Buyouts of U.S. shareholders – Chinese “Squeeze Outs” In American Stock Markets And The Need To Protect U.S. Investors by Peter Halesworth – Managing Partner, Heng Ren Partners

Executive summary

Since 2015, an unprecedented wave of 38 Chinese companies whose stocks trade on U.S. exchanges announced buyouts of U.S. shareholders. The premiums offered are less than three-fourths of the U.S. average, with more than half below the price paid at the Initial Public Offering (IPO). This is despite these companies on average increasing their cash holdings six-fold while in U.S. markets. Many U.S. and Chinese investors are discontent. However, because of jurisdictional issues and a relative lack of shareholder rights in the offshore tax havens where these companies are domiciled, a regulatory gap exists, leaving U.S. investors little to no recourse to challenge these low offers. Eventually, these managements use ownership control to “squeeze out” U.S. shareholders at low prices, and then move on to offer their company stock at much higher prices in Chinese stock markets. This white paper makes six recommendations to regulators, lawmakers, and institutional leaders to close this regulatory gap in U.S. stock markets to help align the interests of managements and shareholders.

Chinese “Squeeze Outs” In American Stock Markets And The Need To Protect U.S. Investors

Chinese issuers of U.S. securities are taking advantage of their American shareholders. They are exploiting weaknesses in U.S. corporate governance to “squeeze out” these shareholders at low prices. In 38 Chinese management buyouts announced since the start of 2015 totaling $44.4 billion in value, the average premium offered to U.S. shareholders was less than three-quarters of the average paid in all U.S. buyouts. This has created shareholder discontent and disenchantment.* The lower premiums offered were not due to lack of financial wherewithal. Indeed, Chinese issuers subject to management buyout offers had increased on average their cash holdings six-fold since before listing in the U.S.

Why are companies doing this? Because they can. They are taking advantage of a regulatory gap. As holders of American Depositary Receipts (ADRs), or American Depositary Shares (ADSs), investors in these lack the fundamental rights enjoyed by owners of stock issued by U.S. companies. Unlike with buyouts by U.S. companies, ADR holders have little to no recourse to challenge low-ball offers. As Chinese companies represent a rising share of the growing ADR/ADS market, which hit $3.3 trillion in value traded in 2014, it is important for investors, legislators, policymakers, stock exchanges, and institutional leaders to act. We must close the regulatory gap that handicaps U.S. investors and align the interests of managements and shareholders. Enforcement action and legal reform are needed to provide investors recourse to challenge one-sided deals that enrich managements at the expense of U.S. investors.

Chinese companies make below-average offers

Since the start of 2015, Chinese companies have announced an unprecedented wave of management buyout offers – 38 by our count.** Many are “orphaned” small-cap stocks that opt to “go private” and “delist” due to Wall Street indifference after the Initial Public Offering (IPO) and low trading volume. While buyout offers are typically good news, many managements are squeezing out U.S. investors that force sales at low prices far below fair or intrinsic value,1 curtailing investor value, and in some cases imposing permanent capital losses. A “squeeze out” is a transaction in which a large shareholder uses an advantageous position, legal device, or management power to eliminate other owners for economic advantage.

The buyout offer premiums from these 38 Chinese companies to U.S. shareholders have averaged 20.6% versus the 28.4% average control premium paid to shareholders in U.S. mergers and acquisitions (M&A) transactions for buyers to gain full control of a company. 2 Ten buyers offered shareholders premiums at or below 10%. Only five of the 38 buyout offers were at a premium more than the U.S. average.

Even more disturbing: Many of these companies seek to “squeeze out” investors below their IPO prices. After 32 of these companies who sold IPOs collected a combined $6.3 billion in IPO funds 3 ostensibly for the long term from U.S. investors, 19 of these 32 companies are now seeking to go private at prices below their U.S. IPO price. For these, their buyout price on average is 54% below their IPO price.

Companies exit much wealthier at U.S. investor expense

These lowball offers aren’t due to a lack of cash. Many of these company owners not only give themselves a bargain when taking full control, but the companies depart the U.S. for China much stronger financially after tapping U.S. markets. On average, Chinese companies pursuing buyouts arrived in U.S. stock markets with $46 million in cash and equivalents on their balance sheets pre-IPO. By the time of their buyout announcements, the average cash balance rose to $280 million – more than six times what they had pre-IPO (see Fig. 1). Total assets tell a similar story. Average total assets rose from $122 million pre-IPO to $994 million at the buyout announcement – increasing eight times.

