The writing is on the Great Wall: the Chinese government doesn't want China's jewels of industry going offshore to list on foreign exchanges anymore. By using a multi-layered channel of regulatory control, it is steering the best companies to stay in China and, if appropriate, list on a Chinese mainland exchange. Nonetheless, Beijing still must keep the gates open to foreign direct investment, and the economic growth that comes with it. With the domestic markets on the rise, foreign private equity firms that previously looked to New York or London for liquidity in their China investments may soon find the Chinese exchanges an increasingly viable and attractive exit venue during the next five years. It may be the smart ones who figure out how to get there first.
Until recently, foreign venture capital and private equity firms relied almost exclusively upon a structure whereby the Chinese company to be invested is first moved offshore so that it can later go public outside of China. Noting that under PRC law a domestic Chinese company cannot list directly on a foreign exchange, the objective is to put the Chinese business into a vehicle that can ultimately achieve liquidity in a more lucrative and familiar market such as New York or London. This makes sense for both the investors and the original shareholders, who want the greatest liquidity possible. Many of China's brightest stars, such as Baidu (BIDU) and Shanda (SNDA) followed just such a path to spectacular IPOs on Nasdaq.
Although the “offshoring” strategy is still viable, Beijing has erected a series of regulatory hurdles that substantially encumber the process of domiciling a Chinese company offshore. Beginning in January of 2005, China's State Administration of Foreign Exchange (SAFE) issued two notices – Circular 11 and Circular 29 – that require all PRC residents to obtain SAFE approval before establishing or owning shares of a foreign company, and further require SAFE approval for any PRC resident who intends to exchange domestic stock for equity in a foreign company. More recently, in August of 2006, Beijing promulgated several new regulations that require approval by the Ministry of Commerce (MOFCOM) for any foreign acquisition of the controlling interest in a Chinese company in a “key industry” that involves “national economic security.”
Conveniently, there are no published definitions for “key industry” and “national economic security,” which effectively means that MOFCOM has a wide berth to decide which companies can be majority controlled by foreign enterprises. Although the regulations do allow domestic companies to establish offshore Special Purpose Vehicles (SPVs) for the purpose of overseas listings, all SPVs are subject to MOFCOM approval (except those with a relatively small net asset value). Further, all overseas listings are subject to approval by the China Securities Regulatory Commission (CRSC).
Sensitive industries, such as media publication and distribution, are likely to receive a more reluctant MOFCOM appraisal then others when it comes to moving the assets offshore. Others, such as steel manufacturing, seem to be off limits altogether when it comes to majority control by a foreign enterprise. In any case, the process for obtaining MOFCOM approval is not transparent, and adds a new layer of risk when pursuing an offshore strategy. By one account, there are about 600 applications pending MOFCOM approval, and the approval process appears to be all but suspended for the time being.
While ostensibly established to dampen fraudulent cross-border capital flows and tax evasion, these regulations, taken together, effectively give the Chinese government a wide purview in determining which companies can be “offshored”. Beyond the reasons mentioned above, protectionism may be the true motive: China's best companies will benefit China most if they can find the capital they need from local markets. No doubt these regulatory hurdles are and will be used to stem the flow of assets to foreign exchanges. The additional risk of this situation should motivate foreign private equity firms to consider alternative exit strategies.
If the prospect of exiting on a foreign exchange seems increasingly complicated, an entirely different picture is emerging regarding China's mainland exchanges.With growing supplies of both equity and capital – direct results of recent reforms and a booming economy – the mainland equities markets are steadily morphing into what could soon be an attractive IPO venue for foreign private equity firms.
A healthy equities market must have deep and diverse pools of equities for investors to trade. Until recently however, China's unusual two-tier system of tradable and non-tradable stock kept much of the country's equity out of the hands of investors, and China did not have an IPO market to speak of. Consequently, as recently as December 2004, 64 percent of all shares issued in China were not tradable on the stock market. However, reforms enacted in 2005 effectively put an end to the two-tier system, and promise to increase the amount of equity available on the markets two-fold by 2012, when the last of the non-tradable shares becomes fully tradable.
A second effect of this reform is to normalize corporate financing via IPOs, which were suspended in 2005 to allow these reforms to take hold. Subsequently, China raised more capital than any other emerging market in 2006 – $56.6 billion – and had the largest IPO ever as the Industrial Commerce Bank of China raised $22 billion alone. 2007 is promising to be China's best year yet in terms of number of IPOs and total funds raised.
However, a healthy market also needs liquidity, more of which also appears to be in store for the Chinese markets. In 2006 China initiated a major reform to its pension system to alleviate what many believe will be an enormous shortfall in retirement payments due to an aging population. Launched by the Ministry of Labor and Social Security (MLSS), the reform establishes community pension funds drawn from employees' salaries—anywhere from 3 percent to 20 percent, depending on the region and industry. This reform has the potential to greatly increase the base of domestic institutional investors, which until recently accounted for just 10 percent of all equities investors. According to research from McKinsey, this shift could grow the funds of China's asset management industry by as much as 24 percent per year from 2005 to 2015.
