To the casual observer, being a venture capitalist probably seems like being an American Idol judge: People kill for that one chance to show off their best moves while all you do is sit back, Sphinx-like, and with a nod of the head make a decision that will change their career forever. That it’s not remotely so cut and dry as ferreting out bad singing is irrelevant; major venture capital firms occupy an inarguably powerful place in the economics of the modern market. It is difficult indeed to trace a single technological development of the past 40 years that didn’t at some point get funding from at least one venture outfit.
The venture capital business model is simple, at least in the abstract: Find a promising company with some compelling technology or business plan and give them enough capital to get moving until they have something approaching critical mass. Depending on where the company is with its product or plan, the VC can often reap a multiple of their investment when an initial public offering occurs.
At the top of this world is Menlo Park’s Sequoia Capital, a fixture in the San Francisco–and now global–technology scene, whose track record includes providing early capital to Apple, Cisco Systems and Google. Though they are as market oriented and commercially driven as any Wall Street firm, VC’s–and Sequoia in particular–have a “white hat” reputation, in that they not only play a key role in bringing game-changing companies to the market, but unlike most of institutional Wall Street, they had no real role in the Credit Crisis. It might be said VC are the last “cool capitalists,” or barring that, at least that no VC screwup led to a bank failure.
Then there is Neil Shen.
The founding managing partner of the $1 billion Sequoia Capital China Fund and a veteran of Lehman Brothers and Deutsch Bank, Shen is the rare bird among VCs in that he hasn’t been just a funder of companies, but also founded a pair of publicly traded companies, Ctrip.com and Home Inns.
Shen’s hat color is subject to debate. According to a host of Securities and Exchange filings, publicly traded companies where Shen is a board member have a robust history of taking spectacularly ill-advised stakes in other Sequoia-backed companies.
That’s the good news.
The bad news is really, really bad.
Shen is a board member of Focus Media, a major Shanghai-based advertising company that Muddy Waters, a West Coast-based short-selling research boutique, recently savaged in an 80-page report. Authored by Carson Block, whose credits include being the first to sound the alarm over the fraud and improprieties at RINO and Sino-Forest, the report details a level of insider self-dealing and board-level incompetence at Focus rarely seen on these shores, even in the wake of the financial sector’s debacles in 2008.
Shen has a small but important role in Focus Media’s strange doings.
Consider Focus’ March 2007 purchase of Allyes Information Technology for just under $297 million. Touted then as “The largest Internet advertising company in China,” the deal was nicely timed for Allyes’ investors, where, as recently as 2005, a trade publication pegged its valuation at $120 million.
What hadn’t been known was that the selling group included Focus chief executive Jason Jiang and board member Neil Shen. Shen, whose given name is Nanpeng, controls a British Virgin Islands shell, Smart Master International Limited, that held his personal investments, including the 0.45% Allyes stake, which was worth about $540,000 before the March 2007 deal, according to Securities and Exchange Commission documents. After the deal, it was valued at $1.33-million, for a profit of $793,000 in under two years time and a 146% return on his capital.
Focus’ disclosure on this deal, to be charitable, was virtually nonexistent. Buried in an exhibit attached to page 22 of an underwriting agreement is a carve out for Focus insiders to “a passive investment” in Allyes. This, it should be noted, defines “passive” so broadly as to be pointless since Focus bought–and later sold–the company. Focus insiders, in other words, were the very opposite of “passive.”
That was merely the pre-game, however. The self-dealing really kicked in when nine months later, in December 2007, Focus wrote the Allyes investment down to $82 million–it would take $259 million in write-downs by the end of 2010–before selling 38% of the then seemingly worthless unit to company insiders for $13.3 million.
As Muddy Waters’ Block noted, the move to allow the insiders to buy-in was odd, in that 87% of the book value had been written down at that point. Odder still was that the $13.3 million figure valuing the entire company at $35 million, a $5 million discount to the cash on hand and a 42% discount to the $60 million book value. Warren Buffett dreams of buying companies at a discount to cash value in his billionaire sleep. It’s challenging–absurdly challenging–to imagine a scenario or accounting regime where a company without liabilities of note would be forced to value itself below cash value.
The reason given for the insider’s purchases are also difficult to grasp.
Ostensibly they were to “incentivize” management to find a way to rationalize the seemingly collapsing Allyes business, but chief financial officer Kit Leong Low, a former Goldman Sachs analyst who covered the company, and CEO Jiang, are both multimillionaires (with Jiang on the path to Billionaire-dom with nearly 101 million shares, amounting to a greater than 15% stake in the company,) so the notion of them not being aware of the need to turn the unit around (or of being problematically under-compensated) is far-fetched.
One can’t argue with results, however, and Silver Lake Partners, a major private equity firm, bought 90.8% of Allyes just nine months later for $181 million.
Cutting to the chase, there are two ways of viewing this sale. Seen Focus’ way, it was a fortuitous rally in the value of online advertisers allowing them to sell Allyes at over three times book value to one of the world’s most sophisticated financial shops. This argument of course assumes Silver Lake, one of the biggest players in Chinese mainland private equity, has no ability to discern or price value, especially in the Internet sector where they own (or owned) numerous high-profile companies.
On the other hand, Focus investors, who booked over $160 million in losses in two years–while insiders repeatedly reaped millions in profits from private, non-disclosed deals they could not participate in–would likely see this as self-dealing with their capital.
Evaluating Shen’s performance as an independent director is easy assuming that everyone is clear on the criteria being used. If U.S. standards were applied, he would likely have been sued into the next dimension of time and space. Alone among his fellow board members, Shen–with a dozen years of U.S. corporate executive experience prior to becoming a VC–has an understanding of what so-called best practices are in terms of conduct and disclosure.
