NEW YORK (The Deal) -- Fueled by the anticipated initial public offering of Alibaba Group Holding, a renewed wave of investor interest has swept into U.S.-registered Chinese companies.
Such companies have raised $4.43 billion in 35 private-investment-in-public-equity transactions this year, compared to $276.8 million in 13 PIPEs last year, according to PrivateRaise, The Deal's data service that tracks the PIPE market. Those figures exclude transactions that raised less than $1 million.
"Everything ultimately comes back to Alibaba," said Peter Fuhrman, CEO of China First Capital, a private equity firm in Shenzhen, China.
Alibaba's imminent IPO has increased investor awareness that all things related to Internet shopping in China could be a "money-spinner," Fuhrman said in an e-mail.
"Pretty much all the China IPOs in US this past 12 months have been internet-related. Now comes the Daddy of them all," he wrote. "This perception of a boom of titanic proportions in online shopping in China is well-founded. The challenge for US investors is whether the companies that have gone public, with exception of Alibaba and to a lesser extent Jingdong will be able to scale up and make real money over time in China."
JD.com (JD) , which is also known as Jingdong, raised $1.78 billion in its IPO in May.
The Internet in China is oligopolistic, Fuhrman said, with most of the spoils divided between search engine provider Baidu (BIDU) , Alibaba and portal operator Tencent Holdings, known collectively as "BAT."
All of the China-based companies that have received financings this year are either listed on the TencentNasdaq or New York Stock Exchange. Last year, three of the deals financed companies not traded on a major exchange.
The scale of transactions has shifted as well. In 2013, the biggest deal during an eight-month period was by Prime Acquisition Corp., a special purpose acquisition company that raised $130 million. This year there have been nine transactions that raised more than that figure.
The smallest deal this year was for $1 million and the biggest was a $1.1 billion private placement of stock. it went to Youku Tudou(YOKU) , an Internet television company.
The structure of the financings has also shifted. In 2013, all of the PIPEs consisted of common shares. This year, 20 of the deals were for common shares, with 13 of the transactions involving convertible debt or convertible preferred stock, one at-the-market offering facility and a single equity line.
"A lot of the deals that are getting done are heavily burdened by warrants. There is a premium that these companies are paying for the financings," said Drew Bernstein, principal with New York-based audit firm Marcum Bernstein & Pinchuk. The firm has four offices in China.
Bernstein is an independent director for the north China paper manufacturer Orient Paper Inc., which recently completed a $2.5 million private placement arranged by H.C. Wainwright & Co. LLC. Orient Paper sold shares for $1.60 each on Aug. 27. That was a nearly 20% discount to where its stock was trading at the time. The company also agreed to sell five-year warrants that will allow investors to buy 781,250 shares for $1.70 each.
In 2013, the only major investment bank involved in placing deals was Barclays Capital, and no bank did more than one deal. This year, Credit Suisse Securities (USA) has done five financings totaling almost $900 million. Citigroup (C) and Deutsche Bank (DB) each did four deals and JPMorgan Chase (JPM) did three. H.C. Wainwright and FT Global Capital Inc. did three placements each. Morgan Stanley completed a pair of private placements.
"The bigger banks are doing the really big deals" now that Roth Capital Partners and defunct Rodman & Renshaw are no longer doing business in China, said Patrick Ko, president of Atlanta-based FT Global Capital, an investment bank that specializes in China deals. "The two gorillas are no longer in the room."
FT Global has raised $88 million in a trio of deals - two of them for Jinhua-based electric car maker Kandi Technologies Group(KNDI) worth $82 million.
Ko said he thinks the rise in China PIPE investment has more to do with the companies seeking financing than the hot IPO market.
"I am not an IPO expert, but I don't think American investors have ever really understood China very well," he said. "Before 2010, China was hot and everybody wanted to invest. And since then, it has been shunned. But most of these companies are technology and solar companies, and investors know more about those sectors."
Eleven IPOs by China-based companies have priced in the U.S. this year, with a majority of the companies focused on technology, according to data from Dealogic plc. The offerings have raised $3.6 billion. According to media reports, Alibaba may price its $20 billion IPO the week of Sept. 8.
Steve Dickinson, a partner with Seattle-based law firm Harris Moure PLLC, has a different take on why there has been an influx of investment in China companies.
"There is too much hot money out there and China is a black hole in terms of information. It can be anything you want it to be," he said. "I don't think it has anything to do with IPOs. The essence of investing is that you have an accurate view of your target. In China, that is impossible."
Dickinson represents foreign companies that do business in and with China.
