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China’s SOEs attract PE interest — Private Equity International Magazine

Private Equity International Magazine

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China’s state-owned enterprise promise big returns for PE investors, as well as a big challenge.

By: Clare Burrows


In 2013, private equity investment in China dropped to just $4.5 billion – about 47 percent below the equivalent figure for 2012, according to data from Thomson Reuters. Since China’s dry powder level was estimated at $59 billion at the end of 2012, it’s clear that China’s GPs need to find new ways to deploy the vast amounts of capital raised during better times.

What seems to be catching the industry’s eye more than ever are the country’s state-owned enterprises:large, government-controlled organisations, many of which are in dire need of restructuring. While state-owned enterprises account directly or indirectly for 60 percent of China’s GDP, according to research by China First Capital, almost 100 percent of institutional capital, especially private equity, has
been invested into China’s privately-owned sector.

However, as the number of traditional opportunities falls, “this may leave investing in SOEs as the best, largest and most promising new area for private equity investment,” Peter Fuhrman, chairman and chief executive at China First Capital suggests.

And, some industry sources ask: what better target for private equity than these bloated, inefficient giants, which the newly-appointed Chinese government is apparently so keen to reform? SOEs are highly compliant when it comes to tax and accounting laws (a rare phenomenon among China’s privately-owned companies). Better still, they’re a bargain – because China’s State-owned Assets Supervision and Administration Commission (SASAC) regulates their price based on net asset value.

“If you have a highly profitable SOE that has very low net assets, you can potentially buy it at incredibly low P/E multiples,” Fuhrman says. With one deal China First is advising on, 51 percent of the business is being offered at 2x EBITDA, he adds. China First is currently acting as an investment banker for five of China’s largest SOEs, including China Aerospace, China State Construction, China Huadian, Wuliangye Group and Shandong Energy.

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China SOE Accounting — BAAP Not GAAP Applies

China SOE accounting

If the last two years of crisis in investing in Chinese companies proves anything, it’s that any Chinese company that pays more tax than it should, documents every transaction and practices the most forensic accounting methods is the one with the calmest, happiest investors. Such companies are very rare among the thousands invested in by private equity, and not very common among publicly-traded ones,  if professional short-sellers like Muddy Waters, as well as securities regulators in the US and Hong Kong are to be believed.

Chinese companies, especially private ones,  live under a cloud of suspicion their books are cooked, while their auditors turn a complicit blind eye. While that cloud hovers, it will remain impossible for Chinese private companies in large numbers to successfully sell their shares to the public through an IPO. Chinese companies already listed are not much better off. For many, their share prices remain seriously depressed because of investor doubts about the accuracy of the financial accounts.

For PE firms, it represents a very painful dilemma. To have any chance to IPO, their portfolio companies will often need to pay more tax. But, doing so makes the companies less profitable and so much less attractive to the capital markets. Pay first and pray for an IPO later is pretty much the current PE exit strategy in China.

What a refreshing change, therefore, it is to encounter the financial accounts of a Chinese state-owned enterprise (“SOE”). By Chinese standards, their accounts are often clean enough to eat off. SOEs often seem to take pride in paying as much tax as possible. Rather than hiding income, they seem to want to exaggerate it.

Why do SOEs operate this way? It could be argued that tax-paying is their form of national service. Most SOEs pay no dividends to the state, even though the state is the majority, indeed often the 100% owner. Or perhaps SOEs are trying to set a righteous, though generally ignored, example of dutiful tax compliance?

In fact, the heavy and perhaps over-scrupulous tax-paying can also be seen as the result of a system of diligent, almost fanatical record-keeping practiced inside SOEs. Everything bought or sold, every Renminbi moving inside or outside,  is tabulated by the SOEs large team of in-house bookkeepers. Note, I say bookkeepers, not accountants. An SOE has many of the former and few, if any, of the latter.

That’s because SOEs also operate by their own set of accounting standards. I call it “Chinese BAAP“, or “bureaucratically accepted accounting principles“. This is, needless to say, as different from GAAP as any two financial tracking systems could possibly be.

Under Chinese BAAP, the purpose of the annual financial statement is to produce a record that bureaucratic layers above can use. This means especially the administrators at SASAC, the government agency that owns and manages most SOEs. SASAC’s job is to make sure that SOEs are (a) increasing output while operating profitably; and (b) not engaged in any kind of corrupt hanky-panky.

