China Firms Face Research Armies

China Firms Face Research Armies

By ALISON TUDOR

HONG KONG—In a rundown block in an industrial section of Hong Kong, rows of researchers at a two-year-old firm called Blue Umbrella are trawling through documents such as corporate records, blogs and government watch lists. Their goal: to look for accounting discrepancies or investigate the financial claims of Chinese businesses.

Stuart Witchell is what you might call a private detective for investors who are interested in China but concerned about the accuracy of financial information on Chinese businesses. WSJ's Alison Tudor reports.
.It is a growth industry. Investors around the world eager to profit from China's fast-growing economy want to know the risks. And hedge funds are circling over more and more Chinese stocks they want to bet against.

Blue Umbrella investigates hundreds and sometimes thousands of companies and individuals every month, according to Allan Matheson, who runs the research firm. Blue Umbrella does the homework in China for hedge funds, banks and private-equity firms that are too busy or lack the language skills to do the job for themselves.

Most of the checks help investors conducting due diligence. But recently, there have been a flurry of orders from short sellers looking to make money by selling shares of companies whose financial statements look suspicious. "We're starting to see companies that are going on fishing expeditions," Mr. Matheson said.

Asia's bankers are feeling the heat as IPOs are delayed and worries grow over Chinese accounting. Plus, research firms are sprouting up that look into accounting discrepancies and financial claims of Chinese companies. WSJ's Jake Lee and Alison Tudor discuss.
.Michael Cheng, a 28-year-old Boston University graduate and researcher at Blue Umbrella, describes his job as "finding out who all the bad guys are for our clients."

The booming power of research firms and short sellers that say they uncover information about Chinese companies is highlighted by the splash caused by short seller Muddy Waters LLC, which issued a critical report this month about Sino-Forest Corp., a Chinese tree-plantation company listed in Toronto.

Muddy Waters alleged that there were overstated profits and other problems. Sino-Forest's stock tanked after the report, despite the company's strong denials.

Given the paucity of public data in China, it is often hard for short sellers to prove fraud or to quantify its presence. It is often equally difficult for the companies to disprove the short sellers' allegations quickly to stem the fall of their share prices.

"In emerging markets such as China, it's hard to get documentary evidence," says David Holloway, a former policeman and Interpol agent in Hong Kong who now is a private investigator. "You get the information from very discreetly speaking to people."

The hunger among investors with long or short positions on publicly traded Chinese companies to gain an edge is making lots of work for former diplomats, police officers, journalists and intelligence agents.

An in-depth investigation can cost millions of dollars, say people in the industry. Experts are available for hire at an hourly rate.

"We are giving people on Wall Street a chance to put themselves on the real streets of China, through our network," says David Legg, head of international markets at Gerson Lehrman Group Inc., which says it has a web of experts across Greater China.

Unlike in the U.S., where some so-called expert networks are facing regulatory and legal scrutiny since the prosecution of Galleon Group founder Raj Rajaratnam, Gerson Lehrman Group says it puts investors in touch only with experts who aren't inside the company.

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.In recent months, dozens of Chinese companies have acknowledged problems with their accounting. While there is no way to tell how widespread those problems are, the U.S. Securities and Exchange Commission has said it is investigating accounting and disclosure issues at Chinese companies that list on U.S. exchanges through "reverse mergers," a transaction that can avoid the regulatory scrutiny that comes with an initial public offering.

What researchers dig up doesn't always prove fraud or illegal activity. "There is no doubt that there are cases of blatant fraud among Chinese companies, but there are also a lot of companies who are just weak in corporate governance," said Violet Ho at corporate-investigation firm Kroll Inc. in Beijing.

Some investigators use computer technology. Kim Frisinger, a former U.S. Federal Bureau of Investigation agent based in Hong Kong who now works for consulting firm Control Risks, is setting up a new service in Asia that maps companies electronically by accessing their email servers, backup tapes, computers and laptops with the companies' permission. He is expecting brisk business from litigation as companies, their advisers and accountants seek to pinpoint if and how fraud happened by checking documents. The firm's revenue from its corporate investigations practice in China is up 150% in the past two years, he says.

Such investigators are supposed to abide by privacy laws. And some investors tightly control the questions asked by investigators or prefer to do most of their own due diligence.

"When we've looked at agricultural businesses in China, we've visited the farms, talked to other farmers and counted the trucks," says Jonathan Zhu, managing director at private-equity firm Bain Capital. Mr. Zhu uses advisers to complement his own investigations.

John Hempton, chief investment officer at hedge fund Bronte Capital, based in a suburb of Sydney, Australia, pored through financial statements of New York Stock Exchange-listed Chinese financial-software company Longtop Financial Technologies Ltd. while on a weeklong vacation on a Thailand beach earlier this year.

Bronte Capital decided to short Longtop shares, which Mr. Hempton wrote about in his blog. Since then, Longtop has said its auditor, Deloitte Touche Tohmatsu CPA Ltd., resigned, and the U.S. Securities and Exchange Commission has launched an investigation of Longtop.

"It was like shooting fish in a barrel," says Mr. Hempton, 44 years old. However, more competition from other hedge funds could force him to spend more time researching each company and to hire more outside sleuths to help him dig even deeper, he says.

Longtop has said it will conduct an independent inquiry into why its auditor resigned. Longtop representatives didn't respond to requests for comment. John Nester, a spokesman for the SEC, declined to comment.

A spokeswoman for Deloitte's global network referred questions to its Chinese affiliate. Efforts to reach the Chinese firm were unsuccessful.

Kerrisdale Capital Management LLC said in a report dated May 5 that it had hired investigators to visit the Chinese facilities of Advanced Battery Technologies Inc., to take photographs and provide commentary that helped the New York investment firm decide to short the Nasdaq-listed company. Kerrisdale said it had studied Advanced Battery's financial statements, concluding that revenue and profits were overstated in SEC filings. For example, financial statements filed by the company in China show sharply lower revenue for 2009 than it reported to the SEC, according to Kerrisdale.

Advanced Battery's chief executive, Zhiguo Fu, denied Kerrisdale's allegations in a phone interview. The company's shares are down by about two-thirds since March. According to a letter to Kerrisdale investors, the investment firm gained 73% in the first quarter, net of fees, propelled by short bets on Chinese companies.

Write to Alison Tudor at alison.tudor@wsj.com