Investment in China-based companies has decreased since 2010 when there was a wave of fraud allegations against Chinese companies that had gone public through reverse mergers. Those included claims against Sino-Forest, which filed for bankruptcy in Canada after being accused of overstating its timber assets and revenues, and Longtop Financial Technologies, a Hong Kong software company that exaggerated its profit margins.
"The recent IPOs have all been proper ones, with real underwriters and Big Four accountants, not the back-door IPOs that once proliferated," Fuhrman said. "These back-door deals are where most of the problems have surfaced. So, it's also a 'flight to quality.'"
Deals with mainstream underwriters and Big Four accountants are also sometimes exposed as frauds or targeted by investors with short positions, said Fuhrman. "But, so far, this recent crop of online Chinese companies has held up to scrutiny," he said.
Despite a lull in investment in China, there was no way that investors were going to walk away from the country on a long-term basis, Bernstein said.
"Everybody knows that soon China will be the largest economy in the world. No matter what your business model is, plug 1.5 billion people into it and tell me if it doesn't work better?"
A concrete worry for investors is the ongoing issue of the accuracy of audits and the absence of on-the-ground audit inspections in China by the Public Company Accounting Oversight Board, which oversees auditors of U.S. public companies.
The U.S. Securities and Exchange Commission brought an administrative action in 2012 against BDO China Dahua, Ernest & Young Hua Ming, Deloitte Touche Tohmatsu, KPMG Huazhen and PricewaterhouseCoopers Zhong Tian for failure to turn over audit materials associated with U.S.-registered companies under investigation by the SEC.
The auditors claimed they could not comply with the SEC's requests for audit documents without violating Chinese law regarding state secrets.
An administrative judge suspended the firms, with the exception of BDO, for six months in 2013, but the decision was appealed and now the audit firms are negotiating with the SEC.
Another possible hurdle for investors is the use of variable interest equity structures by Chinese companies. A VIE is a workaround of Chinese laws meant to limit foreign ownership of Chinese companies.
Typically in a VIE, a company locates offshore, often in the Cayman Islands, and that will be the entity that foreign investors hold stock in. The Cayman company will be linked to a company in Hong Kong and in turn there may be as many as five entities linked in turn to the Hong Kong company, with the last one being the operating company in China. The companies are connected by contracts that enable the production of goods or services and revenues.
The byzantine arrangements allow investors to own equity in the company, without having direct share ownership that would violate Chinese law. But it is unclear whether the Chinese government views VIEs as legal. There has been persistent speculation in recent years is that China was poised to declare the structure out of bounds and foreign investors would take a hit.
That concern was addressed in a June report by the staff of the U.S.-China Economic and Security Review Commission, a committee that Congress established in 2000 to monitor the national security implications of trade with China.
"The VIE structure does not appear to be a sustainable model if major Chinese companies continue to list on U.S. exchanges," the report stated. "If U.S. investors continue to buy into such Chinese VIE schemes and the system collapses, the scenario could be akin to the 2001-2011 Chinese reverse merger debacle that cost U.S. investors an estimated $18 billion. If China were to enforce its laws and ban VIEs, the result would be a short-term loss for the foreign investors involved as well as the Chinese and foreign firms that use them to operate in China. If China maintains the foreign equity restrictions that compel firms into the legal ambiguity of the VIE structure, the potential result is a more extensive loss in which U.S. and other foreign Internet and ICT services firms have no legitimate access to compete fairly in the Chinese market, and Chinese firms will continue to resort to legally questionable methods to obtain foreign capital."
Dickinson said that VIEs are "all illegal. It really is that simple. If you take a look at Alibaba and Yahoo! (YHOO) you get an idea of exactly how things work."
Dickinson is alluding to the charges by Alibaba shareholder Yahoo! in 2011 that Alibaba had moved assets out of the company into entities controlled by Alibaba CEO Jack Ma using the VIE structure. Ma said that the asset move was discussed in board meetings and that Yahoo, which held a 40% stake in the Chinese Internet company, was aware of it. Yahoo charged that it learned seven months after the move that Ma had transferred Alipay, a PayPal-like service, out of Alibaba to a company controlled by Ma.
Today, Yahoo holds about a 24% stake in Alibaba, and says it plans to sell 140 million shares in the IPO.
FT Global's Ko defends the VIE structure.
"If you really understand how VIE works, understand it the way we do - you know that it is necessary for technology companies, Internet companies," he said. "I would say you would look at VIE on a case-by-case basis, and for non-technology companies, there is no good reason for VIE."
BY Bill Meagher
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