Introduction
The purpose of this study is to provide a preliminary assessment of the country risk and project viability of equity plays in the PRC market for medium and small investors; proposed avenues include ETF's, Red Chip shares on the HKSE, the purchase of B-shares via foreign exchange accounts, mergers, IPOs and exotic measures such as reverse mergers. There is considerable consternation on behalf of the foreign investor community regarding the medium and long-term trajectory of Chinese equities and how best to invest in them. That said is seems a near certainty that there is significant demand for Chinese investment instruments, which will only continue to grow over the next 5-10 years. Market bottlenecks and general weakness in the Chinese equity markets will continue to drive Chinese companies to foreign equity markets to meet their capital needs. Currently, most foreign capital flows into China via FDI flows. However, for the risk-disposed investor Chinese equities provide an ROI that few other investments can offer. Unfortunately, due to high valuations and heavy government involvement, most foreign listed companies are not a good entrée point for second tier funds and investment firms.
For small to medium sized investment funds looking to get in on the ground floor via IPO or reverse merger, the question is not one simply of value or opportunity presented by the Chinese enterprise (though these are important metrics), rather the ability to find the right companies to list. The viability of any reverse merger or direct listing of a PRC firm is more contingent upon financial and governance due diligence and the ability to select appropriate candidates than on broad market presence, particularly when risk is factored into the equation. Due to the front-end costs it is very important that a specific criterion be developed to narrow the list of candidates and rule out those, which are unlikely to meet the internal Chinese government and US market requirements.
Market Data Points • More than fifty PRC companies are currently listed on foreign stock exchanges • The aggregated market capitalization of just the top 10 PRC companies listed on U.S. stock exchanges is more than $361 billion.
Historical Overview
The Chinese economy began to open in 1979 with the passage of the PRC law on Chinese-Foreign Equity Joint Ventures, which marked the beginning of the PRC’s move toward a market economy. However, despite hundreds of other similar laws and nearly a quarter century of reform China is still a hybrid market economy built on a state owned foundation.
Most of the publicly listed companies are joint stock companies, which means that more than half of the equity stock is not traded and held by local or central government. Moreover, the current legal structure exists in an environment where the Chinese Communist Party (CCP) is above the market and beyond the law (SEE MCKINSEY). This has created many peculiarly Chinese business practices. This will be addressed at length later in this section. This unique mixed market economic situation is further complicated by China’s recent entry into the WTO.
Legal and Business Environment
Under current legal structures Chinese enterprises have the right to list on the foreign equity markets if they receive the approval of the Ministry of Finance (MOF), the Ministry of Commerce (MOFCOM) and/or the industry specific ministry and in many cases the approval of the local provincial authority. As with most transactions in the Chinese economy the State retains the right of refusal. However, the more regularized structures of the market and legal reforms have made this system less ad hoc. In recent years, documentation requirements as well as the application processes are publicly available and have been codified into law. This means that there is higher degree of certainty for projects that meet foreign investment requirements and follow procedure. Despite the above-mentioned legal sanction and governing agencies, personalities still play a significant role in enterprise growth and foreign investment in the Chinese economy. That is without the consent of the right people a legitimate equity venture can be denied or lost in the bureaucratic web indefinitely. Since, China continues to operate under a legal environment, which is sublimated to the will of political authorities it is paramount that any potential venture involving foreign equity has some form of patronage.
For our purposes any company valuable enough to list on US equity markets almost certainly has some significant connections or GuanXi. The term GuanXi, which literally means relationship, is often overused and oversimplified by western analysts. It has been described and as the barter of personal favor that is as fungible as currency. This is an overstatement; however, in a country where relationships often determine success rather than the market it has become a necessity. However, with the advent of stronger legal protections and enforced market regulations it has become less important. When seeking government approval for projects or equity joint ventures it is still a phenomenon worth attention. This hackneyed term aside it is very important to note that corruption spurred by the woefully inadequate level of government salaries does significantly augment the role that relationships play in the Chinese economy. ALL FIRMS SHOULD USE LEGAL MEANS AND/OR PRESSURE TO BUILD THERE BUSINESS; BECOMING A WILLING PARTNER IN CORRUPTION IS A RISKY, LOSING PROPOSITION IN THE LONG RUN.
