Monday, August 27, 2012

Focus Media - big rewards and big risks for private equity firms

I believe you judge the quality of a private equity firm by its ability to say no to a deal.

If you have a billion dollars (or 20 plus billion dollars as in the case of some PE firms) then everyone wants to sell you something. [When I was a fund manager at a firm with 20 billion dollars I used to joke that everyone wanted to be my friend!]

People will sell you anything based on numbers or projections and at minimum what you needed to do was follow Ronald Reagan's dictum: trust but verify.

Focus Media (my new obsession) is a deal requiring verification. 

Focus Media's buyout is attractive on the stated numbers. As of the last results Focus had 758 million dollars in cash, restricted cash and short term investments - and a little over 200 million in borrowings (net cash of above 500 million) and was earning roughly 83 million of operating profits (on their non-GAAP measure) per quarter (call that 330 million per year). Moreover the company has history of very fast growth. The incremental capital returned for growth is low - so incremental ROEs are very high. 

If these numbers are real and sustainable the Private Equity bid to take the company private is likely to be a lay-down winner. Especially if the growth continues.

However these numbers must be verified. Rat-bag short-sellers have argued this company has fraudulent numbers. Allegations to that effect are all over Seeking Apha for instance. Muddy Waters - the firm that bought down Sino Forest - have published an 80 page report detailing what they believe are frauds at Focus Media.

That said, short sellers can be wrong. And the Private Equity firms may be buying a bargain - a bargain driven to bargain levels by nefarious (or just plain erroneous) short sellers.

The PE firms have an advantage

Private Equity buyers can do something that us poor equity investors can't. They can do thorough due diligence. They can check the transactions, they can talk to staff at all levels, they can forensically examine the books. They can probably even ring Carson Block at Muddy Waters (the most prominent critic) and ask him to send his most damning evidence - and they can seek to confirm or falsify Carson's arguments.

If an ordinary investor tried to do what would be ordinary business for a PE firm they would be guilty of insider trading.

In other words they can check whether it is a fraud and you - dear readers - cannot. They have a competitive advantage over you and they have a competitive advantage over me.

And being competent (at least I presume Carlyle, FountainVest etc are competent) they will use that advantage.

To that end though I wish to start them on their way. 

The US Securities and exchange commission has specific correspondence with US listed firms when they question something in the accounts. Sometimes this correspondence is kept private. Sometimes it is included in filings. Sometimes it leads to formal SEC inquiries which may or may not be made public.

Here is a list - with links - of the released component of the formal public correspondence between the SEC and Focus Media. 

1. Letter dated 1 October 2010 requesting more time for answering questions from SEC staff.

2. A further letter - dated 28 October 2010 asking for more time for answering questions from SEC staff. 

3. A further letter - dated 19 November 2010 asking for still more time for answering questions from SEC staff. 

4. A relatively long set of answers dated 10 December 2010. There are a few things I learned here - like that the controller of Focus Media (Jason Jiang or JJ for short) has taken out Singapore citizenship. There are other things that travel closer to the Muddy Waters allegations (such as goodwill write-downs). This filing was accompanied by an amended annual report.

5. A letter dated 9 January 2012 requesting more time to answer SEC requests.

6. A longer reply dated 20 January 2012 which was also accompanied by an amended annual filing. There are a few strange disclosures in here - for instance the company removed their claim that they were a "leading provider of internet marketing solutions in China" from their report. (Other gems abound in these filings.)

7. Another long letter dated 13 February 2012 responding to more SEC questions. This letter was also accompanied by an amended annual filing

8. A letter dated 6 March 2012 which requests more time to respond to SEC inquiries.

9. A letter dated 22 March 2012 which also required amended annual filings.

10. A letter dated 3 April 2012 requesting more time to file amended annual filings.

11. A letter dated 18 April 2012 requesting more time to amend annual filings - but also answering basic questions of financial control (like possession of the chops). 

12. A letter dated 24 April 2012 accompanying amended filings. 

Phew - that was a lot. These letters are not easy reading.

