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Harbin Electric's LBO Skeptics Remain

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NEW YORK (TheStreet) -- Doubts about the truth behind Harbin Electric's (HRBN) leveraged buyout persisted Monday, despite the company's announcement of a definitive agreement for a deal, long promised by the management of the Chinese reverse-merger company.

Harbin shares did indeed soar once the regular session began. By the close of trading Monday, Harbin shares stood at $13.35, up almost 60% on the day.

But that's a far cry from the announced buyout price of $24 a share.

One trader who specializes in merger arbitrage, Thomas Kirchner, of the Quaker Funds, told TheStreet that his fund had sold out of its position in Harbin at the end of May. "There are quite a few red flags in this deal and we continue to be pessimistic about it," he said.

In a press release, Harbin said its board of directors signed a definitive agreement to sell the company to its founder and CEO, Tianfu Yang, along with a Hong Kong-based fund called Abax, which has been involved as an investor and counterparty in several deals with U.S.-listed Chinese companies.

According to Harbin, much of the funding for its LBO, a term loan for about $400 million, will come from China Development Bank, a massive state-controlled institution that last year made a $50 million loan to Harbin, for which Yang pledged his own Harbin shares, 7 million of them, as collateral.

Harbin's U.S.-based spokesman didn't immediately respond to a request for comment.

The events of the last few weeks have quickly made Harbin the subject of one of the noisiest long-short battles in the Chinese small-cap space, which has been rife with controversies for almost a year. A manufacturer of micro motors based in the city of Harbin, in northern China, Harbin came public in a reverse merger in 2005. It is one of dozens of small Chinese companies that have come under extreme scrutiny after an outbreak of fraud allegations and revelations, which have eroded investor confidence in the group at large and triggered an investigation by the Securities and Exchange Commission.

Investigating Chinese Reverse Mergers

Harbin itself has not escaped allegations that it has engaged in fraud. Short-sellers have been swarming around the stock since last year. One of those short- sellers is Andrew Left, who runs the Citron Research blog, where he publishes reports on companies he has taken a short position in. In recent weeks, Left has led the charge against Harbin, calling the company's buyout plans "a sham" and urging the SEC to "halt this security." Left posted his latest missive on Thursday and appeared to help push Harbin's stock down 51% that day.

In its press release on Monday, Harbin CEO and founder Tianfu Yang came out fighting. His words appeared to refer to Left. "A significant amount of information that is false and misleading as well as defamatory has been introduced into the market, and has clearly affected market trading of the Company's stock," Yang said in the press release. "The Company is prepared to take all necessary legal action against those who have made such statements." Yang's threat of legal action follows a recent trend of Chinese companies promising to sue their critics for libel and stock manipulation.

Contacted by TheStreet on Monday, Left said he stands by his position that Harbin's LBO is a fake.

But, he added, "My thoughts are irrelevant compared with what Wall Street says; the Street votes with its dollars. Unless the stock gaps to 19 or 20, then what are we arguing about here? I would venture to say, if they are able to pull this off, in the history of M&A there's never been a stock that's traded so far below the takeover value when a deal has gone through."

Though he has made himself into Harbin's most public critic, Left isn't alone. Short-sellers have questioned the company's results as reported in its SEC filings. They've raised questions about Harbin's profit margins, which had outperformed its peers both in China and elsewhere. Visitors to the company's factories, meanwhile, have reportedly found the facilities outdated in comparison with competitors in China. In recent quarters, though, Harbin's financial fortunes appear to have stalled, its revenue flat and its margins narrowing.

Left and others say that Harbin's buyout plans are designed to prop the company's stock price in the face of worsening business results and the $50 million loan that Harbin took from China Development Bank (the one for which the CEO pledged 7 million of his Harbin shares as collateral). According to Kirchner, the merger arb, this was a major warning sign. "There's always a risk when you have a CEO pledging shares in a loan."

The bears also argue that the economics of the Harbin LBO don't make sense. One way for Yang and his partners in the LBO to exit their investment eventually would be to relist the company on the Hong Kong stock exchange. "But our Hong Kong contacts tell us that that would be very difficult to do with this type of business," Kirchner said. "They just don't think that Hong Kong is that susceptible to a Chinese industrial electric motor company. That basically erased the rationale for that whole deal. So if you put that all together, it was just too risky."

Yang has been attempting to take his company private since last October. But when private-equity fund Baring walked away from an LBO agreement weeks later, skepticism bloomed about whether a deal would ever go through. Several times since the start of 2010, Harbin has issued press releases or made regulatory filings announcing Yang's intention to pursue a management-led buyout, assuring investors that a deal would be done shortly and that financing was in place.

On two other occasions, Yang apparently disclosed information about a deal to individual investors before first releasing that information to the public at large. In April, Harbin was forced to issue an 8-K filing with the SEC, disclosing the fact that Yang had told an analyst at William Blair a few days earlier that a buyout agreement would be struck in a matter of days. Then, in a letter to investors dated Friday, June 3, Peter Siris, the principal at New York-based Guerrilla Capital, one of the U.S.'s major investors in Chinese reverse-merger stocks, said that he had recently met with Yang over breakfast while on a trip to China.

"We believe [Harbin's independent board of directors] will announce that they have accepted a deal within the next week and that the deal will be completed in three to four months," Siris wrote in the letter. The week after Siris sent his letter, Harbin shares rose 12%.

Siris couldn't be reached for comment.

According to Siris in his letter, the China Development Bank will make good on its financing. As a "policy bank," used by the Chinese government "for the purposes of making economic policy," Siris wrote, China Development has reasons to lend money for a Harbin buyout beyond making a profit on the specific deal. That's because the bank "has a unique problem. It is awash in dollars. It has gotten these dollars through buying U.S. T-bills and other assets." Now, the bank wants to dump those greenbacks before China's currency, the renmimbi, rises any more against the dollar, as many market pundits expect.

"If the U.S. pays it 2% on T-bills and if the RMB appreciates 5% a year against the dollar," China Development loses money, Siris wrote. "As a result, it is willing to make deals that help it to get rid of dollars at much lower interest rates and on much better terms than other institutions."

Other longtime observers of Chinese stocks -- including one who typically hunts for opportunities to sell stocks short -- say it's dangerous to believe that a Harbin LBO is unlikely simply because the economics of the deal defy normal logic. "The whole thing is surreal," this researcher said, agreeing that a buyout doesn't appear to make economic sense for the buyers. But a bank like China Development doesn't need the deal to make economic sense, he said. "Look at the ghost cities in China. Those don't make economic sense, either."

Other factors might go in favor of a Harbin deal. Yang's partner in the LBO, Abax Capital, has close ties with China Development (as, reportedly, does Yang himself.) According to Abax's Web site, China Development is one of the fund's anchor investors.

-- Written by Scott Eden in New York

>To contact the writer of this article, click here: Scott Eden.

>To follow the writer on Twitter, go to http://twitter.com/ScottEden.

>To submit a news tip, send an email to: tips@thestreet.com.

Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.

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