Clearly, this is a nebulous market with significant barriers to entry. However, finding the right partner and proper due diligence can solve these problems. The right partner in this case is a company that exports a large portion of its production abroad and is in a growth industry, which takes advantage of China’s competitive advantages (this will be discussed at greater length in later sections). Proper due diligence involves examining its books very carefully and looking at the company’s corporate governance structure. The relationships a company has can most effectively be gleaned from its board of directors. It is important to note that while the reverse merger strategy is in line with stated government goals to attract foreign investment it is perhaps the most risky. To effectively navigate the legal environment and protect the foreign firms position, good Chinese legal representation needs to be found. In order to limit costs and legal fees they should be brought in after the candidate company has been identified and due diligence has begun. Accountants familiar with China’s GAAP should also be brought in to go over the company’s finances. Taken together these measures mitigate the significant country risk involved with this project and create a formula for success.
Accounting Environment
PRC accounting practices were based upon Soviet era command economy accounting practices until the passage of the Enterprise Accounting Reform Law in 1985. This law began to change Chinese standards gradually from a command structure based upon national needs and output to one based upon accrual accounting, asset valuation and profits and losses. Accounting laws have been further refined several times including a significant overhaul in 1993 and an effort to improve the quality of practicing CPAs with the rectification campaigns in 1998 and 1999.
Today, China’s basic accounting structure differs little from IAS and US GAAP, but a lack of enforcement and the historical connection between enterprises and accounting firms allows accounting opacity to continue. Great strides have been made over the previous seven years, which has enormously improved the quality of the accounting sector. China has received international aid to help update their accounting system and is working closely with western accounting firms such as Deloitte Touche Tohmatsu. In January 2001 China’s Ministry of Finance adopted a new comprehensive accounting system known as the “Accounting System for Business Enterprises.” This system was designed to apply to all large and medium sized companies in China, in an effort to eliminate accounting discrepancies that are evident when analyzing the financial statements of most Chinese firms. Although the specific issues addressed by the new system of accounting are beyond the scope of this study, in general, the new accounting system follows the guidelines and regulations of IAS. Despite this Deloitte and Touche management have pointed out, there are still areas of significant concern. These concerns center on certain business combinations, consolidation procedures, discounted operations, revaluation, earnings per share, reorganization, liquidation and employee benefits. In short, the PRC has made great strides, but numerous pitfalls remain.
Strategy & Targeting
A methodology focusing on the strongest industries and targeting the “right” companies within those industries is critical. Furthermore, a specific criteria needs to be developed to narrow potential companies to those that are likely to be both successful and amenable. I have identified the two industries that I feel are ideal for this, the region that they are most likely to come from and the basic criteria they should meet.
A regionally based criterion will help to narrow the search and lower front-end investment. While this may leave out a few viable candidates it will also cut out the greatest number of bad actors and unproductive firms. China has a significant productivity gap between the coastal and inland regions, but this is even more pronounced in the old Special Economic Zones (SEZs) like ShenZhen, Shanghai and Tian Jin. Also, the highly productive region in and around Beijing and the entire GuangZhou province, because of its propinquity to Hong Kong, should be added. This narrows the search to the most affluent and highly productive areas of China.
The industries with the greatest growth potential, which will also most benefit from access to capital, are the EMS industry, which includes IT, and physical infrastructures industry. These two industries will see double-digit growth over the next five years and will both benefit enormously from the government’s continued investments. The IT industry is forecast to have a CARG of more than 20% through 2015. This is a fantastic rate of growth for any industry, but in an industry driven by technology it is also ideally suited secondary market IPO’s and reverse merger projects. Companies’ with access to foreign capital markets will be able to take advantage of technology driven productivity gains and will be able to move up the technology value chain.
