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Opinion: Luckin Coffee shows how risky Chinese IPOs can be, but investors are just not listening

After the debacle surrounding the would-be Starbucks slayer, it’s time for more U.S. government regulation on these dicey deals

MarketWatch photo illustration/iStockphoto

It was less than a decade ago that a series of scandals involving Chinese companies going public in the U.S., some through reverse mergers, blew up — resulting in billions of investor dollars lost.

Undeterred, investors have dumped billions more into Chinese companies in recent years, even as shareholder advocates such as the Council of Institutional Investors — and this columnist — have repeatedly pointed to the inherent dangers of stocks with little visibility or recourse for investors who are wronged.

Just last month, history repeated itself when Luckin Coffee blew up publicly, after admitting that a top executive inflated sales figures at the biggest rival to Starbucks in China. Luckin’s inflated numbers were initially exposed in an anonymous short-seller report that was made public in February by Muddy Waters Research — the same short seller that shone a light on some of the problematic Chinese companies nearly 10 years ago, including Sino-Forest.

Read the latest:Luckin Coffee terminates CEO and COO amid probe of financial misconduct

As other Chinese stocks sank at the time, and investigations here and in China began; the Securities and Exchange Commission issued a warning to all investors about such stocks that boiled down to: “Buyer beware.”

Yet the lesson does not seem to have sunk in even now. As a pandemic washes across the globe and freezes much financial activity, another Chinese company managed to go public last week at a multibillion-dollar valuation that pulled hundreds of millions of dollars from the U.S. to China.

Investors were so excited to dump money into Kingsoft Cloud Holdings Inc. KC, -0.04%, a cloud-computing spinoff of software giant Kingsoft Corp. Ltd., that the company increased the number of shares it sold at the last minute to sate demand. It raised more than half a billion dollars in its IPO, and its market capitalization topped $4.4 billion after investors sent shares more than 40% higher in its first day of trading on the Nasdaq.

The huge Chinese market is just “so alluring” to investors that they can’t turn down a chance to get a piece of it, even with the obvious high risks, said Paul Zarowin, a professor of accounting at the Stern School of Business at New York University. “It’s an enormous market, [and] everybody wants a piece.”

Certainly not all Chinese deals are fraudulent — Kingsoft Cloud is tied to two respected Chinese tech companies, the long-established software company Kingsoft Corp. 3888, +0.50% and smartphone maker Xiaomi Corp. 1810, +1.10%, both of which agreed to buy shares in the deal at the IPO price, buying up to $25 million and $50 million in newly issued stock, respectively.

But investors need to understand the risks of what they are investing in: Every single Chinese company that goes public in the U.S. has a complex and convoluted structure, ostensibly a loophole to enable Western investment in a market that prohibits outside investors. But it also protects the core Chinese company through a host of offshore shell companies and subsidiaries. On top of these structural issues is the biggest problem of all: that the accountants who sign off on company financial statements in China don’t have access to those company’s actual books and records, only what they are allowed to see.

“The basic problem is that they don’t have the same auditing standards that we do here,” Zarowin said. “And compounding that problem is that the PCAOB [Public Company Accounting Oversight Board] which oversees the auditing firms, generally can’t get access to audit the Chinese auditing firms. So a lot of firms go public from China into Western capital markets that don’t meet the same disclosure and auditing standards that we would here.”

That was part of the lesson that SEC Chairman Jay Clayton and other top leaders of the regulatory body stressed in their recent missive, fueled by the Luckin Coffee LK, -37.35% blowup. Shares of the once-high-flying IPO, halted April 7, have still not reopened for trading.

“Shareholder claims that are common in the United States, including class-action securities law and fraud claims, generally are difficult or impossible to pursue as a matter of law or practicality in many emerging markets,” the SEC said last month in a statement about the risks of investing in emerging markets, describing China as the world’s biggest emerging market.

The SEC is now investigating Luckin Coffee, while China’s top regulator began an investigation and raided its headquarters late last month, demanding access to company records. That was a rare move by Chinese officials, who have said they are cooperating with the SEC.

Thanks to the Kingsoft Cloud deal last week, Chinese IPOs are now slightly ahead of last year’s pace, despite the broader market meltdown that’s marked the coronavirus era and a general pullback in new offerings as virus fears and the economic downturn have dented sentiment.

The successful deal may also have further emboldened Chinese companies. On Monday, a small company called Global Internet of People, offering peer-to-peer consulting on the “Global Mentor Board,” with 2019 revenue of $18 million, filed a deal to offer 4.2 million shares at $5 each, to raise $21 million. The company said it has been profitable for the past two years, and its “knowledge sharing and enterprise service” had approximately 520 mentors, 850 experts, 1,400 members and 5.49 million users, as of March. Some mentors can receive rewards for sharing their knowledge.

