Tycoon's allegiance doesn't come without strings

Cheng Yu-tung rarely campaigns for anyone other than his own business. Yet for Evergrande Real Estate Group, he is at centre stage.

He showed up at last week's roadshow presentation as the mainland developer kicked off its HK$6.4 billion share sale.

'I like Evergrande. It is such a good bargain,' the chairman of New World Development told the press. Cheng showed them the money, too. He subscribed for US$50 million of Evergrande shares as a cornerstone investor.

And he showed up with his super-rich friends - Joseph Lau Luen-hung of Chinese Estates Holdings, Charles Ho of Sing Tao Holdings and many more. Lau also spent US$50 million to become a cornerstone investor. Their pictures and support were all over the Hong Kong and mainland media.

Credibility, money and connections ... Cheng is blowing the Evergrande trumpet hard. But why?

Evergrande founder Hui Ka-yan is not known to be among Cheng's family friends. Their first known business co-operation happened only last year. A US$50 million initial public offering bet is not something that a tycoon like Cheng will blink at.

How about a 142 per cent return in 18 months? Will that make more sense?

This is what Cheng will get if Evergrande has a successful offering, according to the company's prospectus.

Let us wind the clock back to April last year. Hui had a HK$25 billion funding hole to fill after years of aggressive bidding for land. A plan to raise HK$15 billion from a share sale was poorly received and called off. Doors of mainland banks were closed, given the state's austerity policy.

Investors such as Merrill Lynch, Credit Suisse, Temasek Holdings and Deutsche Bank, which earlier put in US$900 million, hoping for a windfall with an offering, were reluctant to chip in. Deutsche Bank wanted its money back, and Credit Suisse was dumping its paper at a deep discount.

After three months of painful searching, Hui found Cheng and Kuwait-based Global Investment House. The rescue didn't come cheap.

Cheng gave Evergrande US$150 million. In return, Hui promised him a minimum return of 100 per cent by March next year.

This is how it works. Hui gives Cheng Evergrande shares at a cost of HK$1.65 per share upon the company's global offering, and the offering price is set at a level that satisfies the minimum return.

If the stock is priced at HK$4, he has a 142 per cent return. If it is priced at the low end, the return is 82 per cent. (Given the chance of completing the share sale in November, the return has been adjusted down to 82 per cent.)

In short, as long as Evergrande makes it this time, Cheng will already be sitting on a handsome profit. The better the subscription is, the higher the offering price, the higher his return.

It is true that this is just a paper gain, because Cheng has agreed to a six-month lock-up. Should the price drop, Cheng's real gain will be affected.

But Hui has given Cheng a 12-month promise to compensate him should the value of his stake drop 18 per cent below the offering price.

On the same terms, the Kuwait investor chipped in US$116 million. With two major anchor investors, six others joined, bringing in US$506 million for the debt-ridden developer. Evergrande is once again live and kicking.

Now you see why Cheng is championing Evergrande.

Yes, he did put in an additional US$50 million. But that will only raise the cost of his Evergrande investment from HK$1.65 per share to HK$1.93. That's not too high a cost to pay. There is nothing wrong with that. If you read the prospectus in detail, you will know his interest well.

(In that sense, he deserves more respect than those celebrity-grade stock commentators, academics and fund managers who are paid tens of thousands to show up at a listing conference. Under the law, they are not required to tell the public that they are hired hands. Neither do they have to show that they actually subscribed to the shares as they boasted in the conference.)

The remaining question is whether investors should heed Cheng's advice on Evergrande.

Cheng has made hundreds of billions from the property business and no doubt knows more than I do when it comes to the business of Evergrande, whether it is the yet-to-be reclaimed land on a remote island - a four-hour bus and boat journey from Shanghai - worth 30 billion yuan, or a third of Evergrande's total land bank valuation, or whether the company's 9.7 billion yuan debt exposure is risky, given that the property market has been going wild and banks have been lending aggressively for more than a year now.

I would rather focus on market matters.

First, after the share sale, Evergrande's financial investors still hold 19.77 per cent of the company. Other than Cheng, they are pre-flotation funds, real estate funds and Hui's wife, who bought the shares from Deutsche Bank with financing from a hedge fund. They are not there to hold.

In six months' time, they are free to sell. Their stake is two times the free float in the market, and let's not forget their cost ranges from only HK$1.12 to HK$1.67, about 28 to 42 per cent of the top offering price.

Second, should they fail to achieve their minimum return, Hui would have to pay them a total of HK$1.7 billion, as agreed in the compensation scheme. What alternatives will he have other than to sell shares or land?

Neither of these makes Evergrande a 'good buy'. I must have missed some hidden treasures.