The Ministry of Information Industry has stated that it will push for four or five IT companies to go public abroad over the next 2 years. Based on the sales revenue of the information industry in 2005, the Ministry of Information Industry (MII) estimates that this year the country's technology sales revenue will increase by 20% compared with the same period of last year. According to MII statistics, China's IT industry value reached RMB900.4 billion (circa USD116 billion), an increase of 28.2% from the previous year. Computer and electronic components manufacturers were the major driving force of the industry. Although not highlighted here the Telecom industry in China has also seen fantastic growth rates. Revenues have been growing at more than 20% for the last ten years and are expected to continue to grow at an incredible pace for the next 5-10 years. China is currently the largest market in the world for telecom products and services.
The physical infrastructure industry is another significant market with enormous growth potential. By all accounts China is in the midst of one of the largest physical infrastructure build outs the world has ever seen. China is the largest producer of cement, steel, copper wire and a myriad of other products that fuel its infrastructure investment mania. This building boom has created thousands of large and medium sized companies that supply all manner of products to meet domestic demand. However, China is not the only country in need of enormous investments in physical infrastructure; the world is in the midst of a building boom. Mexico for example has pledge to invest $250 billion dollars in infrastructure improvements over the next five year. Many analysts believe that the aging infrastructure in the U.S. will require 2-5 trillion dollars in investment over just the next 10 years. Currently, China is one of the leading exporters of building block materials for physical infrastructure – from cement, steel rebar, pipes and rivets, etc. According to its 11th five-year plan (2006–2010), the government is expected to spend $20 billion on building and upgrading its railway system alone. Total investment in the highway system alone is estimated to be $256.4 billion over the next 30 years. In order to take full advantage of its natural competitive endowments the industry will need to secure capital for capacity expansion. Moreover, to advance from low-end contract production to integrated sales, brand development and export promotion competitive enterprises will have to secure significant amounts of foreign capital or create strong partnerships with foreign firms. The latter while more secure also provides less of the value to the indigenous firm and leaves it in a dependent position.
Enterprise criteria
Corporate governance boards are an important determinative factor in enterprise success in any country, but it is even more pronounced in the Chinese market. In general enterprise transparency is higher in firms with well-defined boards of governance. These firms tend to have clearer lines of authority and have developed a degree of external accountability, which makes them better candidates for listing on foreign exchanges. Moreover, there is a clear link between the number of outsiders on a company’s board and overall profitability. Many cultural factors work to underscore the importance of this in the Chinese market.
Export orientation is also a criterion that is directly related a firm’s likelihood to gain the necessary ministerial approval to list on a foreign stock exchange. These companies are also more profitable in general than companies that depend solely on the domestic market. It also gives these firms better access to the foreign exchange necessary to successfully complete the IPO or shell merger and promote their stock to the analysts.
Structural Barriers
Structural barriers, often times labeled cultural barriers, which I define as market barriers not common to the US market, are significant in the Chinese market and must be planned for if any foreign investor is to succeed in this market. Personal and familial relationships can be detrimental or advantageous to a firm’s performance or both. These relationships weather based on personal ties or business relationships are oftentimes necessary to do effective business in China. The determinative factor in these relationships is not that they exist, but their overall effect on the firm’s performance. Unfortunately, this is a nebulous factor endowment and it is nearly impossible to quantify when analyzing a firm’s potential. Most companies of any significance boast relationships with important officials in regulatory ministries. As previously mentioned this is a near necessity for companies seeking to grow and even more so for one is seeking access foreign equity markets. If these relationships are strong and leverage the right people they can place a company on the fast track toward approval. Familial and personal relationships can, and oftentimes do, lead to serious problems in a firm’s performance. If incompetence is tolerated because of one of these relationships or if it is used to funnel monies out of the company in the form of components and materials priced over market value it can lead to poor performance. All of these cultural barriers work to hide a firm’s true net worth and its real value to investors. That having been said all of these issues can be identified and properly addressed given solid due diligence.
