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China’s Coming Wave of Going-Private Transactions.

26 January, 2012

 

Legal News & Analysis – Asia Pacific – China – Banking & Finance – Capital Markets – Hong Kong – Banking & Finance – Capital Markets

 

 

Since October 2010, we have seen a sharp increase in going-private transactions
for China-based companies listed on U.S. exchanges. At least 11 of these transactions have been completed or are publicly announced and pending. In addition to the hurdles presented by wholly domestic going private transactions, these deals present a range of execution challenges arising from the intersection of Chinese law and business practice with U.S. securities and corporate law.
 
Challenging Times for China-Based Listed Companies.
 
Over the course of the last two decades, more than 300 Chinese companies have been listed on U.S. exchanges. Most of the public attention has been on prominent Chinese companies that already are state-owned or have been industry leaders at the time of their listing. Underwritten by international, bulge-bracket banks, these companies typically are audited by Big Four accountants, have large market capitalizations and receive meaningful coverage by research analysts. Another kind of company receives much less press coverage and, in terms of numbers, accounts for more listings — Chinese companies that have been listed by way of a reverse takeover by an existing public U.S. corporation. While Chinese companies generally have suffered in the markets, China-based reverse-takeover companies have performed particularly poorly, with the Bloomberg Chinese Reverse Mergers Index having fallen more than 50 percent in the last year. Many of the reverse-takeover companies never developed robust analyst followings and a small number have become the target of a new breed of analysts who actively sell short the shares of the companies they follow and then attack them. These firms purport to reveal weaknesses of Chinese companies, typically alleging accounting irregularities, fraud and insider dealing. In a number of cases, the SEC has initiated wide-ranging investigations into the affairs of these companies, although it is too early to generalize the results. The fact that there have been several widely covered cases where it appears that fraud indeed has taken place does not help.
 
The Going-Private Solution and Financing Challenges.
 
As a result, many China-based companies have pursued (or are considering) the option of going private. Completed going-private transactions generally have been sponsored by a major shareholder, typically the founder of the company, working alongside a private equity investor and using a combination of debt and equity financing. While U.S. financing sources have significant experience with international leveraged acquisitions, most of the going-private transactions involving China-based companies have been completed with financing from Chinese financial institutions. The same factors that cause the capital markets to be unwelcoming to listings of China-based companies give international banks concern about lending in these transactions. The financing offered by Chinese institutions evidences confidence in such companies, but the success of transactions to date does not conclusively demonstrate that financing will be readily available for the much higher volume of transactions possible in the foreseeable future.
 
Short Analysts and Increased Scrutiny.
 
The research analysts who specialize in critical reports on China-based companies often take short positions themselves. If the markets adopt their advice, they have a great deal to gain. Bidders find themselves increasingly concerned that, in response to these analysts’ writings, a financing source could be induced to withdraw its backing for the transaction or that an investigation could delay or derail the deal. Either of these events could damage the stock price, affording those with short positions the opportunity to close out their position at a substantial profit. On at least two occasions, an unexpectedly large negative shareholder vote has been attributed to attempts by these holders to quash a transaction.
 
To date, the SEC’s public inquiries do not appear to be based on specific allegations of wrongdoing. The generality of the inquiries can make it difficult to provide adequate comfort to financing sources and the company’s special committee. Because of these factors, combined with difficult accounting issues common to many Chinese companies, financing sources and the special committee often will demand extra diligence, including accounting reviews, forensic audits and inquiries that require the hiring of experts on a range of questions.
 
The Domicile Difference: Tax Issues.
 
A number of reverse-takeover companies are domiciled in the United States, giving rise to issues that do not affect Chinese companies domiciled offshore (typically in the Cayman Islands). For example, companies domiciled in the United States are U.S. taxpayers. To the extent money made in China stays there, these companies may not pay any U.S. taxes, but following a going-private transaction, there may be a desire to flow funds up to an appropriate level, often a level above the U.S. entity, to service debt. Dividends received can create taxable income and dividends paid can attract withholding tax. Together, these taxes can affect the company’s ability to service debt substantially and, therefore, its value as a leveraged entity. In the same vein, a reincorporation transaction to a tax haven jurisdiction can entail a 35 percent tax on built-in gain (i.e., the prior appreciation of the value of the business under the U.S. shell), which often is prohibitive. Companies can employ a number of sophisticated approaches to ameliorate this tax exposure, but these are very much customized solutions.
 
What the Future Holds.
 
Going private may be a highly attractive approach for many China-based listed companies, but the availability of financing, both from debt and equity financing sources, likely will remain a significant obstacle. If this hurdle can be overcome, these transactions should become progressively more common and provide more attractive opportunities to management and founders, prospective private equity investors and debt financing sources for investment in Chinese companies.
 
 
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