Morgan Stanley Goes Against the Shorts in China
On the morning of May 18, Kevin Barnes published a report accusing executives of Chinese fertilizer maker Yongye International of using acquisitions to loot cash from the company and manipulate earnings. Barnes, an analyst at hedge fund Absaroka Capital Management in Cheyenne, Wyo., said Absaroka had sold Yongye shares short, betting they would decline. The stock fell 23 percent over the next two days.
While that sounds like yet another case of a short-seller bringing down the stock of a Chinese company trading on a U.S. exchange, this story has a twist. Less than two weeks after Barnes published his report, Morgan Stanley‘s Asian private equity unit said it would buy $50 million of preferred stock in Yongye, pushing its Nasdaq-listed shares up 42 percent in a single session.
Morgan Stanley’s is one of at least six private equity funds wagering that accusations made by short-sellers have created bargains among U.S.-listed Chinese companies. (Short investors bet against a stock by selling borrowed shares with the hope of repurchasing them at a lower price. Long investors buy shares, betting the price will rise.) “Half the people, the longs, think the whole market is suffering because of the sins of the few, and therefore it’s a buying opportunity,” says Phil Groves, president of Hong Kong-based DAC Financial Management China, which does due diligence in China for investors. “The other half, the shorts, thinks there are a bunch of companies that are still trading but really worthless. Both have an opportunity to make money, because not every Chinese company listed in the U.S. is bad.”
Short-sellers have been targeting some of the more than 150 closely held Chinese companies such as Yongye that have entered U.S. markets since 2007 by buying a publicly traded shell company, avoiding normal scrutiny by exchanges and investors. On June 9, the Securities and Exchange Commission urged investors to be cautious when buying shares of so-called reverse-merger companies. The agency has revoked the registrations of at least eight Chinese companies since December, and more than 24 have disclosed auditor resignations or accounting flaws to the agency since March, SEC Chairman Mary Schapiro said in an Apr. 27 letter. The problems have cast a shadow over all Chinese stocks trading in the U.S., which have lost about $5.35 billion in market value this year through June 28.
Since February at least six buyouts of U.S.-listed Chinese companies have been announced, with a total value of $1.96 billion, according to data compiled by Bloomberg. On May 20, for example, Bain Capital agreed to buy China Fire & Security for about $234 million. A spokesman for Bain declined to comment. Other buyout firms making deals with Chinese companies include TPG Capital and Hong Kong-based Primavera Capital Group, founded by Fred Hu, Goldman Sachs‘s former Greater China chairman.
The provisions of the Yongye deal give Morgan Stanley plenty of protection. The bank is buying preferred shares that can be converted into common stock in the next five years, giving it a stake of about 10 percent depending on company performance, according to filings. The deal has conditions: If Yongye fails to meet specified targets, including at least 20 percent annual profit growth from 2011 to 2014, Morgan Stanley can get its money back with a premium.
Yongye, which produces nutrients sprayed on plants and added to animal feed, is an “exceptional company that has built significant brand recognition,” Homer Sun, managing director of Morgan Stanley Private Equity Asia, said in a May 31 press release announcing the deal. The fund did “extensive due diligence” on the Beijing-based company, the statement said. Nick Footitt, a spokesman for the bank in Hong Kong, declined to comment.
Inside a two-story cement office building at a company factory complex in Hohhot, a city of 2.7 million in China’s northern province of Inner Mongolia, Yongye Chairman and Chief Executive Officer Wu Zishen says that all of Barnes’s allegations are false. Negotiations with Morgan Stanley had been going on for months, and the bank provided “a thorough health check to prove we are clean,” Wu says.
Yongye is the third Chinese company to be targeted by Absaroka’s Barnes, who says he worked in the global natural resources investment banking group at JPMorgan Chase from 2003 to 2009. China Shen Zhou Mining & Resources and SkyPeople Fruit Juice both saw shares slump after Absaroka published negative reports.
Barnes hasn’t been as successful with his forecast about Yongye. Shares closed at $5.27 on June 28, up 15 percent since the day before release of the Absaroka report. Short-selling has fallen to 3 percent of outstanding shares as of June 24, from a record 9.4 percent on Apr. 4, according to Data Explorers, a research firm based in London and New York. Barnes, who traveled to Inner Mongolia in June to continue his research, says he stands by his conclusions. He adds that if Morgan Stanley’s and the other private equity firms’ investments turn out to be successful, it will be in part because the questions raised by short-sellers highlighted concerns the firms could address before making deals. “Private equity investors that are putting new money to work in U.S.-listed Chinese firms,” he says, “are benefiting from a voluminous amount of due diligence work completed by short-sellers.”