‘China Orphans’ In Dealmakers’ Gunsights

American and international buyout shops are working on a series of deals to buy so-called “China orphans,” mainland firms listed in the United States and Singapore, with their stocks undervalued by investors who don’t understand their business model or home market.

The deals are pushing ahead even as a series of accounting and governance scandals that have tarnished the reputation of China companies listed overseas in recent months, and hammered stock values.

In May, Bain Capital Partners agreed to buy U.S. listed China Fire & Security Group Inc. for $265.5 million, becoming the first major global buyout firm to close in on such a deal. A slew of other buyout deals are in the works, including Kohlberg Kravis Roberts & Co.’s planned bid for Singapore listed Oceanus Ltd, Primavera‘s privatization of U.S.-listed Chemspec Ltd, and PAG Asia Capital‘s planned buyout of Funtalk China Holdings Ltd.

Singapore’s China Animal Healthcare , backed by The Blackstone Group, is in talks with investment banks to list on the Hong Kong stock exchange and delist from Singapore, according to four sources familiar with the matter. Blackstone and China Animal declined comment.

Such buyouts, known in banking circles as “take China privates,” involve delisting companies from the U.S. or Singapore and eventually relisting them in Hong Kong or China to increase their market values. The deal sizes are relatively small, but history shows there is a decent upside potential for the right target.

Morgan Stanley Private Equity‘s delisting of Sihuan Pharmaceutical Holdings Group Ltd is regularly cited as an example of returns that can be made with the right target. MSPE took Sihuan private in Singapore in 2009, identifying a company that required no additional work before relisting in Hong Kong in October 2010. The stock jumped 28 percent on its IPO, with top-end pricing valuing the company at 26.7 times 2011 earnings.

Even hybrid firms are jumping in on the act, with Morgan Stanley-backed Hong Kong fund Abax Capital in discussions with Harbin Electric for a buyout deal, according to sources working on the deal. Harbin has been in the market since last year and was previously in discussions with Baring Asia Private Equity, while banks are one point tried to line up financing to back a bid by CVC Asia Capital.

Such deals are not without significant risks.

The head of a leading regional buyout firm gave an example of a deal where his firm pulled out when it discovered that the target company had hidden unconsolidated shares at a subsidiary and had not disclosed that it had guaranteed loans for the subsidiary company. “I don’t see this kind of behavior anywhere else. I can only put it down to people trying to bury their problems, and hoping to deal with them in the future,” said the source, who declined to be named because the discussions were private.

Many of the small and mid-cap firms listed in the U.S. got there through reverse takeovers, while Singapore’s small and mid-cap “S-chips” ducked the more stringent requirements on profits and management continuity required by the Hong Kong Exchange. “There’s a reason why some of these companies listed through the back door. It’s because they couldn’t get in through the front door,” said one senior banker whose bank is working on a number of potential buyouts for orphan companies.

Funding for buyouts of Chinese companies is done through an offshore holding company, but the risk of non-payment is high, and many banks cannot lend on such deals. Banks have to get comfortable with the risk that the firm will make enough revenue to pay the debt, that it will agree to upstream the money to the holding company, and that the Chinese regulators will sign off on the transaction.

A previous Abax bid illustrated the risky nature of the deals and the need for a thorough due diligence process. Abax, which styles itself as a hedge fund and private equity firm, caught traditional buyout firms off-guard, jumping in with a bid for Fushi Copperweld in November 2010. Abax then broke off the talks in February, shortly before Fushi Copperweld restated its results for 2007, 2008 and 2009.

(Stephen Aldred is a Hong Kong-based correspondent for Reuters news service.)