Shell Games: The Long Term Performance of CRMs


Shell Games: The Long Term Performance of CRMs see article on topic here

Charles M.C. Lee

Stanford University – Graduate School of Business

Kevin K. Li

The Man Behind TCI: One Of The World’s Top-Performing Hedge Funds

TCI David Marcus Investment ResearchThe Children's Investment Fund Management LLP is a London-based hedge fund firm better known by its acronym TCI. Founded by Sir Chris Hohn in 2003, the fund has a global mandate and supports the Children's Investment Fund Foundation (CIFF). Q3 2021 hedge fund letters, conferences and more The CIFF was established in 2002 by Hohn Read More

University of Toronto – Rotman School of Management

Ran Zhang

Guanghua School of Management

August 14, 2014

Rock Center for Corporate Governance at Stanford University Working Paper No. 183


We examine the financial health and performance of reverse mergers (RMs) that became active on U.S. stock markets between 2001 and 2010, particularly those from China (around 85% of all foreign RMs). As a group, RMs are early-stage companies that typically trade over-the-counter. Chinese RMs (CRMs), however, tend to be more mature and less speculative than either their U.S. counterparts or a group of exchange-industry-size matched firms. As a group, CRMs outperformed their matched peers from inception through the end of 2013, even after including most of the firms accused of accounting fraud. CRMs that receive private-equity (PIPE) financing from sophisticated investors perform particularly well. Overall, despite the negative publicity, we find little evidence that CRMs are inherently toxic investments. Our results shed light on the risk-performance trade-off for CRMs, as well as the delicate balance between credibility and access in well-functioning markets.

I. Introduction

Well-functioning markets require both credibility and access. On the one hand, security markets require sufficient regulation to establish credibility – to convey a sense of fairness, transparency, and trustworthiness to both investors and listing firms. On the other hand, these markets also need to provide adequate investor access: to multiple counterparties, sufficient liquidity, and an attractive set of securities. Laws aimed at increasing one dimension (e.g., market credibility through more stringent disclosure/reporting or listing requirements) can often lead to a reduction in the other (e.g., the number of potentially attractive firms on the exchange).

This delicate balance between credibility and access is in sharp relief as regulators (and investors) in developed countries evaluate firms from emerging economies. On the one hand, companies from emerging markets often offer access to more attractive growth opportunities. On the other hand, these companies may operate in countries with much weaker governance structures and regulatory safeguards. A central challenge for both U.S. regulators and investors is how to judiciously assess the risks and rewards of such firms.

In this study we provide empirical evidence on a particularly controversial case involving a subset of Chinese firms listed in the United States. Since the end of 2000, hundreds of Chinese companies have gone public on U.S. stock exchanges, most doing so through a “reverse merger” (RM).1 This rapid growth in the number of Chinese RMs (CRMs) listed on U.S. markets drew considerable media attention recently, when a number of them were accused of accounting fraud. In June 2011, the SEC issued a blanket warning to investors against investing in firms listing via RMs. In the same year, over 20 U.S. listed CRMs were either delisted or halted from trading, while a number of others had auditor changes or were the target of high-profile short sellers.

The recent waves of negative publicity have not only tarnished the reputation of CRMs but also directly impacted the pricing of other Chinese companies listed in the United States, including many that have not been accused of any wrongdoing (Darrough et al. 2012).3 Since 2011, U.S. regulatory actions, along with the pervasively negative sentiment toward CRMs, have effectively frozen the flow of Chinese listings into U.S. markets. In fact, the direction of the overall flow had largely reversed, as a number of Chinese firms publicly listed in the U.S. have been taken private through acquisitions. Even as U.S. regulators review current listing requirements for foreign entrants entering the country via RMs, Chinese firms have been going home in record numbers.

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