhaps one of the few people on Wall Street that have a good understanding of how to invest in small cap growth Chinese companies. He has put it very well in one of his media interviews: “Most people who own these China stocks don’t go to China, they don’t know thesecompanies, and they don’t speak the language. And so they can be suckered in both long and short.”
NYGG’s Due Diligence Process May Have Uncovered Some Problems Early On:
Significant cultural advantages help NYGG and our clients avoid pitfalls as well as identify undiscovered opportunities in the China investment space. The following are a few examples of some of the recent cases that have confirmed our due diligence results:
Case #1: We suspected China Energy Savings Corporation (“CESV”) could be a problem as early as in 2005. At the request of a multi-billion dollar investment fund – a potential investor in CESV, we conducted a due diligence assignment on this company. Our mandate from the institutional investor was simple: take a final look before he invested. “Our due diligence is 99% done and our legal reviews were conducted by a large global law firm…since you guys are the best in the China space, please help us take a final look before we close the deal…we need your blessing and we only have a few days to wrap it all up”, stated the fund manager to us. Our work at our U.S. and China offices was very efficient. Within days, we advised the fund manager to walk away from CESV. He walked away on our advice and saved his fund at least $20 million from potential losses. In less than a year, the SEC sued CESV for fraud and the company folded. We later on received sincere gratitude from the fund manager thanking us for our advice.
Case #2: We sensed Rino International (“RINO”) could become a problem for U.S. investors as early as the beginning of 2009. We had learned from several senior executives at large Chinese steel mills at that time that steel mills were not motivated to cut waste gas emissions since those efforts cost money while the steel industry itself was already suffering significant losses. However, the steel mills must meet certain minimal emission reduction standards or face large fines. As a result, steel mills spent as little as possible on pollution control equipment, just enough to get by. Pollution control equipment providers such as RINO’s operating business in China were likely to have a much smaller market size than portrayed publicly and the crowded industry meant that it would have been unlikely for RINO to be as profitable as it claimed to be. In addition, our conversations with the local government officials confirmed our view that RINO was also running low on cash. In order to save the company from potentially a much earlier demise, RINO was in a hurry to raise $100 million in an equity offering in 2009. In late 2010, RINO was subpoenaed by the SEC and its stock was swiftly delisted by the NASDAQ citing accounting concerns at the company. RINO shareholders will most likely recover very little, if at all. RINO’s corporate structure is in the form of a Variable Interest Entity – “VIE”, created by highly “creative” lawyers.
In addition to the above, a few names currently listed on the NYSE and the NASDAQ did not pass our due diligence checks either, with more than half of them having gone public through an IPO. Some investors prefer public companies that have gone public through IPOs. But the reality is that it makes no difference whether the company went public through an IPO or a reverse merger – they go through the exact same level of SEC reviews when a financing related registration statement SEC Form S-1 is submitted to the SEC.
In our view, problematic Chinese companies represent a very small percentage of all China based, U.S. listed companies. The majority of
China based, U.S. stock exchange listed companies are compelling opportunities for investors to tap into the growth of China. Structural changes however, should be made so that the investing public in the U.S. gets as much protection by investing in China names as they invest in U.S. companies. The following are our observations:
China Based Companies with VIE Structures Are the Single Biggest “Time Bombs” in the U.S. Markets:
In a VIE structure, the public shareholders do not own the underlying assets in the operating entity – the actual business that generates revenues and earnings for common shareholders. Instead, all of the sales and incomes reported by the public company and filed with the SEC are booked through contractual agreements whereby a company’s management and founders agree to transfer their rights to sales and incomes from the operating business to the public company. The original founders retain the ownerships of the underlying tangible hard assets such as cash, factories, land use rights, machinery, customers etc. In theory and in reality, company management and founders can choose to walk away and leave the public shareholders with no legal claims to the assets of an operating entity. Doesn’t this sound crazy? It certainly does.
RINO was a good example of a VIE structure. RINO’s market capitalization was at one time approaching $1 billion. Shareholders that bought shares in RINO apparently did not realize the inherent risks involved since they perhaps did not bother to read the company’s SEC filings which disclosed risks associated with a VIE deal structure.
In our view, a public company in the U.S. with a VIE structure poses the single biggest risk to U.S. investors. Alarmingly, companies with the VIE structure represent more than 20% of the entire universe of China based, U.S. listed companies listed on U.S. stock exchanges, including almost all of the high flying internet stocks. The vast majority of them have become public companies in the U.S. through IPOS.
In contrast, China’s own domestic stock exchanges do NOT permit listing of any company whose revenues are organized under a VIE structure. The VIE structure was created by global law firms in the early 2000s to intentionally circumvent legal requirements in China that prohibit foreigners from owning shares in China based internet companies. That law is still applicable in China today. However, the “creative” VIE structure has become a main stream listing process for China based companies – with almost all of them listed through IPOs in the U.S. markets. What do shareholders own by buying shares of a company organized under a VIE structure? Legal professionals may argue that shareholders get sufficient protection through those management contracts. The reality is, in today’s China, a VIE structure is nothing but a piece of paper evidencing certain “right” that is next to impossible to enforce under Chinese laws. At New York Global Group, we avoid companies with VIE structures completely.
Companies with “Earnings Make Good Provisions” Pose Significant Risks to Investors:
The typical audience of early investors in U.S. listed China based companies are small hedge funds, those with less than $100 million under management and are never long term holders. The vast majority of them are unwilling to or are unable to perform much due diligence on the target companies in China. A popular mechanism that caters to these types of investors is created, by Wall Street bankers and lawyers and is given the fancy name of “earnings make good provisions.” In this approach, investors demand a company CEO make personal guarantees as well as on behalf of his company that certain minimum net income targets must be met by the company, typically for 3 years in a row from the date of the investment. If the company misses its earnings targets in a particular year, the CEO could lose the majority control of his company to the investors to “make good” on those earnings promises. This financing mechanism is worse than a weather forecast. Unless one can predict weather conditions precisely on a specific date, three years in a row, one may lose control of his company. Such mechanism not only stimulates management fraudulent behavior but also limits the investing public’s upside – earlier investors often sell short against their positions. This is one of the main reasons why many China based, U.S. listed high growth small cap companies trade at single digit current year multiples and are highly vulnerable to short seller attacks – they fight the short sellers on a daily basis as a result of their previously entered “earnings make good provisions” related financings. We have met with many Chinese company CEOs who complain about these “poison terms”, often sold to them by small investment banks. We are highly concerned that management often expresses their willingness to do “all things possible” to achieve those earnings targets – a high risk endeavor for both the companies and the investing public.
NYGG Follows Strict Client Acceptance Criteria:
NYGG is regularly approached by both institutional investors and companies for our knowledge on the China space and the capital markets. Having worked with more than two dozen U.S. stock exchange listed names, we have gained much experience in identifying quality companies.
As a disciplined equity investor ourselves, we have avoided every single one of those publicly acknowledged problematic China based U.S. listed companies. Here are our “NYGG 10 Commandments” which we strictly follow during our client acceptance process.
Mr. Benjamin Wey is the President and a founding partner of New York Global Group (“NYGG”), a leading middle market advisory firm on Wall Street specialized in executing China related transactions.