Marketing Plan
Marketing to previously identified firms is likely to focus as much on market data as the relationship that is developed with the firm. This dual strategy of outlining the benefits that access to foreign equity brings along with developing a strong personal relationship with the principles of the firm is the best way to secure a market presence. As in any market the project fundamentals are of greatest importance. However, for an investment group new to the Chinese market developing strong relationships will be very important. Having a presence on the ground in China is critical to developing these relationships. Here again structural barriers and the bad actor problem make this a complex issue. Simply partnering with a Chinese consulting firm will not solve the relationship problem because significant structural barriers work to undermine the value of the information shared. These structural barriers lead most reporting and consulting firms to omit any information, which could be deemed in opposition to official government claims. This translates to a form of self-censorship on the part of most domestic analysts. Numerous studies show that foreign companies rely upon personal visits; internal staff and direct personal relationships do develop their market picture. Therefore, it will be necessary to set-up a satellite office in China located in one of the four major market cities. The function of this office will be to do the due diligence on perspective firms, develop relationships with the principles multiple enterprises in the industry, obtain reasonable legal and accounting services and build a market presence.
Equity Market Data
There are several significant benefits for firms seeking to list on the NYSE or the Nasdaq exchange. The two most glaring examples are the differences in market capitalization and daily volatility. Continued barriers to entry on the two PRC exchanges also make going public in the US very profitable for the owners of these enterprises. Public companies have much higher valuations than private companies and the saleability of stock positions further increases the value of a publicly listed company to its owners. The total market capitalization of all the stocks traded on the two national exchanges, Shanghai and Shenzhen, aggregate to roughly $1.7 trillion. The NYSE/Euronext alone boasts a market capitalization near $22 trillion (perhaps less in recent months). And the Nasdaq despite its recent weakness still has a market capitalization of roughly $4 trillion. These are literally orders of magnitude larger than the Chinese markets (note figure 1).
Figure 1 related markets comparison
Historical market volatility may also play a role in attracting PRC firms to the US equity markets. The A and B markets have daily volatility rates 650% higher than the NYSE and nearly 300% higher than the Heng Seng index in Hong Kong. While much of this is mitigated over the long run, market noise and speculation lead to sustained volatility rates that are 250% higher on the PRC markets than in the US. This degree of volatility makes it harder for publicly traded companies to attract foreign investment and make acquisitions with company stock (see exhibit 2)
Figure 2 Market Volatility Comparison
Benefits: Reverse Merger vs. IPO
• The company does not need an underwriter
• List time is much shorter
• Lowered market instability risk, protecting up-front investment
• Company requirements are generally lower
• Requires less time investment from upper management
• Ownership valuation usually higher than IPO
• Significantly reduced costs
Benefits of Going Public
• Ability to compensate employees with company stock
• Greater access to capital through new stock offerings
• Provides and strong retirement or exit for company ownership
• The company can grow through stock based mergers and acquisitions
• Market value of a public company is often significantly higher than a private company with the same market structure in the same industry
China’s Stock Markets
There are several noteworthy features of the new-issue and offering process in China. First, the aggregate amount of new shares to be issued in the two national exchanges each year is determined by a quota set by the State Planning Committee, the central bank and the China Securities Regulatory Committee (CSRC). The quota is then distributed to individual provinces. The stated criteria used for allocation of new issues among provinces reflect the central securities regulatory authorities’ perceived regional development needs and provincial differences in production structure and industrial base. Within each regional quota, the local securities regulatory authorities invite enterprises to request a listing and make a selection based on criteria, which combine good performance as well as sector development objectives. Infrastructure enterprises, especially those specializing in electricity and water supply, are given priority for approval.
