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China SOEs, the meaning of their existence — Week In China Magazine

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His was a deceptively simple question. “What exactly is the purpose of a Chinese SOE?”

I had just finished speaking to the Asian management committee of one of the larger and more successful Fortune 500 companies operating in China. They have for years done profitable business with large SOEs in China. That business has begun to evaporate. Having just heard me summarize the deteriorating situation at many SOEs, and the decision last month by the Chinese government to quietly shelve plans for a root-and-branch restructuring, one senior executive wanted to know what Chinese SOEs are now in business to do. Make money? Provide and protect jobs? Project national power?

I reminded him Chairman Mao was a keen student and devoted follower of Lenin. He fully embraced the Leninist concept of the state and party controlling the “commanding heights” of the economy. China’s SOEs are still very much in that business: owning most, sometimes all, of China’s large-scale assets in petroleum, gas, electricity generation and distribution, coal, banking and finance, transport, steel, aluminum and a wide range industrial chemicals.

The executive then reminded me that Mao had been gone a long time and anyway hadn’t Deng Xiaoping begun 35 years ago dismantling state power to create the conditions where today’s vibrant Chinese private sector could emerge. The private sector is the source of all net new job creation in China and contribute far more to GDP than the SOE segment. The country’s best companies are private sector firms, not SOEs. What, he insisted, were SOEs in business to do?

It was obvious he wasn’t going to accept an answer based on Leninist political economic theory. “Why don’t they just privatize the state-owned sector?”, he pushed back. That, I told him, was out of the question, at least for now. “Why?” he wanted to know.

Looking for an opening to collect my thoughts, I steered him toward the coffee machine.

Above all” I started in again, “an SOE is an instrument to achieve Chinese government and party policy goals. This is as true today as it was at their origin. Sometimes those policies, at least originally, were quite high-minded, even socialistic, like providing sufficient energy at an affordable price to everyone in the country.

Energy is today plentiful in China, but cheap it’s not. Subsidies have been eliminated and prices hiked to levels generally well above those in the US. The money paid to the petroleum and power monopolies are a transfer of private wealth to state-owned coffers, in other words, a mechanism for hidden tax collection.

 

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China’s SOEs attract PE interest — 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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SOE Reform in China — Big Changes On the Way

Qianlong emperor calligraphy

China’s state-owned enterprises (SOEs) are a lucky breed, or so conventional wisdom would have it. They have lower cost of capital and less competitive pressures of private sector competitors. China’s big banks (also state-owned) are always happy to lend, and if things do turn sour, China’s government will bail everyone out.

The reality, however, is substantially different and substantially more challenging. SOEs live in a different world than they did ten, or even three years ago. They are more and more often under intensifying pressure to achieve two incompatible goals: to continue to expand revenues by 15%-25% a year, but to do so without corresponding large increases in net bank borrowing. The result, over time, will be that SOEs will need to rely increasingly on private sector capital to finance their future growth.

This message came through especially loud and clear in the policy document published by the Chinese leadership after the recent Third Party Plenum in November.  SOEs are told they need to become more attuned to the market and less dependent on government favors and protection. This new policy pronouncement is reverberating like a cannon blast inside the state-owned economy, based on conversations lately with the top people at our large Chinese SOE clients.

No one at these SOEs is entirely sure how to fulfill the orders from above. But, they are all certain, from long years of experience, that the environment SOEs operate in is going to undergo some significant change, likely the most significant since the “Great Cull” of the mid-1990s when thousands of SOEs were pushed into bankruptcy.Too many of the surviving SOEs have done little more than survive over the last twenty years. They managed to stay in the black, sometimes by resorting to rather idiosyncratic accounting that ignored depreciation.

The Chinese leadership is embarking on a tricky, somewhat contradictory, mission:  to simultaneously shake up the SOE sector, make it more efficient and responsive to market forces,  while keeping SOEs embedded in the foundation of China’s economy.  Much has changed about the way Chinese leaders view and manage SOEs. But, a key principle remains intact. The architect of the policy, Deng Xiaoping, put it this way, ” As long as we keep ourselves sober-minded, there is nothing to be feared. We still hold superiority, because we have large and medium state-owned enterprises.

In other words, SOE privatization is not on the menu, at least not in any large-scale way. SOEs, particularly the 126 so-called “centrally-administered SOEs” (央企)  will remain majority-owned by the government. The government is suggesting, however, it wants these SOEs, as well as the other 100,000 or so smaller ones active in most parts of the Chinese economy, to be run better and more profitably. But how? That’s the a topic of discussions I’ve been having over the last month with the bosses at our SOE clients.

The rate of return (as measured by return on assets) at SOEs has, in almost all cases, drifted down over the last ten years, and is now probably under 3% a year.  If bank borrowing and depreciation were more properly amortized, the rate of return would likely turn negative at quite a lot of SOEs.

In some cases, this reflects the cruel reality that many SOEs operate in low-margin highly-commoditized industries. But, another key factor is that the government body that acts as the owner of most SOEs, SASAC (国资委), is not your typical profit-maximizing shareholder.

SASAC manages the portfolio of SOE assets like the most risk-averse executor. It demands three things above all from SOEs: don’t lose money;  don’t pilfer state assets and keep revenues growing.

When your owner sets the bar a few inches off the ground, you don’t try to break the Olympic high jump record. No SOE manager ever got a bonus, as far as I’ve heard, from doubling profits, or improving cash flow. Pay-for-performance is basically taboo at SOEs. The whole SOE system, as it’s now configured, is designed to produce middling giants with tapering profits.

Rather than shake-up SASAC, the country’s leaders have given SOEs a green light to seek capital from outside sources, including private equity and strategic investors. They should provide, for the first time, a voice in the SOE boardroom calling for higher profits, higher margins, bigger dividends.

