Bloomberg News

China Reverse Merger Pits Morgan Stanley Against Hedge Funds

June 21, 2011

June 22 (Bloomberg) -- On the morning of May 18, Kevin Barnes published a report accusing executives of Chinese fertilizer maker Yongye International Inc. of using acquisitions to loot cash from the company and manipulate earnings.

Barnes, an analyst at Cheyenne, Wyoming-based hedge fund Absaroka Capital Management LLC, set an estimated share value of $1 for Yongye. He said Absaroka had already bet an amount he wouldn’t reveal on a decline in the stock, which closed the day before at $4.58. The shares fell 23 percent in two days.

Less than two weeks later, Morgan Stanley’s Asian private- equity unit said it would buy $50 million of preferred stock in Yongye, pushing its shares on the Nasdaq Stock Market up 42 percent in a single session. The fund is one of at least six that are wagering the short sellers are wrong by investing in U.S.-listed Chinese companies that have had about $6.78 billion of market value erased this year following allegations of financial fraud by short sellers such as Barnes.

“Half the people, the longs, think the whole market is suffering because of the sins of the few, and therefore it’s a buying opportunity,” said Phil Groves, president of Hong Kong- based DAC Financial Management China Ltd., which does due diligence in China for investors. “The other half, the shorts, thinks there are a bunch of companies that are still trading but really worthless. Both have an opportunity to make money, because not every Chinese company listed in the U.S. is bad.”

Short investors bet against a stock by selling borrowed shares with the hope of repurchasing them at a lower price. Long investors buy shares betting the price will rise.

Private-Equity Buyouts

Since February at least six buyouts of U.S.-listed Chinese companies have been announced, totaling $1.96 billion in value, according to data compiled by Bloomberg. Four of the acquisitions involve private-equity funds, including TPG Capital, Bain Capital LLC and Hong Kong-based Primavera Capital Management Ltd., founded by Goldman Sachs Group Inc.’s former Greater China chairman, Fred Hu.

Shares of the target companies -- CNinsure Inc., Funtalk China Holdings Ltd., China Fire & Security Group Inc. and Chemspec International Ltd. -- have gained an average of 10 percent since the deals were announced, according to calculations based on Bloomberg data.

Yongye, which produces nutrients sprayed on plants and added to animal feed, is an “exceptional company that has built significant brand recognition,” Homer Sun, managing director of Morgan Stanley Private Equity Asia, said in a May 31 press release announcing the deal. The fund did “extensive due diligence” on the Beijing-based company, the statement said.

Hohhot Factory

Morgan Stanley’s investment buys it preferred shares that can be converted into common stock in the next five years, giving it a stake of about a 10 percent depending on company performance, according to filings. The deal has conditions: If Yongye fails to meet specified targets, including at least 20 percent annual profit growth from 2011 to 2014, Morgan Stanley can get its money back with a premium. Nick Footitt, a spokesman for the bank in Hong Kong, declined to comment.

Inside a two-story cement office building at a company factory complex in Hohhot, a city of 2.7 million in China’s northern province of Inner Mongolia, Chairman and Chief Executive Officer Wu Zishen said in a June 10 interview that all of Barnes’s allegations were false and had been concocted by him to make a quick profit at the expense of shareholders.

Negotiations with Morgan Stanley had been going on for months, and the bank provided “a thorough health check to prove we are clean,” Wu said.

‘Nervous and Helpless’

“At first we were so angry at the short sellers,” said Wu, his eyes puffy and tired. “Then we calmed down and thought those attacks were not personal, they were profit-driven, so we should be rational in responding.”

Wu, who drives a Mercedes-Benz sport-utility vehicle and doesn’t speak English, said he watches his company’s stock price closely and has “not lived a single day in peace” since Yongye was listed in 2008.

“Anytime the stock price fluctuates dramatically, I feel nervous and helpless,” said Wu, who bought $3 million worth of shares in the company last week, according to company filings. “We feel hurt because we have put in effort. We have had more than 700 investor meetings over the past 1,000 days.”

During a tour of the Hohhot factory at 2 p.m. on a weekday afternoon, only a few workers were visible and workshop doors were padlocked. The company, which reported sales of $214 million last year, has a second facility in Wuchuan County, about an hour away by car, decorated inside with the faces of smiling farmers. Yongye executives call it the “smiley-face wall” and say the pictures are of satisfied customers.