Second, the Chinese government has introduced a variety of share categories to allow ownership of state-owned enterprises to be dispersed among the government itself, other state-owned enterprises, firms’ own employees, domestic public and foreign investors. There are currently five types of shares: (1) government shares, which are retained in the state institutions and government departments and are non-tradable; (2) legal entity shares, or C shares, which can only be held by other state-owned enterprises. C shares cannot be listed in the two official exchanges (Shanghai and Shenzhen Security Exchange), but a very small number are traded on the Security Trading and Automated Quote System (STAQS) and National Electronic Trading System (NETS); (3) employee shares, which are non-tradable until the firm allows their convertibility; (4) ordinary domestic individual shares, or A shares, which can only be purchased and traded by private Chinese citizens in the two official exchanges in China; (5) foreign individual shares, which can only be purchased and traded by foreign investors in security exchanges in China (B shares), in Hong Kong (H shares) or in NYSE (N shares). An issuer of B shares must, in addition it satisfying requirements stated in the securities regulations, meet the following conditions: (1) It must have obtained approval from the relevant authorities for its use of foreign investment for its conversion into a foreign-funded enterprise. (2) It must have a stable source of adequate foreign exchange income and the total amount of its annual foreign exchange income must be sufficient to pay the annual dividend. (3) the proportion of B shares to the total number of shares must not exceed the ceiling determined by the relevant authority. The aggregate amount of shares is fixed each year and the total number of firms allowed is to issue foreign shares is also limited. An issuer of H or N shares is not subject to the quota system, but is subject to case-by-case approval.
Third, most stock sales are partial sales. The government still maintains control in varying degree over many firms. The size of government ownership ranges from 10% to 88%. Only 89 out of 308 issuers going public between 1986 and 1996 did not report government ownership of shares. However, none of these 89 issuers has reported IPO size that is above 50% of its total market capitalization, which indicates that a larger portion of its shares are still controlled by other state-owned enterprises. Fourth, the average time elapsed between the announcement of IPO and the first day market trading is 260 days for A shares and 72 days for B shares, which is considerably higher than other countries. There are a number of steps a firm must take after it is selected for initial public and before the market trading begins. Some typical steps include: (1) publication of prospectus in newspapers and selection of underwriters; (2) purchase of application forms by prospective investors; (3) a lottery to determine which individual and institutional investors will be allowed to purchase new issues at the IPO price; (4) delivery of shares to the lottery winners after payments are made. Reforms enacted in 2001 allow for a limited number of Chinese citizens to legally trade on the B stock market. These individuals must qualify for foreign exchange accounts and have to open specific trading accounts, which are used exclusively to trade on the B markets. There has also been significant talk about combining the A and B markets into one market and opening them up to free trading among all participants. This is unlikely, however, until China liberalizes its capital accounts. Without free movement of currency by both domestic and foreign investors merger of the two markets will do little to increase valuations and will only serve to build further market instability.
Private Firm Access to Capital
Private firms are often locked out of both bank loans and equity markets, leaving them with only internal financing and foreign equity venture options. Accounting deficiencies leave partial statistics for banking loans to enterprise, which leads to market-wide under reporting of bank loans to state owned enterprises (SOE). Nevertheless, more than two-thirds of all bank loans went to SOEs in 1998, despite the fact that they accounted for less than one-third of national production (see exhibit 3 and 4). The actual numbers are likely much higher than the officially stated two-thirds.
Figure 3 Bank Lending by Sector
Figure 4 NSE Source of Funds
Competition
Competition in the investment bank market in China is weak as compared to markets in developed world; however, the incumbents have a powerful advantage access and experiential asymmetry. As with most industries there is an early mover advantage. Today, only the big players are active in the China Market, which leaves considerable room for smaller more agile firms to enter and build long-term relationships with the smaller gazelle firms that are likely to grow up during this era of change.
There is currently, tremendous demand for well-trained investment banking professional that can speak Mandarin Chinese. This is being sparked by the incredible growth in the nascent investment banking and equities market s in China. Morgan Stanley and a Chinese partner, for example, recently started a joint venture called China International Capital Corporation in Beijing, which started with initial funding of $100 million paid in by the partners. Despite these early moves no firm of coalition of firms has a clear market lead, but as the market matures and grows the long-term advantage will go to the early entrants and major players.
