China Finance: Domestic RTO is not the exit going privates want
In the middle of tough conditions it appears that we may finally be seeing the first domestic relisting of a company that went private from the US exchanges. Initial signs point to this potentially being something of a whopper of a deal for the taking private consortium, so will this push more money into this sphere?
China Security & Surveillance Technology, Inc. (CSS) went private from the NASDAQ at an historic price/earnings (P/E) valuation of six in 2011. The early signs here in the deal is of a trailing P/E around 41, that looks like good money for the investors involved and could make this into the success story that the industry has been looking for. However, there are a lot of things here that point to a lot more risk than most would want to admit to.
For a starter, CSS is a former reverse-takeover (RTO) company in the US and was part of the pool of companies that were heavily linked with fraud. In fact this was one of the main reasons why the company could be taken private so cheaply, the trust was simply gone.
This could simply have been a case of the market overreacting and lumping good companies in with bad, certainly that’s what the going private offer implied, but now the company is yet again going the RTO route to market in China. This isn’t standard practice by any stretch of the imagination, it’s likely to have been forced through by the IPO freeze in China that left no other route to a domestic listing open at present.
The fact of the matter is that a RTO, in China or elsewhere, will hit investors' trust in a company, especially when it’s the second time the company lists without going through regulatory inspection. To think that this isn’t known or understood by the consortium that took the company private is unthinkable, the reason they delisted from the US in the first place was ostensibly that their RTO affiliation pressed down prices too far.
So why are they going through this procedure now rather than look for alternatives? It looks a lot like something that’s been pushed through due to time constraints of some sorts, possibly from the private equity (PE) funds involved. Or perhaps the valuation is simply so good that they believe they can take the hit and still have this be the best way forward. Either way, the PE money is likely to get a good exit from this, which means they’ll have limited exposure to the future downside risk.
What’s most interesting about this, however, is the company CSS is merging into, because this isn’t actually a shell company, it’s an active company with more revenue than CSS disclosed. Yet they company has stated that it will simply stop its current line of business and go in full-scale to CSS’ business. The listing vehicle is Shanghai Feilo, a government owned company in the auto industry, so the potential to transit current operations into security and surveillance isn’t immediately apparent.
There’s a lot about this deal that doesn’t immediately make a lot of sense, Feilo simply abandoning its current business for a smaller one (albeit potentially more profitable), the valuation looks extreme, especially as the average P/E on among the A-shares is currently just over 10, and yet another RTO by the same company should have investors asking themselves just what would happen if CSS actually came under proper scrutiny. The fact is that the deal also has to get approval from the Chinese authorities, and seeing as they have closed down IPOs, there’s a decent chance they will shut this down as well.
The reason IPOs are shut down is partly to keep the market from being flooded by new shares, but it’s also due to fraud issues among domestically listed companies. The China Securities Regulatory Commission (CSRC) has put in place new, very stringent, listing requirements to make sure only quality companies make it through. With this in mind, it seems largely self-defeating to allow the reverse merger of a former US reverse merger, especially with so many things seemingly not quite making any sense.
Another big issue with the view of this as the white knight exit option for the going private transactions is that as a domestic listing it will exclude anything with a variable interest entity (VIE) structure, which means that if a similar path is to be taken by any company using this structure it will have to be disassembled before the listing. This will likely mean that foreign investors will have to be cashed out before any transaction or listing can take place, which presumably means the company needs to find yet another financing option for this part of the process, as this is likely to mean a lower valuation for the foreign parties this is unlikely to go down too well. What these investors are really looking for is a Hong Kong listing to show that the delist-relist deal can also work for VIEs.
What we have now is a company that has managed to find a highly unlikely backdoor into a domestic listing in China, this is not exactly what one could call a bankable option going forward. The chances of this type of listing becoming a trend is miniscule, the one thing that would potentially lead to more money jumping on the going private bandwagon is the absolutely astronomical valuation the company is rumoured to get, but it remains to be seen if this is real and if it will go through.
Fredrik Oqvist writes regularly about Chinese equities, mainly those listed on foreign exchanges. If you'd like to comment on this story or be notified by email whenever a new China Finance story is published, become a member - it's free, and you can use your Twitter, Facebook, Google or LinkedIn login - and "follow" the China Finance blog during the sign-up process. You can also bookmark the China Finance blog page.