SEC Investigation

The arrival of private equity into companies like Yongye means short sellers no longer have it all their own way. They’ve dominated the discussion since November, when Rino International Corp., a Dalian, China-based supplier of water-treatment equipment that was targeted for criticism, said two years of its financial statements aren’t reliable.

The U.S. Securities and Exchange Commission has revoked the registrations of at least eight Chinese companies since December, and more than 24 firms have disclosed auditor resignations or accounting flaws to the agency since March, SEC Chairman Mary Schapiro wrote in an April 27 letter.

The SEC began an investigation last year into the use of reverse takeovers, a common method used by Chinese companies such as Yongye to list their shares in the U.S. without the regulatory and investor scrutiny of an initial public offering. On June 9, the regulator urged caution when buying stakes in reverse-merger companies.

‘Risk-Free Short’

The market tone made reverse-takeover companies a “virtually risk-free short,” said John Bird, an Austin, Texas- based private investor who holds more than $10 million worth of short positions on 30 U.S.-listed Chinese companies, including 35,000 shares of Yongye as of June 8.

The 101 Chinese companies with a market valuation of less than $1 billion listed in New York trade at a median of 3.9 times 12-month trailing earnings, well below the 10.2 times similarly sized firms in Hong Kong fetch, Bloomberg data show.

“If the longs start seeing a buyout as a potential safety net, it ends up making the short side less effective,” said Bird. “I hate to see it, but I congratulate the people who are able to put something together.”

Private-equity funds are targeting U.S.-listed Chinese companies because they offer better potential value compared with private enterprises in China, where owners demand high prices partly because of the large number of buyers chasing each opportunity, said Donald Yang, managing director at Abax Global Capital Ltd. in Hong Kong.

Abax, Bain

Funds focused on China raised $12.8 billion between January and May of this year, according to the Hong Kong-based Centre for Asia Private Equity Research Ltd. That compares with $20.4 billion in all of 2010, and $11 billion in 2009.

Abax, which manages $900 million in private-equity and hedge funds according to its website, is backing management-led buyouts of Harbin Electric Inc., an electric-motor maker, and Fushi Copperweld Inc., a Beijing-based producer of copper-clad wire. Abax counts Morgan Stanley among its investors.

The strategy of using a management buyout and relisting in either Hong Kong or China will release the embedded value of a company, Yang said.

“Even when you see value, you still have to think about how you crystallize that value,” Yang said. “Just buying the long stocks in the U.S. is no way to do it.”

Yang declined to discuss plans for Harbin Electric or Fushi Copperweld.

Bain, which is buying all of China Fire & Security for about $234 million, may relist the company after three years, according to a person with knowledge of the matter who asked not to be identified because the plan isn’t public. A spokesman for Boston-based Bain declined to comment.

Fair Price

The high legal and advisory costs of going private, including the need to show shareholders they are getting a fair price, means that buyouts have been a rarity for U.S.-listed Chinese companies, said Paul Strecker, a Hong Kong-based partner at Shearman & Sterling LLP, which has served as a legal adviser on nine deals announced in the past year.

Only two of the take-private deals have closed: the $70 million management buyout of Beijing-based Sinoenergy Corp., which operates compressed natural gas filling stations in China, and a $14 million management buyout of Tongjitang Chinese Medicines Co., a pharmaceuticals firm in Shenzhen, China.

Paulson’s Losses

Bain and Morgan Stanley are moving into territory where big investors have been burned. Paulson & Co., the New York hedge fund run by John Paulson that oversees about $37 billion, and C.V. Starr & Co., a firm run by former American International Group Inc. Chairman Maurice “Hank” Greenberg, have lost on respective investments in Toronto-listed Sino-Forest Corp. and U.S.-listed China MediaExpress Holdings Inc.

Shares of both companies fell after short seller Muddy Waters Research issued reports accusing the firms of fraud. Paulson’s fund sold all 34.7 million of its shares in Sino- Forest, a tree-plantation owner, it said in a June 20 regulatory filing, potentially losing C$705 million ($720 million). C.V. Starr’s loss may be more than $30 million.

