State authorities recognizing MBOs
By Mo Fan and Su Yufeng (China Business Weekly)
Updated: 2004-08-20 14:01

[The authors Mo Fan and Su Yufeng are industry observers and regular contributors to China Business Weekly.]

Management buyout (MBO) fever is sweeping across China, amid the deepening of the country's State-owned enterprise (SOEs) reform.

As a new entrepreneur dimension is quickly emerging in this somewhat backwards market, some cryptic problems, behind the reform, must be resolved as soon as possible.

After four months of waiting, Xiao Wei, board chairman of Shanghai-listed Jiangsu Kanion Pharmaceutical Co Ltd, and 45 other board members finally received good news from the State-owned Assets Supervision and Administration Commission (SASAC), which is under the State Council.

SASAC recently approved Jiangsu Kanion's MBO plan.

The plan's approval was the first by SASAC since China's Ministry of Finance halted MBOs of domestically listed companies last March.

Henrui Group, the biggest shareholder in Kanion Pharmaceutical Co Ltd, announced last month it received approval from SASAC to transfer 27.65 per cent of its stake in the firm to three companies.

After the deal is completed, Angel Investment Co Ltd, formerly the second-biggest shareholder in Kanion Pharmaceutical, will become the largest shareholder in the firm.

Angel Investment is owned by Kanion Pharmaceutical's executives, who established the Angel solely for the MBO.

SASAC's approval, in some sense, indicates companies' executives are becoming the real controllers of their firms.

MBOs, in theory, an executive's purchase of the controlling interest in a company, are no longer new to China.

Many such buyouts have been completed in China in recent years. Some of those transactions involved publicly listed companies.

Two factors make MBOs attractive in China: First, an MBO strengthens a firm's corporate governance.

An MBO can magnify the role of a company's management team in the firm's daily operations, and in the implementation of future strategies, by offering stronger incentives to the managers.

Second, an MBO helps guarantee the stability of a firm's senior management team. The continuity of management is important, especially as Chinese companies are aggressively exploiting overseas markets.

While some people suggest MBOs will mushroom, others are wary.

An MBO can take much longer time to complete compared with a traditional share transaction.

The successful MBO involving a listed company is even more time-consuming. For such MBOs, SASAC is in charge of the transfer of State assets. The China Securities Regulatory Commission (CSRC), meanwhile, regulates the process.

Sometimes it is not easy for regulators to approve an MBO. SASAC and CSRC must balance fairness, to State shareholders, while solving possible conflicts of interest between the purchasers and the minor shareholders.

Zheng Peiming, chief executive officer of Shanghai-based Realize Investment Consulting Co, said a major flaw in many MBO projects is the proposed buying prices are often far below the firms' net assets.

That prevents SASAC, the watchdog of State-owned assets, from approving the applications.

Realize Investment Consulting Co, established in 1998 to provide investment advisory services, has been quick to seize opportunities in China's MBO market.

Some listed companies, who submitted their MBO schemes to government regulators, have not received approval to implement their MBO plans because State-owned shares would be sold at a discount.

Executives at Shanghai-listed Erdos Cashmere Group Co Ltd plan to spend 900 million yuan (US$1.9 million) to buy State-owned net assets, worth about 3.2 billion yuan (US$387 million).

Meanwhile, executives of Shenzhen-listed Shenzhen Huaqiang Holdings Ltd have created an entity to purchase State-owned shares in the firm -- at a 75 per cent discount.

Transfer prices of listed firm's State-owned assets are generally determined by earning potential and market performance, which is based on the net asset per share.

Lack of financing is also hindering MBOs in China.

Mature market economies have diversified financing sources that give executives greater options to finance their MBOs.

For example, mezzanine finance (similar to subordinated debt) is a type of debt that, from a security point of view, ranks behind senior debt finance. Other financing solutions include high-yield bonds, or junk bonds, and MBO trust funds.

Under China's current situation, firms' executives must either be wealthy or have connections to financial institutions -- both are unlikely -- to complete their MBOs.

Yu Bowei, the independent director at Yili Group, one of China's leading dairy producers, recently uncovered a scandal involving the company's treasury repurchase agreement.

And some big money reportedly changed hands inappropriately during the MBO.

Institutional defect, not the executives' lack of funding, resulted in the MBOs failure.

Yili's case highlights the risks associated with funding MBOs.

In addition, there will be greater risks to the market if the MBO process is not implemented successfully. For example, listed companies that fail to complete their MBOs may pose huge investment risks to investors.

"Listed companies with MBO plans will sometimes mislead investors," Zheng said. "Some retail investors in China, who know little about MBOs, may regard all MBOs as bullish news."

Based on recent MBOs, it appears central and regional regulators are easing the supervision over MBOs, said an expert with Realize Investment Consulting Co.

"The only way to resolve the problem is by adhering to the rules, and avoid playing tricks," the expert added.

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