Welcome to the IPO kitchen - where the deals are cooked up

MONEY MATTERS
Shirley Yam
May 07, 2011

The company's investors include two international private equity funds and dozens of "long funds". A leading investment bank was one of its sponsors. Its auditor is a Big Four accounting firm and its bonds are rated by Moody's.
Yet this week China Forestry told the market that almost everything of significance at the company had been falsified by its former management - its logging permits, its management accounts and its bank statements.


"The Board has reason to believe that the financial statements in previous years might not reflect the true and fair view of the Company's financial performance and position," said China Forestry, which was listed in late 2009.

China Forestry said it had managed to verify most of its forest ownership and cash deposits. But its auditor KPMG said with most accounting staff and papers missing, they could not form an opinion about management's assessment of its ability to continue as a going concern.

How could the big names get it so wrong?

Welcome to the IPO kitchen where the deals are cooked up. Everyone gets paid for delivering a dish, even if they don't taste it. And nobody is punished for sending out rotten food.

China Forestry had two of the best ingredients to make any scam - China plus forests. Both are opaque to outsiders and yet are very inviting.

The mainland did not open its forestry business to private investment until 2003. There are few rules and regulations. Approvals are made by local officials, who are more interested in making money than keeping records.

Even though China Forestry's management had limited logging experience, Carlyle Group chipped in HK$312 million in late 2007 and 2008. Five months before the listing, Carlyle put in another HK$116 million, bringing its stake to more than 11 per cent. Switzerland's Partner Group invested HK$233 million to get more than 5 per cent.

According to the company's announcement this week, China Forestry's former chief executive - who is now under arrest - as well as its heads of forestry, finance, sales and human resources were all "behind the irregularities".

With the money from private equity funds, China Forestry bought more forest. By aggressively revaluing its forest land, it was able to generate sufficient fair-value gains to cover its operating losses, giving the company a three-year profit record. The company headed for listing.

KPMG was brought in to do the audit.

"A significant part of its profit is valuation gain and an auditor will largely rely on a valuer's report unless he or she sees reason to doubt the latter," said a retired auditor.

Greater China Appraisal was the valuer. It said in the prospectus: "We have been provided with copies of title documents of the properties owned by the group. However, due to the current registration system of the PRC, no investigation has been made for the legal title or any liabilities attached to the properties. We have relied upon the legal opinion given by the Commerce and Finance Law Office [a mainland law firm]."

New Zealand-based Chandler Fraser Keating did the report on the quality of the company's forests. In the prospectus, it said: "We have relied on the accuracy, completeness of the forest inventory, operation costs and other data supplied by the group ... We have not been able to independently verify the forest description."

There were limited visual inspections of the forests but no aerial inspections because Yunnan, where the company's forests are concentrated, is the site of a major army base.

The sponsor is supposed to be the ultimate gatekeeper of these experts' work. In this case, it was Standard Chartered, Cazenove and UBS. Yet sponsors get paid only when a deal goes forward. In fact, they profit from future fund-raising by the company and its management.

The initial public offering application reached the regulators. Under Hong Kong's disclosure-based regulatory regime, their job is not to say whether a company is legitimate or a scam but to vet the prospectus, look for suspicious numbers, raise questions and ensure answers are provided in detail. In fact, the limitations of China Forestry's valuations and business model were disclosed in the prospectus.

But who reads these massive documents? Listings are now covered by capital markets journalists who spend most of their time chasing information about the deal's pricing and investors' response instead of reading the prospectus.

China Forestry's initial trading was far from impressive. But that changed within weeks. Its name began to appear on the stock commentary pages of almost every major Chinese newspaper.

"Trading at an 11.5 price-to-earning ratio, China Forestry has much upside" said one. "Favourable government policy is putting gold on the face of this industry." Soon its share price traded up from below HK$2 to HK$3.50.

The price took a hit in April 2010 when the company announced a 90 per cent fall in profit due to a drop in its forest valuation. UBS immediately issued a buy report, raising its target price from HK$3.76 to HK$4.85 after "factoring in the 120,000 hectare forest addition in Yunnan?.

The market always needs more stories to dream about. In June, China Forestry announced an agreement with a central state-owned enterprise to supply logs, prompting China Construction Bank (SEHK: 0939, announcements, news) International to raise its target price to HK$4.70.

More non-binding memorandums of understanding for forest purchases were signed with county authorities in the southwest. China Forestry's stock price rose with the positive news.

In between, dozens of institutional investors jumped on the bandwagon, holding about 10 per cent of China Forestry. Among them was the Capital Group fund manager.

The real push in stock price came in early November when it got its credit rating. Moody's assigned a Ba3 corporate family rating, while Standard & Poor's gave it B+. Noting a high execution risk, Moody's said: "We expect China Forestry's profitability to remain good over the next two years."

China Forestry's share price reached a record high of HK$4.18. It did not matter that the rating agencies gave favourable ratings to subprime loans; or that investment banks paid them to assign ratings; or that they simply conducted management interviews and ticked off items on their checklists instead of independently verifying the company's claims.

What is important is that the rating made possible the company's sale of US$300 million in senior notes, providing more money for forest acquisitions. The notes were brokered by UBS and Standard Chartered.

Each party was having a good time until January 13 when the company's CEO, Li Hunchun, sold HK$400 million worth of shares, in a deal brokered by Standard Chartered, triggering an insider-trading investigation by the Securities and Futures Commission.

shirley.yam@scmp.com