Dear Sino-Forest investors: Sorry. Love, John Paulson

Posted by John McDermott on Jun 24 19:52.

Here are extensive extracts from the memorandum sent by John Paulson, Michael Waldorf, and James Wong of Paulson & Co. Inc. to investors on Thursday:

It begins:

On June 20, 2011, Paulson & Co. Inc. filed a public regulatory disclosure in Canada reporting that it has sold its funds’ entire position in Sino-Forest Corporation. Our position in Sino-Forest has been the subject of considerable media attention given recent allegations about the company’s financial statements and given Paulson’s status as the company’s largest shareholder. Now that we have sold our position, we can discuss this matter with our investors in more detail. Therefore, we would like to discuss with you why we believed the company was an attractive investment, our due diligence process, the reasons we sold our investment and the impact of the sale on our Advantage funds.

Why Sino-Forest shares were originally purchased:

Sino-Forest first came to our attention in January 2007 when Bloomberg News reported that CVC Asia Pacific and Macquarie Bank were considering making an offer for the company. Prior to the appearance of the Bloomberg article, the stock had been trading in the C$7.00 to C$9.00 per share range; on the day the article appeared it rose to C$10.85. We began research on Sino-Forest, and when Sino-Forest stated publicly that no offer from these parties would be forthcoming and the stock fell to the C$9.00 per share range, Paulson started accumulating its first position.

Paulson & Co’s hope was that Sino-Forest would again become a takeover target and/or relist on a different exchange. It was also drawn in by that now-famous tree-flipping business model:

The investment thesis was consistent with the event-driven investment strategy of the Advantage funds, given the possibility of an acquisition or another development such as a re-listing from the Toronto Stock Exchange to a local exchange. The company was also transitioning its business model from purchasing and re-selling trees to a self-sustaining high-yield planting model, and had the opportunity as a natural resources company in a potentially inflationary environment to benefit from Chinese economic growth and development.

Paulson & Co writes that it did perform due diligence, which included a member of the fund going to visit Sino-Forest’s “operations” (it doesn’t mention which province):

As a passive investor in public companies, Paulson has access to the same information that everyone else in the securities markets does. Like other public market investors, we must rely on audits and underwriter due diligence for comfort that financial statements and disclosures are accurate and reflect the true state of affairs at companies with publicly traded securities.

Our investment team conducted considerable due diligence on Sino-Forest. We reviewed Sino-Forest’s public filings, participated in conference calls with the investment community, followed up privately with management on specific questions, discussed Sino-Forest with analysts that covered the company, and regularly met in-person with management. A member of our team also went to China to visit Sino-Forest’s operations and to meet with a major customer and representatives of the Chinese government on forestry matters.

After noting the publication of the Muddy Waters report on June 2, the memo’s authors explain why they decided to sell up. Interestingly, there’s no reference to the veracity of the MW report but there is a strong nod to the legacy of the short seller’s previous attack on Orient Paper. In short, it doesn’t matter to Paulson & Co. whether MW is correct or not:

Paulson reviewed both sides’ written materials, asked questions, and engaged in further independent research, including conversations with the chairman of the special committee about the scope and process of their investigations. Although Sino-Forest steadfastly denies the Muddy Waters allegations, stands by its public disclosures and financial statements and maintains that there is no fraud, we believe significant uncertainties exist and we made the determination to sell our full position and await the results of the independent investigation.

Our decision was also based on the likelihood that even if Sino-Forest’s special committee investigation clears management and supports the public disclosures and financial statements, the stock may remain depressed for an extended period of time. We considered the case of Orient Paper, another company with Chinese operations on which Muddy Waters issued a report. Even though Orient Paper’s own special committee conclusively and publicly rejected the allegations of fraud, the stock price never recovered to its previous levels.

So what’s the damage? A figure of C$500m had been speculated, which is about right when measured on a mark-to-market basis. However, Paulson & Co would prefer you to think of the loss as closer to C$106m, based on its total net loss over the lifetime of its Sino-Forest investment:

In May 2011, our Sino-Forest position was 31.0 million shares, just over 12.5% of shares outstanding. At that point, net of proceeds from share sales into the market, the average cost basis of our Sino-Forest position was C$7.43 per share. This position was only in the Advantage portfolios and not in any other Paulson strategy. …

We sold the remainder of our Sino-Forest stock in the market from June 6 through June 17, 2011 at an average price of C$4.53 per share. Measured from December 31, 2010 when the stock price was C$23.29 per share, this resulted in a mark-to-market loss on the Sino-Forest position of C$562 million (-2.7% on the Advantage portfolio NAV). Measured from May 31, 2011 when the stock price was C$19.27 per share, the mark-to-market loss was C$462 million (-2.2% on the Advantage portfolio NAV).

Because Paulson sold a substantial portion of its Sino-Forest shares between C$19.00 and C$25.00 per share from early 2010 through May 2011, the net realized loss to the Advantage portfolio over the full life of the position was C$106 million.

Of course, whichever way you look at the loss, it’s been a bad year for the fund — and not just because of some disputed trees in a Chinese woodland.

Related links:
Paulson And Co Only Lost $107 Million On Sino-Forest – Dealbreaker
Sino-Forest coverage – FT Tilt
Sino-Forest coverage – FT Alphaville
Paulson $9bn hedge fund falls 6% in May – FT

This entry was posted by John McDermott on Friday, June 24th, 2011 at 19:52 and is filed under Capital markets, Commodities, People. Tagged with , , , , .

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