Dismal Outlook for Reverse Mergers

Hampered by an avalanche of negative publicity and regulatory scrutiny, reverse merger activity has plunged to its lowest level in seven years, and the outlook for 2012 is dismal, say industry analysts.


“2011 is likely to record the lowest number of reverse mergers since 2004,” says Brett Goetschius, editor of The Reverse Merger Report.

A reverse merger was once a popular way for private firms, especially foreign-based, to gain a listing on the U.S. exchanges by merging with an existing public company, while by-passing a more costly and rigorous initial public offering process.

Only 166 reverse mergers closed so far this year compared to 258 in 2010—a 36 percent decline. Investment in reverse mergers stands at $149.6 million to date versus $343 million last year.

Goetschius calls the overall outlook going forward “poor”. “Investment in new reverse merger companies is likely to remain at 10-year lows, and merger activity well below the 5-year average of 225 deals a year,” he says.

The practice this year came under a firestorm of regulatory scrutiny after a slew of firms, primarily China-based, were involved in accounting scandals and saw their trading suspended or halted.

Federal regulators even issued a warningabout the risks of investing in reverse merger companies, including potential for fraud and sub-standard accounting. In November, the SEC also toughenedlisting requirementsfor reverse merger companies seeking to trade on major U.S. exchanges.

These developments put a damper on the reverse merger activity, which has already been severely restricted as a result of the 2008 financial crisis.

“After 2008, Chinese reverse mergers remained the only sector of the market where investors felt strong returns were still possible,” says Goetschius. “The accounting fraud scandals that swept through the Chinese market this year destroyed investors’ confidence in that thesis.”

Only thirty-eight of this year’s reverse mergers involved Chinese companies compared to eighty-one in 2010, according to the Reverse Merger Report. The amount of money raised by Chinese reverse mergers plunged 95 percent to $13.45 million compared to $259.3 million last year.

“The accounting risk overhang on Chinese reverse merger companies will likely persist into the first half of 2012, making it virtually impossible for Chinese companies to raise capital subsequent to a reverse merger for the foreseeable future,” adds Goetschius.

But industry insiders believe that despite the headwinds, this is not the end of reverse mergers.

Nanette Heide, partner at law firm Duane Morris, says for smaller companies reverse mergers may prove to be the only way to raise capital given that venture capitalists have been moving towards later stage companies.

“The IPO market is substantially for the larger capital raises—in excess of $100 million—due in part to the consolidation of underwriter firms resulting from the recent economic downturns and the disappearance of the smaller firms that specialized in the small IPOs," adds Heide.

”Reverse mergers will continue to be a very credible and predictable alternative to an IPO for properly sponsored and organized companies to access the public markets,” believes John Borer, senior managing director at Rodman & Renshaw. “The current scrutiny on many levels will improve the quality of the transactions coming to the market.”

Questions? Comments? Email us at marketinsider@cnbc.com and follow me on twitter @kfrayter