Further, the ever-growing Chinese middle class has the potential to create enormous amounts of new liquidity by shifting their assets from bank deposits – currently 75 percent of China's financial assets (compared with just 20 percent in the US) – to the market. According to Deutsche Bank Research, the Chinese save as much as 50 percent of their household income, but keep it in low-interest bank deposits. The mainland stock markets will be an increasingly attractive alternative for this large pool of retail liquidity, as seen in the first six months of 2007 when Chinese investors opened an astounding 27 million brokerage accounts, five times the number opened in all of 2006. In the last four months alone, the ETF, which represents China's leading 25 stocks (FXI), surged 40.9 percent, mostly driven by retail investors.
Given the mounting complications of moving Chinese companies offshore, and what appears to be the impending rise of domestic Chinese stock exchanges, private equity investors ought to be considering a new exit option: invest in Chinese companies and target a liquidity event on the Shanghai or Shenzhen exchanges. Given that it is in the Chinese government's interest to keep Chinese companies in China and foster growth in the capital markets, future applications to list in Shanghai or Shenzhen are likely to be met with less resistance than applications to bring companies offshore (all things being equal). Further, given that many business managers and shareholders are unfamiliar and uncomfortable with the foreign capital markets, it may be a little easier to make the case for taking them to a Chinese market. Consequently, this path may, in the coming years, offer lower risk for the same liquidity.
The early players on China's private equity scene have already figured out that an A-Share listing can be at least as lucrative as a listing on any western exchange. Consider the July, 2007 IPO of Western Mining on the Shanghai stock exchange. The IPO, handled by UBS Securities, drew $34.26 billion in orders. Goldman Sachs, who invested $12.8 million prior to the IPO and held an 8.07 percent stake at the time of the offering, raised $827 million by selling just 19.3 percent of its expanded share capital.
Once the purview of a select group of large investment firms such as Goldman or Blackstone, the ability to target, manage and achieve an A-share listing will eventually be required skills for smaller PE firms that want to compete and succeed in China.
Despite the impressive progress, listing on the A-Shares still carries risks unique to the environment. Some risks pertain directly to the process of getting listed, while others derive from the structure and regulation of the post-listing environment itself.
To begin, each IPO-hopeful must circumnavigate a four-step government approval process managed by “Fa Sheng Wei”, a CRSC subcommittee. The process is far less transparent than that in the US and Europe, and success may heavily depend on politics and personal relationships, rather than pure market dynamics and the ability of the company to meet listing requirements. Consider for example that an applicant must not have had a major change in shareholding, management or business model within the last three years. What constitutes a “major change” is not defined, but seems to be at the discretion of the committee.
That said, insiders claim that the environment has improved drastically, and is much fairer than it used to be. Nonetheless, even today a large SOE would likely have a much easier go of the application process than would a joint venture with substantial foreign ownership.
Structural barriers, however, remain as well. Foreign investors will quickly notice the absence of a mature industry to support the entire underwriting and listing process, as exists in New York, London and Hong Kong. Currently, UBS and Goldman are the only foreign investment banks allowed to underwrite share sales in mainland China.
Additionally, private companies cannot issue preferred stock. Thus, foreign investors who invest in a domestic Chinese company have no advantage over other creditors in the event of liquidation. Further, Chinese law does not allow for stock options, which eliminates one of investors' most effective incentive tools.
Perhaps most challenging of all, corporate governance on the Chinese markets is woefully lacking as compared with that on the (Sarbanes-Oxley over-regulated) US markets. The current lack of transparency, though improving, still leaves plenty of room for fraud and mismanagement at the expense of unsuspecting minority shareholders.
One final concern is the apparent bubble in the equities markets, which has been inflated by the “irrational exuberance” of China's inexperienced retail investors. A sharp and sustained downturn in the next 12 to 18 months, as many have predicted, would likely have a strong negative impact on new IPOs for months to come.
Despite these challenges however, there is reason to believe that Beijing will do everything in its power to keep reforms moving in the right direction. With as much as 90 percent of corporate financing still coming from bank loans, the Chinese government has a huge incentive to foster more efficient capital markets. In the absence of alternative sources of capital, many otherwise-healthy companies are stifling under excessive bank debt burdens. A vibrant domestic PE industry can provide an alternate source of growth capital and abate the currently untenable dependence on bank debt. However, before a domestic private equity industry can thrive, Beijing must morph China's public markets into a truly viable and lucrative exit venue—one that inspires confidence and attracts investors. By many counts, they seem to be moving in the right direction, and as reforms continue to take hold, learning how to play the A-Shares may soon be the right game for the smart private equity investor.