George Town, Cayman Islands (AHN) – Hedge fund manager MR Capital Management said on Tuesday that the current mispricing on Chinese reverse takeover (RTO) companies still offer opportunity to investors but due diligence must be conducted before investing in such firms.

“It is not a normal mispricing situation. It is a mispricing in value of growth and quality companies. This could be a great opportunity,” says Mohannad ALRashoudi, founder and fund director of MR Capital Management, which is managed by the Cayman Islands-based Global Consumer Loyalty Fund Ltd.

ALRashoudi’s advice comes as American companies avoid Chinese RTO companies in reaction to a regulation prohibiting U.S. accounting firms from opening their own auditing offices in mainland China. Instead, American companies are required to hire the services of local auditing firms.

He says that such market reaction is justified, especially when the subject is accounting fraud.

RTO, also called reverse merger, allows private companies to become publicly traded without undergoing an initial public offering (IPO) by buying sufficient shares, which are then exchanged for shares in the public company. This type of merger enables a private company to avoid paying expensive fees associated with an IPO. However, no additional funds are acquired through such merger and the private company must have enough funds to complete the transaction on its own.

Reverse mergers allow companies to immediately start trading without undergoing the usual underwriting process as required by the Securities and Exchange Commission. Many companies that took this route used unknown American audit firms that did very little due diligence.

The U.S. Securities and Exchange Commission and Chinese regulators are currently involved in an impasse about auditing procedures for U.S.-listed Chinese companies believed to be involved in fraud. These Chinese firms are able to fend off U.S. accountants from conducting audits, hiding from a Chinese law that forbids disclosure of “state secrets.”

According to ALRashoudi, this stalemate should be resolved quickly and added that no company should cover anomalous trading and use sovereignty to hide their insufficient financial transparency.

The alleged fraud has completely damaged some of these U.S. traded Chinese firms. But the MR Capital executive insisted that all that are needed are transparency and more compliance aside from conducting extensive due diligence.

“The problem here is that diversification in those companies isn’t a solution to participate, as diversification may well increase the risk. In our views, proper and extensive due diligence is the only solution. Then, you may and may not end with a single holding. As of today, no fund manager would like to be associated with Chinese reverse mergers, especially on the long side. But we prefer to do our due diligence,” says ALRashoudi.

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