China Finance: Under the radar IPO soars despite underlying risk
Something rather strange happened earlier this week. Investors in Chinese stocks decided to throw caution to the wind and take a real plunge into the deep end. Economic issues ahead for small businesses? Please! The dangers of the shadow banking system? Not today! Throwing all your money into a variable interest entity (VIE) which will be locked down? Huh!?
China Commercial Credit (NASDAQ: CCCR) listed without making much noise, partly this was down to the fact that the company only raised USD 8.9 million in its offering, and partly it was due to the fact that the holding company is American, making this an S-1 filing rather than an F-1. Further, if this is any gauge of investors appetite then the Cinda IPO should rocket, the company has more than doubled in value this week, making it a great investment for anyone who got in early.
In the long run though, I’m not so sure that we will see a very good return from this company. There are a lot of risk factors involved both in terms of the business and the corporate structure. This means that if anything does go wrong, foreign investors should be ready to lose everything.
CCCR is in the business of making small loans to SMEs in China and is therefore part of the country's shadow banking system. There seems to be a lot of exposure to this these days, so much in fact that investors appear to be to flocking towards it. The demand for new loans of the type that CCCR provides is big and is likely to rise as we move forward, so the market should be there, as long as the company can keep bad debts to a minimum.
The company also has another business line in guaranteeing loans for companies that could not otherwise get them. They charge a fee for this service (naturally) and this currently accounts for almost 13 percent of the net revenues. This seems essentially like a way for CCCR to expand its loan portfolio without making the loans itself. The question here is about the quality of the loans itis guaranteeing — which is always hard to gauge — but this type of expansion is aggressive and risky.
The reason why it has had to expand in this way rather than simply building on its own loan portfolio is because the amount of loans it is allowed to issue is tied to the amount of registered capital attached to the company. Only if it expands this will it be able to expand its business. And this is what has prompted the foreign listing in this case, getting more registered capital to be able to grow the business faster than if it simply used retained earnings.
This is also where the problem arises from a corporate structure point of view. CCCR uses a variable interest entity (VIE) structure to operate in the market, for all intents and purposes it seems like the entire company is in its VIE, which is owned by 16 Chinese individuals. Now, in order to get the money from the IPO into the VIE it has had to resort to lending the money to these individuals, who are then “obliged” to use the money to inject capital into the VIE.
However, in order to get any use of this money for expanding the business it has to be used to increase the registered capital in the VIE, which has some interesting consequences. Registered capital in the VIE cannot actually be used by the wholly foreign-owned entity (WFOE). A common phrase in the industry is "the WFOE has free access to the assets of the VIE except for the registered capital". How truthful this is really doesn’t matter that much. What does matter is that in this case the WFOE definitely doesn’t have a right to the money that is injected as registered capital.
One consequence of this is that in the exclusive options agreement (standard in all VIE structures giving the WFOE the exclusive right to purchase the shares of the VIE should it become possible/legal) the price is already set as the amount of registered capital in the VIE.
Now, this basically means that what investors have just done is give all the proceeds from the IPO to 16 individuals, and if they ever actually want it back their only option is to buy it back from these same 16 individuals. Doesn’t sound that brilliant.
Added to this you have the fact that basically the entire company is in the VIE, which can easily lead to misalignment of interest between the VIE equity holders and shareholders in the listed company. The VIE also appears to have only one financial transfer agreement, which has two implications.
- There is only one contract to establish economic benefits from the VIE for consolidation. This means this contract has to be able to transfer all residual income from the VIE to the WFOE, whilst remaining an arm's length agreement.
- Any intellectual property (IP) or other things that might be licensed to the VIE to create more financial transfer mechanisms as well as further control, are not held in the WFOE. Hence there has been no structuring of IP, assets, or operations away from the VIE.
This structure, then, has not been set up with the interest of shareholders in the listed company in mind. It seems to be very one-sidedly favouring the VIE equity holders and is therefore prone to interest misalignment issues.
So with all these risks, what prompted such an extreme pop in the value?
I would posit that this was the result of a lot of investor interest, partly drummed up on twitter and blogs, coupled with a very limited float. This has created something of a scramble to get in on the action, even if the underlying risks look off-putting.
After this crazy race to the top it seems likely that this risk should start being felt, and the downside potential for the stock is now very real. If there are shares to short, now might not be the worst time to start building a small position, even if the risk of continued upward pressure shouldn’t be underestimated.
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.