The RTO a/k/a The Poor Man's IPO
Going public is no picnic. There are lots of required regulatory filings. It's time consuming. The issuer can be expected to fork over a substantial portion of the proceeds to the investment bankers in the form of a fee. When it's a foreign firm that want access to the U.S. market, there's an additional layer of paperwork relating to the creation and maintenance of American Depositary Receipts (ADRs) which are the instruments that actually trade in the U.S. each of which is made equivalent to a specific number of actual company shares (which don't actually trade in the U.S.)
Traditionally, companies wanting to enter our equity market had no choice but to grit their teeth and bear it.
Lately, though, we've been seeing a lot of companies choosing to bypass the process through something known as a reverse takeover (RTO).
This is accomplished when a privately-held operating company acquires a publicly-traded entity. The idea is that the latter not be a legitimate business but, essentially, a corporate shell. These aren't hard to find. If you remove all liquidity filters from your own screens, you may find many penny stocks that are little, if any, more than shells. After the takeover is completed, the managers of the acquiring firm take control over the newly merged entity and usually change its name to match that of the privately-held business. Voila! A privately held business is now associated with trade-able U.S. stock. If the stock already has a NASDAQ listing, so much the better. When the RTO is completed, listing applications are filed for those that aren't yet listed.
Lately, RTOs have been in the news because so many of the privately-held acquirers were domiciled in China. A lot of Israeli tech firms also entered the U.S. market in this manner. There's been little public fuss regarding the Israeli companies, but it seems that anything relating to China can't help but to generate debate. And indeed, this is not just idle chatter. It appears there have been instances of fraud among some Chinese RTOs and as might be expected, an army of commentators eager to mount the soapbox and preach about the evils of RTOs.
So let's consider some pros and cons.
The Pros
The RTO mechanism is fast and inexpensive. This may not have been a big deal to Google when it went public. LinkedIn seems to coping with the process today as it prepares its IPO. Facebook doesn't look to be going that route, but if it changes its mind, it could certainly handle the rigors.
But not every company worthy of our attention is up there with the likes of Google, LinkedIn or Facebook. There are many smaller firms for which the expense of an IPO would be significant. When dealing with micro-caps (often the smaller end of the micro-cap spectrum), it seems hard to criticize a CFO who would rather keep cash in the business than hand it over to investment bankers as a fee (a much bigger fee than for an RTO) for a service that could easily be avoided.
Another factor is timing. Because it takes so long for an IPO, a change in market conditions can easily cause the deal to be scrapped. That's not much of an issue with an RTO, since the shares to be traded are already in the marketplace and the RTO process can be concluded rapidly.
Although time and cost issues would seem most pressing for very small companies, they're big enough that sometimes, even larger firms that could handle an IPO if they wished have chosen instead to go the RTO route. The most well-known among these is, interestingly, the New York Stock Exchange itself (NYSE Euronext - NYX).
Logistically, for us as U.S.-based investors, there is an interesting additional plus for RTOs. The documents we look at are 10-Ks and 10-Qs prepared in accordance with U.S. accounting practices. We don't have to cope with currency translations. And since we use data to build screens and ranking systems, the fact that the RTO companies, following U.S. practice, report four quarters per year spares our models the occasional and at times substantial headaches associated with the semi-annual reporting we sometimes see in connection with ADRs.
Finally, there is what may be the biggest (and some would say most debatable) plus: the tendency to bring more companies into the capital markets. Simply put, there are many firms now available to U.S. investors that would not be available if the RTO path didn't exist.
As noted, the impact of this is debatable.
I present it as a positive because I believe the capital markets function more effectively when access is more open, with investors being the ones who get to make thumbs-up or thumbs-down judgments regarding merit.
Obstacles to access that knock investors out of the decision process sound good when considered in the context of a company that went bad. But it restrictions are what you really want, be careful of what you wish for.
Without broad access to the markets, Apple Computer might have been stillborn. There was tremendous opposition to Apple's IPO with many seeing it as being way too risky to be suitable to offer to the investing public. I remember an especially vehement fuss by the then Massachusetts Attorney General who proposed barring the sale of IPO shares to residents of that state (I think, but can't recall for sure, that this restriction actually occurred).
Without creative ways of dodging traditional the traditional IPO and borrowing processes, cable TV and cellular phones, and all we associate with them, might not exist. (Imagine your iPhone vaporizing! Blackberry and Droid users couldn't cheer, because their phones would likewise vaporize. But at least nobody would have to worry about their ESPN apps, because ESPN would also vaporize.) In order to get off the ground, those industries required junk bonds, the IPO-avoidance strategy of a prior generation. Junk bonds are popularly associated with LBOs, hostile takeovers, and some nasty and occasionally felonious sideshows that accompanied them. Actually, though, a big part of the junk bond market's ascent had nothing to do with that. "Original issue junk" was crucial as a way to provide financing for whackos like Ted Turner, John Malone and Craig McCaw who were viewed with scorn in the conventional equity and credit-market paths. (Equity was raised, but not nearly as much as was needed; junk bonds gave these businesses the push they needed.)
The Cons
A huge critique of the RTO process is that it lacks the vetting that supposedly occurs via the IPO process.
On paper, that's a compelling argument. But I don't think it stands up in real life. I think by now, we've all seen so many IPOs that went bad for one reason or another, with all such reasons being quite visible right from day one, I think we can pretty much assume that the notion of vetting is fiction. Regulators presumably do check to make sure the documents are correct in terms of the formalities, and undoubtedly, portfolio managers who are invited to attend investment-banker-led road shows enjoy the luncheons, or at least the cocktail hours. But experience suggests that these highly-orchestrated events are not conducive to serious securities analysis.