So far in 2020, eight Chinese companies have raised $898 million, compared with the six companies that raised $626 million in the same time span a year ago, according to research firm Renaissance Capital, which also manages an ETF IPO, +1.72% tracking the IPO market. Luckin Coffee’s IPO was completed in mid-May 2019 and raised $561 million.

From the MarketWatch archives (March 2020):Audacious Chinese coffee chain Luckin, not content with its quixotic battle against Starbucks, dreams of becoming Amazon, too

In 2019, the pace and size of deals fell to 25 companies going public, raising a total of $3.5 billion, compared to 33 deals that raised over $9 billion in the boom year of 2018.

So far, the prices of some of the hottest Chinese IPOs over the past two years have fluctuated greatly. Shares of Pinduodou PDD, -2.04%, whose app enables group e-commerce buying, are up 122% from the date of the company’s IPO in July 2018, with a recent spike likely attributable to the growth in e-commerce during the global lockdown.

Shares of China’s version of Netflix, iQIYI IQ, -2.43%, are up only 12%, even though it would seem to be one of the biggest beneficiaries of COVID-19 lockdowns. Last month, short seller Wolfpack Research issued a report saying that the company has inflated revenue since before its 2018 IPO.

Shares of another potential beneficiary of a global lockdown, Douyu DOYU, +5.03%, a developer of a videogame streaming service, are down about 28% since that company’s IPO in July 2019. The company is now the target of shareholder litigation in the U.S., alleging that it made false or misleading statements in its IPO regulatory filings.

After the market closed in the U.S. on Friday, Kingsoft Cloud’s market valuation surpassed $4.4 billion, undoubtedly helped by the fact that it is addressing the enormous cloud-computing market in China, where the top three players in public cloud services are Alibaba Group Holdings BABA, +1.22% Tencent Holdings Ltd. 700, +2.32% and Baidu Inc. BIDU, +2.66%according to Synergy Research Corp.

John Dinsdale, chief analyst at Synergy, said in an email that Kingsoft Cloud was No. 8 in the Chinese cloud market in the first quarter. In the company’s prospectus, it describes itself as the “third-largest internet cloud-service provider in China, with a market share of 5.4%” and does not list or describe its competitors.

Investors did not seem to mind the fact that Kingsoft had net losses of $159.6 million on revenue of $563 million (up 78%) in 2019, or that the company could not say when it expected to be profitable.

“It’s fair to say that Kingsoft Cloud’s potential to become the AWS AMZN, +0.88% or Azure MSFT, +1.01% of China is a big draw for IPO investors,” said Matthew Kennedy, senior IPO market strategist at Renaissance Capital. “Kingsoft Cloud may be able to position itself as an ‘independent’ cloud-services provider, though, yes, the industry is highly competitive, with heavy capex spend and relatively little product differentiation.”

It is understandable that investors are enticed by the massive market potential of China. But that does not change the fact that these deals are different from those of other foreign issuers in the U.S. Investors should not buy into them without going through the prospectuses carefully, and if they cannot understand the complex org charts, the warnings about conflicts of interest, or the uncertainties related to the interpretation of foreign investment law, they should just stay away.

These often risky deals are among a growing list of problems that the U.S. is now dealing with, courtesy of China. But it’s not clear how a solution can be found, when powerful Wall Street banks are involved.

Last year, a bipartisan committee led by Sen. Marco Rubio, a Florida Republican, introduced legislation called the Equitable Act, which would force Chinese-based and other companies to be delisted in the U.S. if they do not comply with U.S. accounting standards and oversight.

The bill was sent to the Senate Committee on Banking, Housing and Urban Affairs, where it seems to have stalled. Wall Street, which makes billions of dollars off these Chinese deals, is likely heavily lobbying against the bill. And as long as the big investment banks continue to fight this and other potential legislation, it’s not likely that anything is going to change soon. Rubio’s office did not respond to a request for comment on the status of the bill.

“If the New York Stock Exchange said, ‘We are not going to accept any Chinese IPOs that don’t meet the American standards,’ [the Chinese listings] will just go to London, or somewhere else. Western investors want the securities,” NYU’s Zarowin said. “Unless there was a coordinated Western response — all the major Western exchanges — I don’t see the problem going away.”

The Renaissance IPO ETF has gained 9% so far in 2020, outperforming the S&P 500 SPX, +1.73%, which is down 9%. 

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