Process and risks in due diligence

Here is my point: if a bunch of lawyers without access to inside information at the SEC office can think of such an extensive and difficult to answer set of questions then the private equity firms - with inside information - should be able to ask and answer many more questions.

These questions only scrape at the beginning of what the more vocal (but possibly less credible) shorts have been saying about the company. 

The private sector due diligence people are possibly more competent than the SEC officers (certainly they are paid far more) and they have full access to the books in China. So this due diligence should be done and it should be thorough.

Further because of the allegations around this company a thorough due diligence will be expected. It would be deeply embarrassing for a PE fund to close this deal and afterwards determine that they had been swindled (as per the way Richard Heckman was swindled in China).  

Further - given that the SEC has paid a fair bit of attention to this company - you can guess that at least some people at the SEC have their doubts about this company and its disclosures. If a PE firm were to buy this company and later discover it was a fraud they would run a real and nasty risk that the SEC would switch their investigation to them.

The risks to the private equity firms are thus uniquely high here. This is a large cheap transactions with an extensive SEC history of investigation and with untested fraud allegations.

If the PE buyers are right they make good money. And as it is the biggest deal in China that win could be huge.

But if the people alleging fraud are right not only will the PE firms lose money, but they will lose a lot of reputation and they will probably score a major SEC investigation into the process.

Big rewards. Big risks. And all soluble with thorough due diligence.



Bill Bishop said...

"There are a few things I learned here - like that the controller of Focus Media (Jason Jiang or JJ for short) has taken out Singapore citizenship. "

Jason Jiang is founder and CEO, not controller

Anonymous said...

I didn't see any mention of a likely closing date for the deal. Any guesses on the maximum time? I would think that even if one of the PE firms has already decided to drop out, they will wait a decent amount of time for appearances sake.

John Hempton said...

Bill - actually I think JJ is the controller.

In this case he owns the variable entity and the company has pretty thin powers of attorney over him.

You can't do very much without JJ -

So controller and CEO is accurate.


Anonymous said...

Hi John:

Nice analysis.

What bothers me is the fact that JJ is opening up books for the big PEs to examine. Not a smart thing to do if books are cooked. I am not saying this is not a fraud, just maybe the company is prepared somehow

Anonymous said...

An alternative narrative is that FMCN is a fraud but Carlyle doesn't care because there is an arrangement to flip it to a big-4 Chinese bank a few months after the buyout. In this view, Carlyle is just a big foreign name brought in to cover the Chinese PE partners. The outcome is capital extraction from a big-4 bank by the Chinese PE partners, and Carlyle effectively just earns a fee for renting its name & warehousing the fraud for a short time (like an investment bank). As we've seen with HRBN, big-4 banks are not averse to giving big loans for buying out Ponzi-schemes, if the Ponzi-operator is part of the kleptocratic class. The big-4 bank can later simply write down the fraud-buyout-loan, and the Chinese citizens will be none the wiser for how their negative-real-interest rate bank deposit ended up as a kleptocrat's Singapore condo.

Anonymous said...

To the commenter above:
That scenario is plausible but Carlyle should be out of their damn minds to sign up on it.
And I'm not talking reputation, I'm talking the elegant move of a "pre-agreed" Chinese bank SUDDENLY, as they say, refusing to buy it from Carlyle. (On the grounds that it is fraud, perhaps, hehe).

That way Carlyle is left holding the sack and being the subject of "captal extraction", and everyone else - fraudsters as well as good guys in banks - rub their hands and laugh.
This turn is a very likely component of a scenario you described :)


AAA said...

re last two comments -

anon I was thinking along similar lines but had missed the HRBN wrapup. Really interesting. I was also thinking the interested parties could be moving their target from the US equity markets to the US fixed income markets, where they might find some fresh sheep to shear.

Dmitry I've never worked at a firm of Carlyle's size and reach but as an observer I'd worry about what might politely be called agency problems. In this case presenting credible information to headquarters would be quite valuable to those on the short side.

As mentioned even considering the chances that the buyout and in fact the profits are perfectly legit, the risk/reward here is exciting.

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