OK, so we can imagine Ashton Kutcher misplacing his vehicle after a night's heavy partying (hey, if you end up with Demi Moore, we'll allow you room for quite a few transgressions!) However, it's another thing to misplace an entire forest...or if it turns out that all of those trees don't belong to you after all.
The saga of the Canadian quoted Sino-Forest Inc. impacts hedge fund investors in several ways.
According to the National Post, a leading Canadian newspaper, "Sino-Forest was one of the darlings on the TSX over the past five years, rising more than 2,000% since 2002 to a peak valuation in excess of $6 billion." This was, of course, before a damning report written by a short seller, Carson Block, of the firm Muddy Waters.
According to Muddy Waters (full research report available here), "like Madoff, Sino-Forest is one of the rare frauds that is committed by an established institution....The foundation of Sino-Forest's fraud is its convoluted structure whereby it runs most of its revenues through "authorized intermediaries" ("AI"). AI's supposedly process Sino Forest's (symbol: TRE) tax payments, which ensure that TRE leaves its auditors far less of a papertrail. On the other side of its books, TRE massively exaggerates its assets. We present smoking gun evidence that TRE overstated its Yunnan timber investments by approximately $900 million."
The most recent reports from another Canadian newspaper, The Globe and Mail, certainly don't look promising. This weekend, the Globe published a detailed article with the headline "key partner casts doubt on Sino-Forest claim".
"The Globe's investigation raises particularly hard questions about a key agreement in March, 2007, that SIno-Forest says gave it the right to buy timber rights for up to 200,000 hectares of forest in Yunnan for between $700 million and $1.4 billion. The trees were to be bought through a series of agreements with an entity called Gengma Dai and Wa Tribes Autonomous Region Forestry Co, Ltd., also know as Gengma Forestry. The company (i.e. Sino-Forest) says it has fulfilled virtually all of the agreement with Gengma and now owns more than 200,000 hectares in Yunnan. But officials with Gengma Forestry, including the chairman, dispute the company's accounting of the deal, telling the Globe and Mail that the actual numbers are much smaller."
The Globe decided to do due diligence the good ol' fashioned way - put boots on the ground, and physically go to meet the parties involved in China.
"To find Gengma Forestry, SIno-Forest's local partner in the so-called 'Yunnan master agreement" - the 2007 deal said to be worth as much as $1.4 billion - you have to duck down an alleyway behind the drugstore on the main street of this nondescript trading city, then up a dusty cement staircase. On the landing is the litter-strewn office with an open door and a window protected by metal bars. Despite signing a deal with Sino-Forest that should guarantee a windfall, the company has clearly fallen on hard times. 'Our relations with [Sino-Forest] were not totally good. They talked about a lot of things, but in the end it was hard to get money from them,' said Zhang Ling, Gengma Forestry's office manager."
Obviously it remains to be seen what happens with Sino-Forest, but even a generous observer would say that there is plenty of smoke and likely quite a few flames. Among those impacted is, of course, Sino Forest's largest shareholder, the Paulson funds - their 14% holding has lost, according to Business Week, more than $500 million since the Muddy Waters report.
In our next post, we'll consider some more implications from the Sino-Forest saga - particulary with respect to the audit process.
UPDATE: Bloomberg reports that Paulson, referenced above, has now sold his firm's stake in Sino-Forest, leading to a potential loss of up to $720 million.
Hedge Fund Operational Due Diligence
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