Forced Chinese ADR De-Listings Will Harm Americans the Most
Targeting U.S.-listed Chinese companies, the Senate passed the Holding Foreign Companies Accountable Act on May 20th that is likely to lead to the delisting of 233 Chinese ADRs with a total market value exceeding $1 trillion, according to estimates by Goldman Sachs. To become law, this bill will also need to be passed by the House and signed by the President.
Chinese ADR Delistings Already Happening
Passage of the bill, which had been introduced more than a year earlier without much fanfare, has made headlines amidst a backdrop of increasing tensions with the U.S. and China over trade, spheres of influence, Hong Kong and human rights. What was overlooked in the brouhaha over the bill is that delistings are already occurring at a steady stream under the guise of going-private transactions.
The playbook of these M&A deals involves typically making a cash offer to U.S. ADR holders by a group of executives with the financial backing of private equity houses. Sometimes, financing is provided entirely by Chinese banks or funds; in other transactions, U.S. private equity funds play a key role. In either case, after having been taken private, the Chinese firms are relisted later in Hong Kong.
Vast profits can be generated with these transactions because the multiples at which the ADRs can be acquired from U.S. investors can be substantially lower than the multiples at which the shares are relisted in Hong Kong. One private equity fund pitches investors profits of 500-800% over three to five years. In a way, this is a return to the roots of private equity in the 1980s when conglomerates were acquired, split up and the pieces relisted in short order for a quick buck.
To illustrate how lucrative this strategy can be for the insiders, let’s look at one of its pioneers. WuXi AppTec founder Ge Li took the U.S.-listed company private in 2015 at a valuation of $3.3 billion. WuXi Biologics, a subsidiary, went public in Hong Kong in June 2017 at a valuation of approximately $1.7 billion and rallied to a $13 billion valuation within a year. In 2018, parent company WuXi AppTec listed in Hong Kong at a valuation of $10.2 billion.
While these valuation discrepancies exist between what skeptical investors in the U.S. are willing to pay for Chinese companies and the premium that Chinese investors are willing to put on domestic firms, the incentive to take a U.S.-listed firm private and relist it in Hong Kong persists. Congressional action against Chinese ADRs should accelerate the trend, but it will not cause or trigger it.
Fraud in Chinese ADRs
The skepticism of U.S. investors against Chinese firms is, of course, not without cause. Too many instances of fraud have undermined confidence. According to the 2018 documentary The China Hustle, more than 200 Chinese stock frauds have been delisted in the U.S. resulting in investor losses of $50 billion.
Underlying these problems are restrictions by Chinese regulators on the ability of U.S. auditors to examine the operations of Chinese companies. Since Sarbanes-Oxley, auditors of public companies have to be inspected by the Public Companies Accounting Oversight Board (PCAOB).
In 2013, after the first wave of Chinese stock frauds, the PCAOB and China signed a memorandum of understanding that finally gave the PCAOB access to Chinese audit firms’ records. However, local authorities in China have undermined this memorandum. State secrets are the argument – China wants to ensure that auditor inspections do not reveal anything classified. The unintended consequence of this culture of secrecy is that bad actors can take advantage of it.
Moreover, financial fraud against foreigners is not a crime in China so that fraudsters get to keep the proceeds of their scams even when caught. As to civil litigation, it may be next to impossible for a foreign plaintiff to win against a Chinese defendant in a Chinese court, which is also unlikely to recognize any foreign judgments.
China Investors Not at Risk
It is clear that something needs to change in China. When China joined the WTO in 2000, the West anticipated that it would gradually adopt Western standards. Instead, the piracy elements of its economy have entrenched themselves so deeply in the system that any major change would produce too many vocal losers. Moreover, the political rhetoric has supported the notion of Chinese exceptionalism, further inhibiting any movement toward Western investor protection standards.
However, unlike most issues at stake in the US-China trade dispute, the PCAOB problem has already the agreed-upon 2013 memorandum. Therefore, China could resolve this by a mere administrative order to local authorities to follow the existing memorandum, which would not create the appearance of having caved in to foreign pressure. Moreover, the Senate bill gives Chinese companies a three-year deadline to implement Sarbanes-Oxley compliant audits. This leaves plenty of time for China to implement the PCAOB memorandum quietly.
Other Options for Chinese ADRs
In a worst-case scenario, should ADRs actually be delisted, Chinese companies have many alternatives. Many U.S.-listed ADRs already have listings in Hong Kong or mainland China. For example, Alibaba listed its shares in Hong Kong in November 2019, well before the Senate passed its bill. U.S. investors can continue to invest in Alibaba through Hong Kong should the ADR be delisted.
Undoubtedly, other companies will list in Hong Kong or mainland China if they were to lose their U.S. listing. Many marketplaces around the world would likely be delighted to welcome listing exiles – London is the first exchange to come to mind with its long history of accommodating foreign issuers, but Singapore would also be a logical choice.
Just because an ADR is delisted does not make it impossible for U.S. investors to purchase the shares. Institutions invest worldwide anyway and do not require a U.S. listing. Even many retail brokerage firms offer their clients today access to global markets, albeit at a cost. Just because an ADR has been delisted and the company has relisted elsewhere does not make it uninvestable in today’s global markets.
Going Private Transactions to Accelerate
If Chinese companies ultimately get delisted due to the Senate bill becoming law one day, we expect many management teams at those companies to repeat the privatization playbook. And it could be quite advantageous to them.
Forced selling by some institutions could depress stock prices, enabling takeover offers at lower premiums and attractive multiples and ultimately much higher payouts if those companies are relisted at higher multiples a few years later, on bourses such as Hong Kong.
Most shareholders will have no option other than to take a hit and sell their shares at a low valuation. Very few institutions will perfect appraisal rights, which is a mechanism that lets shareholders ask a court to have independent experts review the valuation at which companies are taken private. It is a costly process but our own experience shows that for those shareholders with deep enough pockets and the relevant skills, it is a very lucrative route to get fair value for their shares.
As much as the Senate bill may have good intentions, it is likely that it will accelerate going private transactions that will force most U.S. shareholders to sell their shares below fair value to corporate insiders and private equity.