18 August, 2020


Watch out for the privatisation “squeeze out”

Gillem Tulloch

The proposed Holding Foreign Companies Accountable Act could force hundreds of Chinese companies listed on US exchanges to delist over the next few years. For many large companies, seeking a secondary listing in Hong Kong or the mainland is a sensible insurance policy. However, investors should be wary of companies which decide to privatise and then relist. Our analysis of 20 past privatisations shows that market value has risen 5x since the acquisition; however, there is a suspicion that profits were managed down prior to privatisation to lower buyout values, and then managed up during the relisting period in order to maximise valuations. As a result, insiders booked over 90% of the valuation gain, arguably at the expense of minorities. Watch out for the squeeze-out.

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Don’t squeeze me

The proposed Holding Foreign Companies Accountable Act[1] could force around 240-odd Chinese companies with a combined market capitalisation of US$1.5trn to delist from US securities exchanges over the next few years. Our research suggests that the mechanism by which these companies choose to relist on other exchanges is likely indicative of future shareholder returns.

The cleanest way for these companies to return to Asia is to secure a secondary listing in either Hong Kong or China, similar to Alibaba (BABA US, 9988 HK) in November 2019. Other large companies are reported to be following suit, such as NetEase (NTES US, 9999 HK) and JD.Com (JD US) [2]. The cost associated with a secondary listing might be expensive but could weed out potentially problematic companies. Presumably, shares will be fungible, meaning that ADR/ADSs will be transferable to Asian exchanges, thereby ensuring a relatively fair and transparent process. However, of the 240-odd Chinese companies listed on US exchanges, just 50 have a market capitalisation over US$2bn. The other 190-odd companies might be unable to afford a secondary listing, might not pass the due diligence process and might not be wanted by the exchanges.

The murkiest route to secure a market listing would be via some form of privatisation in the US, followed by a relisting or, even worse, a reverse take-over on an Asian exchange. Our research suggests that insiders tend to be the major beneficiaries from this process and that minority investors are more than likely to either suffer outright losses or substantial opportunity costs.

According to Bloomberg, just over 100 Chinese companies listed on US exchanges have been privatised over the past decade, as shown in Figure 1. The number of privatisations has slowed in recent years, presumably as the number of Chinese companies listed on US exchanges has dwindled. Of these privatisations, we have found evidence that 20 subsequently relisted on Hong Kong or Chinese exchanges. We suspect that the number is higher but the data is difficult to collate.

Performance of these 20 companies prior to privatisation has been poor with some exceptions. For example, Qihoo 360’s share price rose 431% over the five years that it was listed in the US, as shown in Figure 2. However, investors recorded losses in eight of the 15 companies which came to market via the IPO process, recording a median average loss of 7%. This does not include returns from the five companies which came to market via reverse take-overs as it is difficult to determine the starting point for measuring share price performance.

In general, companies have been taken private at a 28% premium to the average closing share price over the prior 20 days, which is broadly in line with the US average[3]. However, this does not tell the full story. The median average operating margin for these 20 privatisations almost halved in the three years prior to privatisation, as shown in Figure 3. This was accompanied by 20-25% share price decline leading up to the privatisation announcement, as shown in Figure 4, which was typically nine months before the deal closed. This raises the suspicion that profits were managed down prior to the privatisation, possibly in order to secure a lower price advantageous to the buyout group, but clearly at the expense of minorities.

The first three years of financials produced by the newly listed entity show a remarkable recovery in operating margin over the intervening period, as Figure 3 shows. Once again, this works to the advantage of the buyout group by helping maximise valuations upon relisting. The average duration between privatisation and relisting for our sample was just under three years, meaning that no company ever posted the same financial year in different jurisdictions. For example, a company privatising in June 2015 will have produced financials up until 2014 (based on a December year-end). Assuming it relists three years later, in June 2018, it would have to provide three years of financials, from 2015 to 2017. This helps avoid any obvious accounting changes and makes like-for-like comparisons difficult.

A similar trend of margin compression and share price depreciation pre-privatisation, followed by margin expansion post-privatisation, is seen at other privatised overseas-listed Chinese companies (mainly in Singapore). Operating margins for the six companies in this sample halved in the three years prior to privatisation, as shown in Figure 5, while share prices fell by an average of 60% in the two years prior to the privatisation announcement, as shown in Figure 6. Margins then recovered in the intervening years.

The performance of US privatisations has been mixed since relisting on Asian exchanges, with share prices falling by a median average of 3%. However, there is some subjectivity in calculating these numbers. Of the original 20 companies, shown in Figure 7, seven relisted via reverse takeovers, primarily on the Chinese mainland (Hong Kong’s regulator has made this route harder), which makes it harder to determine a starting share price to calculate performance. We have generally used the share price as of when the company issues new shares to the market which was normally soon after the reverse takeover. In general, those that have gone through the proper IPO process have recorded a median average 68% share price rise, whilst investors in RTOs have lost 32%.

Part of the reason for share price disappointment might be deteriorating operating margins which fell in the fourth year in both samples, as shown in the above charts. Again, this gives the impression that profits were managed down prior to privatisation in order to lower buyout values, and then managed up during the relisting period in order to maximise valuations.

Putting some numbers on this, the market value of US privatised companies was US$26bn on their last day of trading. These companies then listed on average three years later at a market value of US$134bn, just over five times higher, and are now worth US$138bn. Insiders have taken 96% of the valuation uplift via the privatisation and relisting process.

In summary

It is tempting to believe that prior to privatisation, Chinese companies were misunderstood by overseas investors and a return to Asian exchanges was a natural consequence; however, in our opinion, there is too much evidence of opportunism. A suspicious deterioration in margins in the run-up to privatisations conveniently supressed valuations at the expense of US minorities. A sudden rebound in these margins supported a far higher relisting valuation which has been crystallised by insiders – again at the expense of minorities, but this time Asian ones. Arguably, it is easier to manage this process to the advantage of insiders if subject to less due diligence; hence the popularity of reverse take-overs in returning to Asia.

[1] The proposed Holding Foreign Companies Accountable Act prohibits securities of a company from being listed on any of the U.S. securities exchanges if the company has failed to comply with the Public Company Accounting Oversight Board’s (PCAOB) audits for three years in a row. The bill would also require public companies to disclose whether they are owned or controlled by a foreign government. While the bill was passed by the Senate in May, it will also need to pass the Democratic-controlled House of Representatives before reaching the president’s desk to be signed into law.

[2] SCMP: NetEase targets as much as US$3 billion in Hong Kong listing, as more Chinese companies eye move closer to home, 1 Jun 2020

[3] The control premium average comes from a study by Business Valuation Resources (BVR) of the U.S. This authoritative industry study showed the average control premium paid – based on 3,659 transactions closed between 2000-2010 in the U.S.– was 28.4%.