Bronte Capital’s John Hempton believes that Focus Media is a compelling short. He thinks that the risk in the trade is $2 which is the buy out price, while the reward is potentially $22 for an 11x reward/risk ratio. His thinking is that the deal to take the company private at $27 will fall apart when Carlyle performs full due diligence and that Muddy Water’s Carson Block is right about the company’s numbers being made up. Here’s what Hempton has to say about Bronte’s short position in the stock:

I would love to be a fly-on-the-wall as they work out how to test the Muddy Waters allegations. Due diligence is sometimes (incorrectly) treated as a formality. But in this case the stakes are real. Billions of dollars are on the line and the very credibility of some firms (especially Carlye) are on the line with it. Carlyle has been burnt by some frauds in Asia before. If – after warning by Muddy Waters – Carlyle were to buy this firm and it turned out to be fraudulent the question would arise as to whether Carlyle staff were deliberately buying frauds to loot the Carlyle funds. My guess is that the very existence of Carlyle is at stake.

But Carlyle have competent staff laced throughout their organization. They will do their due diligence – and if the deal closes I think you can presume that Muddy Waters was wrong.

If the deal doesn’t close with the backing of the the largest shareholder and at this pricing then you probably have to conclude that Muddy Waters is right. If Muddy Waters is right then the revenue and the margins of this firm are grotesquely overstated and the stock is probably going to settle somewhere below two dollars.

Disclosure: I think there is a reasonable chance that Carlyle – and perhaps some of the other firms in this syndicate will walk. In all honesty I have no idea whether they will or not but as the stock will wind up at $2 (or less) if they walk the bet is worth taking. So I am short and risk losing the difference between the current price (25 and change) and the bid price (27) if the deal does close.

I suppose there is a risk that someone else comes over the top with a bid that is greater than $27, but would one really want to bid against a controlling shareholder with superior information? But whether Hempton is right or wrong about the stock, he is definitely right about one thing. This is definitely an intriguing story that is well worth being obsessed about.