ShangPharma (SHP) going private

ShangPharma announced at the end of December that it has reached a definitive merger agreement for a going private transaction. The company intents to pay shareholders $9.00 per ADS (minus a 0.05$ ADS cancellation fee) and expects to close the transaction in the first half of 2013. With the shares currently trading around $8.57 a successful transaction would generate a 4.4% return. This is certainly above average, but is it also above average risky?

Going private transactions in China

I wrote a few paragraphs about this subject in my post on Nuokang, and I’m not going to repeat that. One interesting thing to note is that all going private transactions mentioned in that post have been completed successfully with the exception of Nuokang itself, but that’s not a surprise since this was the only deal that was scheduled to be completed in the first quarter of 2013. So far the Nuokang deal also seems to be progressing as planned, and I expect it to close this month shortly after the extraordinary general meeting of shareholders on January 15. Even the Fushi Copperweld (FSIN) deal closed last year.

ShangPharma Corporation

The obvious question to ask when looking at something Chinese is, “is it a fraud?”. The most important check is in my opinion looking at the history of debt offerings, equity and insider sales. If you want to defraud investors you need to sell them something first.

ShangPharma went public (prospectus) at the end of 2010. The company sold 3.2M ADSs at $15, raising $44.6M after fees and insiders sold 2.6M shares for a $36M payday. Before the IPO directors and executive officers owned 74.9% of the company, and after the IPO this percentage dropped to 55.8%. Since then there were no big changes in the ownership structure: today directors and executive officers as a group own 55.5% of the company. The company never issued debt, and last year both the company and the CEO bought back stock. So while the IPO created a nice payday there isn’t a pattern of insiders trying to sell whatever they can to outsiders suckers.

Related party transactions (or other significant transactions) also deserve to be examined. Because once you have raised cash from shareholders you need a little bit of creativity to let it disappear. With most of the cash that was raised in the IPO still on the balance sheet there doesn’t seem to be a big problem in this area. I would have liked to have seen a bit less related party transactions though: I would guess that ~10% of revenue is paid to suppliers that are related to the CEO.

One thing that is good to see is that the financials aren’t great. If the numbers aren’t real, why would you report declining income and declining margins? At the same time the numbers are still good enough that you would think that the buyers are getting a good deal at the offering price. That’s of course also important: you want that the buyers are motivated to complete the deal, otherwise you risk that they find an excuse to walk away.

So ShangPharma passes my “is it real” smell test, but that’s not the only thing that could stand in the way of a successful transaction: most notably financing and shareholder approval could be an issue. Based on the proxy statement released by the company those two risks seems to be quite small. The buyer group does have financing available, and they also have enough voting power to approve the deal. The buyer group controls 66.9% of the outstanding shares while 66.7% of votes are required to approve the transaction.

Conclusion

The possible return of this merger arbitrage deal is limited, but I think the same can be said about the related risks. I don’t think the deal is significantly more risky than the average deal, yet at the same time the market is offering a significant above average return. That sounds like a good combination to me. Making a 4.4% return in three months time isn’t bad.

Disclosure

Long SHP & NKBP

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