Of the two, SASAC is probably more concerned that government property is not being pilfered, misappropriated, wasted or diverted to pay for senior management’s weekend gambling junket to Macao. This isn’t to say that such things can’t occur. But, the accounting system used by an SOE is designed to be so meticulous, so focused on counting and double-counting, that bad acts are harder to do and harder to hide.

If I could bill out all the time I’ve personally spent during 2013 studying and complying with SOE payment procedures, I’d probably have at least 100 billable hours by now. I should bill the SOE for all this time, but figuring out how to do so would probably take me another 60 hours.

The main purpose of all the rules seems to be to keep a very solid tamper-proof paper trail of money leaving the SOE. This is a far cry, of course, from accounting, at least as its understood outside China. The way assets are valued, and depreciated, follows a logic all its own. One example: an SOE client of ours bought and owns a quite large plot of suburban real estate outside Chengdu. Its main factory buildings are set on top of it. The land is booked at its purchase price as an intangible asset on the company balance sheet. Under Chinese BAAP, this is apparently allowed.

To meet SASAC-imposed growth targets, SOEs are known to boost revenues through a kind of wash-trading. Profit isn’t impacted. Only top-line. BAAP turns a blind eye.

Every SOE is audited once-a-year. Few private companies are. The main purpose of the audit is not only, as under GAAP, to determine accurately a company’s expenses and revenues. It’s also to make sure all of last year’s assets, plus any new ones bought during the current audit year,  can be located and their value tabulated.

From the standpoint of a potential investor, while the logic of Chinese BAAP may take some getting used to,  an SOEs books can be understood and, for the most part, trusted. There should be little worry, as in private sector companies, that there are three sets of books, that sales are being made without receipts to escape tax, and that company cash flows through an ever-changing variety of personal bank accounts. SOE management, in my view, wouldn’t know how to perpetrate accounting fraud if they were being paid to do so. They’ve grown up in a system where everything is counted, entered into the ledger, and outputted in the annual SASAC audit.

An investor who takes majority control of an SOE, as in the two deals we are now working on,  would want to transition the company to using more standard accounting rules. It would also want the company to avail itself, as few seem now to do, on all legal methods to defer or lower taxes. In short, there is good money to be made in China going from BAAP to GAAP.

 

SOEs That Are SOL – China’s Forgotten and Unprivileged State-Owned Enterprises

Perhaps the most commonly-heard criticism these days of the Chinese government’s economic policy is that secret policies favoring State-Owned Enterprises (so-called “SOEs”) are becoming more numerous, heavy-handed and harmful to the prospects of private business in China. This criticism, like others of China,  gains strength and credence because it is basically unfalsifiable. Since the policies are secret and the impact hidden from direct view, the only evidence offered is the continued growth and profits of SOE giants like China Mobile, ICBC, Sinopec and others.

While it’s undeniable that SOEs do enjoy a lot of advantages private companies can only dream of, often including easier access to bank loans and markets rigged to prevent free competition, I’m dubious that a real shift really is taking place, and that the Chinese government is wholesale turning its back on private business in order to make life easier for SOEs.

Not all SOEs are living a life of wine and roses. For them, government support is limited, haphazard, often counterproductive. There are hundreds of such SOEs in China. They aren’t the giant companies many foreigners have heard of. These SOEs are surviving, but not really prospering, with clapped-out equipment, low profits, bloated workforces and balance sheets larded with debt. It’s by no means clear that having a government owner is more of a benefit than a liability.

These SOEs have no real pressure to optimize profits and increase efficiency.  Their government owners, to the extent they even notice these smaller industrial SOEs,  are mainly concerned that they should continue to provide jobs, hand over a bit of money each year in taxes and dividends, and continue to increase output. In many ways, for all the epochal changes over the last 30 years in China, many SOEs are still run much as they were during the days of complete central planning:  growing bigger is still more important than growing more profitable, innovative, dynamic.

Thirty years ago, all of Chinese industry was state-owned and most urban Chinese were employed by the state. Then came the private sector reforms and liberalization under Deng Xiaoping, the rise of private business (which officially now contribute more than 70% of China’s gdp) and the bankruptcy of thousands of large SOEs, when many of the largest loss-making SOEs were forced to close. This process of culling the loss-making SOEs is often called “淘汰” (“taotai”) in Chinese, a term I quite like. It literally means to “wash clean” or “wipe out”.