Of the 9.2% remaining stake in Allyes, The Financial Investigator has been unable to discern the ownership structure of two British Virgin Island trusts that hold one-third (or 3%) of the remaining non-Silver Lake shares, Bronco Venture Ltd. and Unidex Holdings Ltd. It is highly likely those entities, however, are owned in some combination by CFO Low and Jiang.
The Financial Investigator sent Shen an E-mail seeking comment trying to reconcile these transactions with the idea of being an independent director but did not receive a reply. FI called Mark Dempster, Sequoia’s chief of U.S. marketing, but he declined to comment. An E-mail sent to Focus’ Investor Relations department was not returned.
[It should be noted that this is not the only instance where a Chinese management has bought a company and shortly thereafter written nearly the entire value of the unit down. In 2008, Spreadtrum Communications purchased San Diego-based Quorum Systems for $70 million in cash and stock. Backed by some of the highest profile VCs in the US, Spreadtrum had taken $53 million in impairments from the Quorum deal by the end of the year.]
Focus Media isn’t the only battleground stock Shen is on the board of. Short-seller Andrew Left’s Citron Research website has released a series of increasingly scathing articles on Qihoo 360 Technology, an Internet portal claiming to be China’s third largest. Of special interest is the conclusion to Left’s December 7th report where he casts a critical eye on Qihoo’s claims of growing ad sales 25% quarter-to-quarter (144% annually) at a time when Sina’s Weibo, China’s most popular Internet property, reported only 26% annual growth.
Another possible trouble spot for Shen and Sequoia is VanceInfo Technologies, an information technology company in Beijing that the fund had seeded. Gradient Analytics, an accounting research shop with a track record of picking off trouble early for its subscribers, initiated coverage with an “F” rating in June, raising extensive concerns about its revenue quality, receivables, accounting controls and margins.
Then there is Shen’s circular world, a sort of movable feast of baffling deals that appear designed to reduce Sequoia’s exposure to a series of Internet companies he invested with.
As with the Allyes deal, the effects are zero sum: Sequoia and Shen profit, investors lose.
The transactions start with Sequoia’s participation in the March 2009 $180 million private placement in New Wave Investment Holdings, a holding company controlled by Charles Chao, the CEO of Sina, a large Internet portal and social media company that was a key investment for Sequoia before its 2000 IPO.
Sina, whose most valuable property is Weibo, the Chinese language equivalent of Twitter, bought a 34% stake in China Real Estate Information corporation, a real estate listings and services website, in its October 2009 IPO. Whether this was a good idea depends on where you sit. It has been a disaster for Sina shareholders, who suffered a $128.6 million write-down in their stake in CRIC in March–the American depository shares were then $6.63; they are now $4.27–but it has given Shen, a board member since the IPO, a chance to help arrange a non-binding $6.62 bid from E-House, another online real estate company where Shen holds an 11.5% stake personally and through a stake in a holding company.
Somewhat amazingly, given the deeply non-confrontational nature of the relationships between Asian equity research analysts and the companies they cover, at least one sell-side analyst has used the Muddy Waters driven debate over Focus to reiterate his bearishness of Sina. Paul Wuh of Samsung Securities has maintained a Sell rating on Sina at least in part because of the money-losing investments.
Another crummy trade for Sina has been its purchase of a $66 million block of online apparel portal Mecoxlane from Sequoia. The block, amounting to 19% of the ADS, was at an average price of $6 and including call options to purchase the stock at $8, has given Sina a $51 million hickey at current ADS prices.
[A brief aside: While looking at the investor list of Sequoia-funded Noah Holdings, several curious patterns emerged. As of November 2010, apart from Sequoia's 21.6% stake, most every major investor owned their shares through an entity whose address traced to Drake Chambers, Tortola, British Virgin Islands. Moreover, several of the entities were traceable to players in collapsed promotions like American Oriental Bioengineering, China Pacific and Lingo Media.]
Sina’s investors are far from being the only ones to come up short for having played a former Sequoia portfolio name. Nearly everyone who has played Shen’s IPOs have suffered mightily as the following chart–which looks at the performance of Shen/Sequoia backed IPO’s in the U.S. markets–shows. Ironically the two exceptions, VanceInfo Technologies and Qihoo 360 Technology, have faced heavy public criticism.
Though the concerns over Chinese macroeconomic health, coupled with growing concerns over accounting and governance, have likely weighed on Chinese stock prices, this portfolio’s blues can’t be traced to the collapse of the reverse-merger market. Every one of these companies had Sequoia and other VC backing, major Wall Street underwriters (and their uncritical research support,) big law firms signing off on the books and white-shoe legal advice. Put frankly, their share prices are sinking because of well-documented failures to execute or because their products are facing stiff competitive headwinds.
On paper, it might seem that life could get hairy for Neil Shen at virtually any second. Muddy Waters doesn’t appear to be going away anytime soon on Focus Media and Andrew Left is firmly at war with Qihoo 360. None of the U.S.-listed companies from Sequoia looks terribly robust and any future IPOs are certain to meet with much more skepticism than the first batch from 2007-2010 encountered.
But we can be assured Neil Shen isn’t suffering. Sequoia got out of its positions at many multiples of the value of its original investment and, should that prove insufficient, he has his board seats, stock holdings, his disclosure-lite deals and behind-the-scenes influence. More importantly, he appears to have the tacit approval of his colleagues in Menlo Park, who privately must wonder at how one man can get away with so very, very much.