Big Funds See Red in China

Date: Thursday, June 9, 2011
Author: Steve Elder, Mary Pilon and Michael Rapoport, The Wall Street Journal

Hedge-fund titan John Paulson is hardly alone in his wager on a Chinese company whose stock lately has swooned. Several other prominent money managers, including mutual-fund giants that invest individuals' money, made similar bets on stocks now struggling.

A Wall Street Journal review shows that some big-name investors, from Fidelity Investments to Carlyle Group, in recent years snapped up shares in Chinese companies that trade on Western exchanges.

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Shares of some of the companies shot up after the financial crisis as investors looked for ways to share in China's fast economic growth. But, in recent months, shares of many of these Chinese companies have tumbled amid questions from regulators and investors about the truthfulness of these companies' finances and operations.

The Securities and Exchange Commission has said it is investigating accounting and disclosure issues at some Chinese companies that list on U.S. exchanges. Trading has been halted in more than a dozen U.S.-listed stocks of Chinese companies.

An SEC official said the commission plans to issue an investor bulletin as soon as Thursday detailing some of the risks surrounding companies that have listed in the U.S. through "reverse mergers"—a mechanism that helps companies avoid detailed disclosures required in initial public offerings. The bulletin is expected to mention accounting problems at some Chinese companies recently been hit with SEC trading suspensions.

Trading was halted in Beijing-based Longtop Financial Technologies Ltd. in May when its chief financial officer and external auditor resigned amid an SEC inquiry over its accounting practices. The financial-technology company, listed on the New York Stock Exchange, announced the inquiry and investigations in a news release, saying it "intends to cooperate fully" with the SEC.

Longtop shares have gone from trading around $12 after the financial crisis, to $40 in the past year, to $18.93—where they has sat since May 16.

Among Longtop's biggest investors has been Boston-based Fidelity. The mutual-fund giant held 14.5% of common shares outstanding as of March 31, according to Capital IQ, which tracks investments based on regulatory filings. Other major investors have included hedge funds Maverick Capital Ltd, with a 9.8% percent stake as of that date, and Tiger Global Management LLC, with a 4.6% stake. Other holders, according to Capital IQ, have been mutual-fund houses Putnam Investments and Janus Capital Management.

Fidelity, a shareholder since the company was listed in 2007, invested in Longtop mostly through its two funds Fidelity Advisor Global Capital Appreciation and Fidelity Advisor Mid Cap II, according to people familiar with the matter.

The Longtop holdings were small for Fidelity, making up a sliver of the large funds, according to data from Morningstar. Based on the March 31 holdings data—and provided that its stake had remained constant—Fidelity would have recorded a fall of about $100 million in the value of its investment since March 31.

A Fidelity spokesman said, "We perform rigorous analysis on all potential investments for our funds," adding that Fidelity has "decades of experience investing in the Asia region, and our funds that invest there have been successful."

Representatives for Maverick, Tiger Global and Putnam declined to comment on the holdings. A representative for Janus didn't respond to a request for comment. A spokeswoman for Longtop this week said that the company's audit committee has hired a U.S. law firm to coordinate with the SEC in launching an independent investigation.

Critics of investors who have dabbled in Chinese companies say pain they suffer may be deserved.

Gordon Chang, author of the book, "The Coming Collapse of China," called U.S.-listed Chinese companies a "classic bubble," saying investors want to believe the narrative coming from China.

"Anyone who knows the first thing about the way Chinese companies operate know there are severe problems," he said. "If you are going to invest in a company, you've got to investigate."

Others say investors betting against these companies are spreading negative sentiment that is overdone and punishing legitimate firms.

Critical reports from short sellers, who benefit when stocks' prices decline, are "akin to rumor-mongering," says Perrie Weiner, an attorney who has represented U.S.-listed Chinese companies in shareholder lawsuits and SEC investigations. The short sellers "have a built-in economic motive" to broadcast critical research about these companies, he said.

A long list of money managers like Fidelity have invested in Chinese companies that have made public filings over the past six months, alerting investors to potential accounting errors, fraud, a change in auditor or regulatory investigation.

Firms to have invested in Chinese companies that have made such filings include the Vanguard Group; hedge-fund managers Citadel LLC, AQR Capital Management and Renaissance Technologies LLC; and private-equity firms Carlyle and Oaktree Capital Management, according to Capital IQ. Wall Street firms such as Goldman Sachs Group Inc. and Morgan Stanley invested on behalf of clients, the database said, as well as the California Public Employees' Retirement System, the largest U.S. public pension fund.

For many large investors, the holdings are tiny slices of their portfolios. Also, investors may have exited their positions, so gains or losses are unclear.

For Vanguard, the shares reflect holdings in passive index funds, a spokesman said. Hedge funds like AQR and Renaissance often buy stocks based on quantitative factors rather than any belief in their fundamentals.

Besides Vanguard, managers or their spokesmen at these funds and banks declined to comment on the reported holdings.

Mr. Paulson's hedge-fund firm has owned about 14% of shares outstanding of Sino-Forest Corp., a Toronto-listed Chinese company whose stock has fallen in the wake of a highly critical report by a short seller last week.

Sino-Forest has strenuously denied the report; it has appointed a committee of independent board members to investigate and answer the allegations. Meanwhile, it has been posting documents it says dispute the report's conclusions.

On Wednesday, the Ontario Securities Commission, Canada's largest provincial securities regulator, said it is investigating the controversy. Paulson & Co. last week sent a letter to its investors, saying it is "aware of, and is investigating, claims" made by the short seller. Paulson said its position in the stock represented about 2% of its Advantage hedge fund, but wasn't in other funds managed by the firm.

Some observers say the broader controversy won't necessarily take a big toll on investors.

"The market will punish those who invested in" these firms, said Mercer Bullard, a professor at the University of Mississippi School of Law, who said some mutual-fund managers don't do forensic accounting of investments on their own but rely on the company auditors. "Those who were diversified within China or weren't heavily exposed at all are going to be okay," he said. "It's more of a blow to China as an investment than to fund managers."

Write to Steve Eder at steve.eder@wsj.com, Mary Pilon at mary.pilon@wsj.com and Michael Rapoport at Michael.Rapoport@dowjones.com