But, many thousands of smaller, barely-profitable SOEs survived “taotai”. They are the ones now often living in a state more akin to Dickensian squalor than the plush recipients of government favor. Visit, as I did recently,  one of the “un-taotai’ed”  SOEs, and you will soon be disabused of the idea that all SOEs are prospering and that the Chinese government is running an economy to benefit SOEs at the expense of private business.

The SOE I visited is in Shaanxi province, about an hour’s drive from the capital, Xi’an. The factory was established in 1966, at the start of the Cultural Revolution, by a team of thousands of workers forcibly relocated from Tianjin. It manufactures certain special types of fiberglass, including some used by China’s military and space program. The SOE still produces many of the same products, on 45 year-old equipment, in a sprawling and broken-down facility the likes of which I’d never seen before in China. Most of the buildings are dilapidated, the roads inside potholed. Polluted waste water belches from pipes into overflowing holding pens.

This company, in one sense, is lucky. It has no competitors inside China, and only two elsewhere, Soviet-era factories in Byelorussia and Latvia. Saddled with unnecesarily large payroll and other ancillary costs not related to producing fiberglass, profit margins are low. But, the company earns money most years, including about $1 million in profits in 2011.

The problem, though, is that the company can’t get the capital to modernize, expand or rationalize its workforce of almost 2,500. It’s still responsible for the running costs of a local hospital, school and kindergarten. When the company’s boss goes to the government for help, he’s mainly told to fend for himself. The company is too small to get any attention from its government owners. So, it floats along in a kind of sad limbo.

With money and profit-seeking owners, the company could probably grow into a quite successful industrial business. The market for its products is actually growing. If they could let go excess payroll and obligations, margins would likely rise above 15%, generating sufficient surplus to finance the large expansion plans and upgrade the company’s boss has been trying, unsuccessfully, to implement for six years. The government says it has no cash to inject. State-owned banks, for all their supposed leniency towards SOEs, won’t increase lending. Instead, the government is urging the factory boss to find a private investor, to put together some kind of privatization plan.

But, in this case and many like it, whenever the Chinese government won’t invest, few if any sane private investors will. Any new investor would have to fund the cost of layoffs of up to 1,800 people. Most are entitled to one month severance for every month of employment.  Average salary is around $500 a month.

The new investor would also, according to Chinese law, probably need to buy its shares from the provincial arm of SASAC at a price tied to the company’s net assets, not its rather dismal operating performance. The entire business may be worth only $10 million. But, using the net asset formula, which includes a big chunk of valuable land, the price almost triples. After all this money goes out the door, the new investor would need to pump another $12mn-$15 mn into the company to finance improvements and expansion.

For any investor seeking to buy control of the company, the likely rate of return after all these outlays, even under the most optimistic scenarios, would be under 10% a year.  That’s a deal that few investors would consider. Along with the need to shell out all the money, a new owner would also acquire lots of contingent liabilities of unpredictable size and severity, including the cost of an environmental clean-up, repairs to company-owned housing where most of the current 2,300 workers, as well as retirees, live.

After spending the day with him, I sympathize with the company boss’s plight. He wants to run an efficient operation, turn it into a leading producer of certain high-technology fiberglass materials, and maybe earn his way into owning a small piece of the company. But, the current mix of policies in China will make that hard, if not impossible, to achieve.

While big SOEs do enjoy a lot of political clout, with sparkling new headquarters, and a low cost of capital that other companies envy, these smaller SOEs inhabit an altogether different and inhospitable world. Government ownership is far more of a hindrance than a help. And yet, they have no real way to free themselves.  These SOEs are, as Americans would say, SOL.

 

Teaching the Elephant to Dance – China’s SOEs Transform

Over the last thirty years, China has gone from a country where just about all companies were state-owned enterprises (so-called “SOEs”) to one where now fewer than 30% are. Much of the dynamism in China’s domestic economy comes from these newer private companies. There are some very strong SOEs dominating key sectors of China’s economy, including China Mobile, Sinopec, ICBC and other large banks, as well as airlines and utilities. These companies have also been partially privatized by selling minority stakes on global stock markets. This has provided huge amounts of new capital and brought with it improved performance and corporate governance at these top SOEs.

But, many SOEs have failed, while others languish with inefficient production, overstaffing and outmoded products. For many of these, the prognosis is not good. But, at the same time, there is a entrepreneurial transformation getting underway at some of these SOEs. Managers are beginning to act more like owners and less like civil servants. We are seeing this now in our work. Some of the most interesting companies we’re talking to are SOEs eager to bring in outside capital as a first step towards privatization, and subsidiaries of larger SOEs looking for ways to split themselves off from their parent and go public independently.

