This week Tencent Music Entertainment (TME), a music sharing subsidiary of Chinese entertainment giant Tencent Holdings Ltd, issued American depository receipts (ADR) representing a 5.5% share of the company. The issuance was conducted under an IPO at the New York Stock Exchange. Initially thought that the IPO would value TME at $25 to $30 billion ($16/share to $19/share), shares of the IPO were lowered to $13 after underwriters were unable to promise a complete subscription at the higher valuation. Shares of TME jumped 7% after the IPO and stayed at those levels until markets closed.
The IPO garnered $1.1 billion from investors, a nice pile of cash for the little amount of equity offered, and the resulting thin trading volume should continue to offer a floor under the IPO price. It wasn’t clear why TME chose to raise funds in the US instead of Hong Kong, although prestige and Chinese IPO saturation in the Hang Seng may have played a large part in the decision.
Perhaps more germane to TME’s valuation is the fact that Chinese company audit records are not re-viewable outside of China. Or more specifically, the US Securities and Exchange Commission (SEC) and the Public Company Accounting Oversight Board (PCAOB). Both institutions have been stymied by Chinese government refusal to allow the US to inspect the audit records of Chinese companies capitalized on US stock exchanges. Chinese regulators yielded records in 2013 and 2014 for two Chinese companies that had allegedly engaged in financial fraud in order to win a regulatory stay from US courts and the SEC, but have otherwise remained firm in their opposition to US regulatory oversight. Recently the SEC quietly issued market guidance that investors should be aware that Chinese companies do not release audit records and thus should be treated with caution.
Thus if Chinese audit records are not subject to US regulatory oversight for those firms capitalized in the US, then accounting fraud is theoretically possible and the value of affected firms should not be quantifiable. Or in other words, the value of those Chinese companies is essentially zero. And therefore the value of TME ADR shares is zero.
The inaccessibility of Chinese records is perhaps of secondary concern to the power of the Chinese Communist Party, which controls the organs of the Chinese state, to seize any business in China without compensation. There would be no recourse to such a move. So not only can Chinese companies commit accounting fraud under US law with impunity, they can also misappropriate company assets either directly (through fraud) or indirectly through seizure by the state. Circumstances like these would lead any US-based public company to be de-listed by any of the US stock exchanges and be put out of business by the SEC and the US Department of Justice. Instead, the SEC looks on in mute frustration while Chinese companies raise billions on US exchanges.
This situation is likely to continue until a significant amount of US investment is repatriated from China, thereby reducing the Chinese government’s leverage over the US government. Until then, investors should stay away from TME and other Chinese listings.
I hear Sears is looking for a buyer. Sure, go ahead and laugh.