There is some bona fide pre-IPO analysis that takes place outside the official context; i.e. by ordinary portfolio managers and investors who crunch the numbers and opine as to the merits of the IPO (we're seeing lots of debate like this now with the pending LinkedIn IPO). That is very healthy. It's also no different than what can be and is done when considering an RTO company. Prudent investors can just as easily do their analysis before actually buying shares.
The IPO process does enjoy an aura of superiority given the glow of publicity and the rallies often enjoyed by the shares immediately after the public trading debut.
Actually, though, the post-IPO rallies we've seen stem from the shadier side of the endeavor.
Consider that these early profits are not usually enjoyed by investors in general but by a small number of clients of the firm that managed the offering as a "gift" of some sort for who-the-heck-knows-what favors. You are more likely to buy from the early profit takers, not the issuer, and as we all know, buying form profit takers is not generally seen as a path to equity-market success.
Next, consider the fact that these immediate post-IPO profit opportunities exist at all. What does that tell you about the pricing decision made by the underwriter? It seems that capital that could and should have gone to the company has been diverted, as a gratuity of sorts, to favored clients of the underwriting firm (this, of course, being above and beyond the official investment banking fee).
So when an RTO firms chooses to bypass the IPO, it's not exactly as if it's turning its back on one of the more hallowed aspects of our capital markets.
Another often-leveled critique of RTO firms is that the auditors many use are not drawn from the cream of the accounting crop.
That is true, as can easily be seen by looking at the financials. But I think the critics here are confusing causation with correlation. I suspect the cause of propensity to select lower-tier auditors relates to the fact that these companies are, at least at the time they debut, among the smallest in the publicly-traded universe, and that they'd have lower-tier auditors regardless of their method of going public. Investors who are bothered by use small, little-known auditors shouldn't be thinking RTO at all and should simply be avoiding much of the micro-cap sector, period.
The final, and most serious, con with regard to RTOs is similar, in flavor, to the auditor argument. There has been fraud here.
Actually, though fraud occurs in all segments of the market. Enron and WorldCom, as you may recall, were quite large and heavily followed on Wall Street. But this shouldn't diminish the fraud risk associated with the smallest companies. But that's the point! The risk is related to extreme small size and the associated obscurity. Tiny Chinese micro-caps bear this risk. So, too, do tiny domestic companies brought to the U.S. market via the IPO. I prefer not to elaborate because I don't want to have to use the word "alleged" ten times in each sentence. But I think most experienced investors recognize that this risk is significant and exists whether or not RTO is part of the picture.
There is one point I do need to make in terms of the fraud issue. Commentators often bash Chinese companies for presenting one set of numbers to U.S. investors and another to Chinese regulators. Yes, that's true.
It's also typical of U.S. companies, even the biggest and the best. If you read 10-K documents, particularly the accounting policy commentaries and footnotes, you see the impact of this sort of thing all the time. For example, most companies compute income for shareholder reporting using a depreciation method known as "straight line," wherein a constant portion of the book value of an asset is deducted every year. But in a separate set of financials presented to the I.R.S., many companies switch to one of several "accelerated depreciation" methods, wherein larger percentages of the asset's book value can be deducted in early years, thereby lowering taxable income. Differences resulting from this sort of thing show up on the shareholder documents in a line item labeled "Deferred Income Taxes" or something like that.
There are also other kinds of oddball numbers in financial statements filed by U.S. firms. Consider, for example, the par value of Walmart stock? Have you any idea what it might be? Hint: Forget the $55-or-so market price, which is not in the ballpark. The answer: $0.10 per share! This is a purely ceremonial; number that was never intended to have any relationship to ongoing market value (when shares are first issued, the difference between par value and the money that initially came in would be recorded as "Additional Paid-In Capital").
The bottom line here is that it would be quite easy for a Chinese writer who doesn't research the details of accounting to criticize U.S. companies as being inherently fraudulent because of a propensity to include fake numbers in their shareholder reports.
The sad reality, here, is that it's exciting to scream "Fraud!" and doing so will undoubtedly boost broadcast ratings and/or internet page views leading in both cases to higher advertising revenue while researching and discussing details of accounting will bore the daylights out of commentators and audiences and pretty-much produce no revenue. Keep this in mind when you encounter an RTO critic who cites reporting differences.
The Bottom Line
Bad things can happen if you fiddle with RTO companies.
Bad things can happen if you fiddle with non-RTO companies.
Most of the time, you'll need to be more on guard with RTO companies, not because they came public via the RTO but because they often reside in the smallest most obscure corners of the market, where risk tends to be high, RTO or no RTO.
Screening To Find Or Eliminate RTOs
You can get basic sense of how the Country function works (which, actually, is similar to the Ticker function) from the standard Portfolio123 reference area. The function is located in FUNCTIONS >> GROUPINGS.
Using the function, you can easily create screens and/or universes that consist of RTO companies or eliminate them. Here are some examples:
To find Chinese RTO firms, use these filters:
Universe(NOOTC) // or any other liquidity filter
Country("CHN") and Universe($ADR)=false
To find Chinese and Israeli RTO firms, use these filters:
Universe(NOOTC) // or any other liquidity filter
Country("CHN,ISR") and Universe($ADR)=false
To eliminate all RTO firms, use these filters:
Universe(NOOTC) // or any other liquidity filter
Country("USA")=false and Universe($ADR)=false
To eliminate only Chinese RTOs, use these filters:
Universe(NOOTC) // or any other liquidity filter
EVAL(Country("CHN"),Universe($ADR)=true,mktcap>=0)