I expect to see more and more private capital, particularly from private equity firms, going into SOEs. In some cases, the investors will find ways to take majority control. In others, they will link their minority investment to a corporate restructuring that gives the SOEs management equity, warrants, or other incentives to improve performance and profitability.

The likely result: some of China’s more tired SOEs are going to get a big dose of free market adrenalin. At the moment, there are lots of legal hurdles for private capital to enter into an SOE. The process is opaque. We’re spending a fair bit of time on behalf of several SOEs trying to figure out workable legal mechanisms. To succeed, any deal will take time and need champions in higher levels of government. But, practical economic policies tend to triumph in China. Private capital is, without question, the best option to improve the profitability and future prospects of many SOEs. This is good for employment, good for economic growth, good for worker incomes, good for accelerating development in inland China. These are all core policy goals in China.

I’m not able to discuss details or provide company names, but I can give an outline of several of the most interesting SOE transactions we are now working on. This should give a sense of the kind of changes that may be on the way for SOEs.

In one case, a subsidiary of one of China’s largest publicly-traded SOE construction holding companies is looking for ways, with the parent company’s encouragement, to spin itself off, raise private equity capital, and then try for an IPO. Though it contributes only about 5% of the parent company’s total revenues and operates in different markets than the parent, this subsidiary is one of the largest, most successful companies in its industry in China. Its profits this year should exceed Rmb 650mn (USD$100mn).

Because the parent company is already public, this subsidiary needs to fight for capital with other larger sister companies inside the conglomerate. It usually comes up short. With access to new capital, the subsidiary’s current managers are confident they could double the size of the business (both profits and revenues) within two to three years.  Outside of China, spinning off a subsidiary or selling a minority stake in an IPO is a fairly straight-forward process. Not so in China.

Under current rules, the CSRC, China’s stock market regulator, will not allow the parent simply to spin off the subsidiary through an IPO. There are related party transactions and deconsolidation issues.  So, we are looking at ways for a large strategic investor to buy a controlling stake in the subsidiary, then pour in as much as $250mn in new capital. The subsidiary will then build up its business to where it could either qualify for an IPO three to five years later, or the PE firm would exit by selling its stake back to the parent.

The management of this subsidiary are quite keen to put in their own money and become shareholders if their business can be separated and put on a path to IPO. They have done a very solid job building the business to its current scale, and would likely do markedly better if they had a real stake in the performance of the company.

In another deal we are working on, a chemical company now majority owned by Sinopec is bringing in new capital to buy the Sinopec shares and recapitalize the business. The company was started seven years ago by a private entrepreneur, who raised the original capital from Sinopec. The entrepreneur now controls about 40% of the company’s equity. Through the deal we’re working on, he will become the majority owner and the private equity investor will own the rest.

We’re also in discussions with the international division of one of China’s giant SOE electricity companies. This group already has sizable projects and revenues in Southeast Asia and Russia, where it built and operates large hydro and gas-fueled power plants. The international division, however, is being held back by high debt levels at the SOE parent. This means the international division has trouble borrowing enough to finance its continued growth. Since the international division is already structured legally as a Hong Kong company, it should be possible for it to raise private equity then IPO in Hong Kong. We think this division can raise as much as USD$500mn in the next three years, both in private equity and IPO.

These three (the construction subsidiary, the chemical company and international power plant business) are all very solid businesses that outside investors will likely flock to. We’re also trying to find a way to help a more troubled smaller SOE based in central China. They make certain types of special fiberglass. The core business is fundamentally sound, but is stuck also doing some other things that lose money.  It is too small now to qualify for an IPO, and is having a hard time in the current environment increasing its bank borrowing. The existing managers are eager to have an outside private equity investor come in and not only provide the capital, but also help improve manufacturing efficiency and marketing, and chop away the loss-making parts. They think an investment of Rmb 50mn could increase profits by a similar amount within two years.

As anyone with experience will tell you, working with SOEs can be a complicated and time-consuming process, particularly compared to dealing with a company founded and run by a private entrepreneur. While we’re fortunate to have strong entrepreneur-led companies as clients, I also quite enjoy working on these SOE transactions. It affords an up-close view of the way SOEs operate and problem-solve. I’m also getting to participate, in a small way, in perhaps the most significant transformation now taking place in China’s economy. With new capital and perhaps new ownership structures, SOEs are going to thrive as never before. Their greater efficiency and greater profits will be a challenge for the private sector, but overall will be a plus for China.