“You have to be unequivocally convinced that the assets are there, that the business is real and that management is honest,” said Matthew Wiechert, research director of Glaucus Research Group LLC, a U.S. short seller specializing in Chinese- based companies listed on foreign exchanges. “There’s no recourse if you’re fooled.”

Humic Acid

Absaroka’s Barnes, who wrote the report on Yongye and traveled to Inner Mongolia this month to continue his research, said he stands by his conclusions and that private-equity buyers are capitalizing on his work.

“Private-equity investors that are putting new money to work in U.S.-listed Chinese firms are benefiting from a voluminous amount of due diligence work completed by short sellers to date,” Barnes said in a telephone interview.

Barnes’s report raised questions about Yongye’s $35 million agreement to acquire lignite coal exploration and production rights from Wuchuan Shuntong Humic Acid Company Ltd. in March 2010. Lignite coal is the main raw material for Yongye’s humic acid products, according to filings. As of March 31, Yongye had not received government approvals, the company said in its most recent quarterly filing. Yongye said it expected to obtain the mineral rights by the end of the year.

Attacks on Yongye

The Absaroka report said Chinese filings by Wuchuan Shuntong show an “insignificant” holding company with no revenue and little capital. The transaction was “a hoax” controlled by Yongye’s management and “apparently created to loot $35 million of public investors’ cash out of the company,” Barnes wrote.

Another purchase in 2010, of the customer list of a Yongye distributor for $3 million in cash and 3.6 million in new shares, was structured in a way that helped the company manipulate earnings, the report said.

Barnes wasn’t the first to attack Yongye. On March 23, a blogger named Ian Bezek challenged the quality of the company’s earnings on Seeking Alpha, an investor website. The stock fell 10 percent that day. Yongye said in a statement that Bezek’s allegations were based on “innuendo and loaded questions rather than any factual basis.”

A May 9 note published by OLP Global LLC, a research firm focusing on China, said Wuchuan Shuntong is a shell set up by Yongye and that the fertilizer firm spent $67 million acquiring assets from “sellers that do not exist.” Yongye’s shares fell 5 percent that day, only to rebound 5.9 percent the next day.

Rebutting Barnes

At the factory in Hohhot, CEO Wu and Sam Yu, the company’s chief financial officer, rebutted Barnes’s allegations. Buying the distribution list gave Yongye more control over channels used to push out its products, Wu said. The purchase of the humic acid supplier opened access to raw materials, said Yu.

“It doesn’t matter if it’s a small company or not, as long as they have the approval and access from local government to explore lignite coal,” Yu said.

Yongye is the third Chinese company to be targeted by Barnes, who said he worked in the global natural resources investment banking group at JPMorgan Chase & Co. from 2003 to 2009. China Shen Zhou Mining & Resources Inc. and SkyPeople Fruit Juice Inc. both saw shares slump after Absaroka published negative reports. Shen Zhou shares have fallen 53 percent since the March 8 report. SkyPeople’s shares fell 18 percent to $2.08 on June 1, the day of Absaroka’s report, and are now down 7.1 percent from the May 31 close.

‘Good Faith’

Barnes hasn’t been as successful with his prediction about Yongye. Shares closed yesterday at $5.19, up 13 percent since the day before publication of the Absaroka report. Short selling has fallen to 3 percent of outstanding shares as of June 17 from a record 9.4 percent on April 4, according to Data Explorers, a New York-based research firm. The average short interest for stocks in the Standard & Poor’s 500 Index is 2.7 percent.

Barnes couldn’t get access to Yongye’s facilities from his base at the Holiday Inn in Hohhot earlier this month. The company denied his request to join an investor visit on the grounds that his interest “is not one anchored in good faith,” it said in an e-mail sent to Barnes.

--Mohammed Hadi, Dune Lawrence, Eva Woo. With assistance from Cathy Chan in Hong Kong and Nikolaj Gammeltoft in New York. Editors: Neil Western, Robert Friedman.

To contact the Bloomberg News staff responsible for this story: Mohammed Hadi in Hong Kong at mhadi1@bloomberg.net; Dune Lawrence in New York at dlawrence6@bloomberg.net; Eva Woo in Beijing at ewoo9@bloomberg.net.

To contact the editors responsible for this story: Philip Lagerkranser at lagerkranser@bloomberg.net Gary Putka at gputka@bloomberg.net


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