Buyouts

Buyouts

Company managements realize their companies are worth far more than the buyout offers they make. Many of them, after successfully buying out U.S. shareholders and delisting their stock from U.S. exchanges, seek a new offering in Chinese markets. So far we have witnessed spectacular windfalls. Their offerings in China have reaped up to seven times the amount U.S. shareholders were paid, as illustrated by the examples of China Mobile Games and Entertainment Group Limited, 3SBio Inc., and Focus Media Holding Limited (see Fig. 2). This is poor treatment of U.S. shareholders who supported these companies when many didn’t qualify to sell IPOs in their home markets. It also highlights that the buyout prices offered to U.S. investors are far too low.

Buyouts

It seems as if at every turn the managements proposing buyouts looked to enrich only themselves. With their piles of cash they could ease the abrupt curtailment of value or permanent capital loss for shareholders by sweetening the buyout offer, or paying a special dividend. This is not what U.S. investors signed up for by investing in public companies trading on the New York Stock Exchange (NYSE) and NASDAQ, where public companies become trusted stewards of investor money. Instead, U.S. investors find themselves in an adversarial zero-sum game with managements of foreign companies who perversely enjoy immunity to many U.S. exchange rules and securities laws – all the while raising funds from Americans and trading in U.S. financial markets. This gaping loophole needs to be closed.

Examples of buyouts below intrinsic value and zero-sum games

Examples of these buyouts illustrate how investors are not compensated fairly. Buyouts are being made at bids that value companies below intrinsic value, or take companies private just as they are poised to benefit from positive developments. Managements have also flattered the amount of the premium they are offering, or made investors a buyout offer less than one-third of the recent IPO price.

In many of the buyouts, managements are paying below intrinsic value. For example, consider China Cord Blood Corporation (NYSE: CO), a leader in umbilical cord storage in China.

The parent company made a bid of $6.40 per share for the company, well below the firm’s estimated value of $15 to $20 per share, according to research published by shareholders. Needless to say this sparked a shareholder outcry.4 A competing bidder from China made a higher offer. The parent company has reportedly agreed to a price of an estimated $13.50 per share from the competing bidder. However, all other shareholders in the U.S. would receive only the original $6.40 – a 53% discount for the same class of shares.

Another example of a bid below intrinsic value is Jiayuan.com International Ltd. (NASDAQ: DATE), the Match.com of China and leader in online dating with over 150 million registered users. The co-chairman unexpectedly sold her 19.6% stake near a 52-week low at a below-average 15.7% premium to the market price to a Hong Kong entity called “Vast Profit.” Three days later, Vast Profit bid to buy out shareholders at the same low price. In the process, multiple bids also were received  for Jiayuan, but without timely public disclosure of the bids higher than the insider bid, which was 54% below intrinsic value.

A more complex example of paying below intrinsic value, and curtailing future shareholder value, is shown by Renren Inc. (NYSE: RENN). Touted during its 2011 IPO as “the Facebook of China,” its social networking site has since faded in popularity. However, this contrasts with the value of one of the investments it has made since Renren began to invest venture capital. Its investments include Social Finance Inc. (SoFi), a U.S. leader in peer-to-peer online marketplace lending, estimated to be the #2 online lender in the U.S., based on loan originations. SoFi’s current value is estimated at around $4.0 billion, with some analysts expecting its value to rise as high as $6.0 billion by 2017. Expectations of an IPO of SoFi emerged in the media. Renren Chairman Joseph Chen moved to buy out shareholders. Renren owns an estimated 24.8% of the shares of SoFi,5 which translates into an approximate current value of $1.0 billion – roughly equal to the management’s buyout bid for Renren. In a buyout, Chairman Chen and his partners would acquire in Renren a lot more than the SoFi stake. They presumably would gain full control of Renren’s social networking business, 16 venture capital investments in addition to SoFi, hedge fund investments, $259 million in cash, and commercial real estate – all for free.

In other cases, buyouts have occurred just as company shares were poised to benefit from material positive developments.

Sinovac Biotech Ltd. (NASDAQ: SVA), a private sector leader in vaccine production, the company announced on Thursday, January 28, 2016, that it had finally received Chinese government approval to produce a transformational vaccine that could ultimately triple revenues. By Monday the company issued a press release announcing its Chairman and CEO, Weidong Yin, and his partners wanted to take full control from shareholders.

China Nepstar Chain Drugstore Ltd. (NYSE: NPD), a nationwide drug store retailer, was similarly positioned for stock appreciation. After Heng Ren Investments pushed for operational improvements to unlock value, China Nepstar’s stock rose more than 115%. In an earnings call, a Nepstar spokesman said the “result-driven approach will reward our shareholders in a very positive way in the coming quarters.” Instead, the reverse happened for U.S. shareholders. Six weeks after this promise, Nepstar Chairman Simin Zhang moved to buy out shareholders at $2.60 per share, a price 21% below the stock’s recent high and an 84% discount to the 2007 IPO price of $16.20.

Buyouts

See full white paper below.