It’s a wise move. SOEs need to carry more of the load for China’s future gdp growth. You can’t do that when you are achieving such low return on assets. Among the SOEs we work with, there’s a genuine excitement about bringing in outside investment, and operating under a new, more strenuous regime. Surprised? The SOEs I know are run by professional managers who’ve spent much of their careers building the business and take pride in its scale and professionalism. They, too, see room for improvement and see the downsides of SASAC’s approach.

Outside capital can help these SOEs finance their future expansion.  It could also open new doors, especially in international markets. The big question: can — will — private equity, buyout firms, global strategic investors seek out investments in Chinese SOEs? It’s unfamiliar terrain.

Earlier this year, I arranged a series of meetings for twelve of the world’s-largest PE firms and institutional investors to meet a large SOE client of ours. These firms collectively have over $700 billion in capital, and each one has at least ten years’ experience in China. They are all keen on this particular deal. Yet, none of these firms have invested in any SOE deals over the last five years. For many of the visiting PEs, it was their first time ever meeting with the boss of a profitable and successful SOE to discuss investing.

In this case, it looks like a deal will get done, and so provide a blueprint for future PE investing in Chinese SOE.  The Chinese leadership ordered a shakeup to the state owned sector. It’s getting one.

 

China SOEs — How They Think and Why

China First Capital blog There are many flavors of State-Owned Enterprise (“SOE”)  in China, from polluting monster chemical factories to quaint dumpling houses that date from before the revolution.  Since coming to China, I’ve seen up-close quite a number SOEs, probably more than most other non-Chinese. No two are quite alike. But, equally, SOEs in China, from the largest centrally-administered “national champions” (known as 央企, or “yangqi”, in Chinese and include such familiar names like Sinopec, China Mobile, ICBC) that earn billions in profits every year to smaller local loss-making industrial companies with a few hundred employees, share a similar genetic code. Or more precisely, provide the same iron rice bowl.

That phrase (铁饭碗 ) was widely used during Mao’s time, and I still heard it frequently when I first came to China 1981.  It’s since faded from common use. But, the concept remains embodied within all SOEs. Simply put, an “iron rice bowl” means a job for life, and so a life without the worry of going unfed. In today’s China, with the threat and the memory of famine now extinguished, it’s more a way of expressing the unique way an SOE functions, how it views its role in society and the benevolent — some might say paternalistic — way it cares for its employees.

An SOE is, above all,  a very Chinese institution, and in many ways, one of the few holdovers from the Maoist era.  Chinese then didn’t so much work for a company as they belonged to a “work unit“, a 单位 (“danwei”). A paying job was in some senses the least important thing provided by one’s work unit, since cash salaries used to be very low, under $10 a month for mid-level managers. Instead, one’s work unit provided housing, schools, communal heating, medical care, ration tickets, permission to marry, to travel or have a child, subsidized meals and fresh food.

In theory, the work unit was the Great Provider, anticipating and meeting all of one’s needs in life. In practice, of course, it offered not a lot more than a very rudimentary existence and a job for life. For most Chinese, especially all working for private sector companies, the danwei system was dismantled ten years ago. A job is just a job, not a lifetime meal ticket.

But, for those working at SOEs, many of the more desirable features of the danwei system have been preserved, starting with the fact you are very unlikely ever to be fired. What’s more, the company itself is also highly unlikely to ever go bankrupt or face a serious crisis that would lead to mass layoffs.  Today’s SOEs hold, in effect, a permanent right to operate, regardless of market conditions.

China’s current group of SOEs are a privileged rump, those spared from a massive cull over ten years ago. That put the worst, least efficient SOEs out of business, and forced tens of millions to take early retirement or go off in search of new jobs, mainly in the private sector.

SOEs, along with the military and the Party, are the third of China’s key pillars of state power. While each is subject to the control of the country’s leadership, each also operates, to some extent,  by rules of its own. Chinese leaders are known to complain, at times, about the power, wealth and influence of the country’s larger SOEs.

SOEs are ultimately kept in business by other SOEs — loans from the state-owned banks, and orders or supplies from fellow SOEs. In most cases, they have a marked preference for doing business with one another.  Partly, this is because SOEs tend to understand better the way other SOEs think and act. Partly, it’s also because SOEs function together as mutual assistance society. If one gets in trouble, others will either voluntarily help out, or be ordered to do so by SASAC (“国资委”), the government organization that manages Chinese SOEs.

SOE jobs usually pay less than private sector competitors. But, for many, that’s more than compensated by the perks that come with the job. While Google is famous for its free food and recreation areas,  an SOE has its own attractions, tailored to the tastes of its Chinese employees. Workloads tend to be modest, and a long lunchtime siesta is built into every working day. During winter, the company will often provide extra cash to pay for heating.

There is, in my experience, an obvious camaraderie among SOE workers,  a shared identity and pride working for what are usually very large, well-known companies that tower over their private sector competitors and neighbors. If not always in practice, at least in theory, an SOE is meant to be in business for the benefit of all of China, not to accumulate profits or generate wealth purely for its shareholders.

It’s a noble mission, but one that can lead to its own rather systematic form of inefficiency. Urged on by SASAC, they set ambitious growth targets every year to increase output. They achieve this, in most cases, by pouring more borrowed money into new capital equipment, often to produce products the government says China needs or wants. The amounts invested, and the returns on those investments, tend to move in opposite directions.

SOEs can borrow at half the cost of private sector companies. Their hurdle rate is also often half that, or less, than private companies’.  As a result, projects with limited financial rationale often get built.

Take LEDs, solar and wind power. All three were heavily over-invested by SOEs because the Chinese government had made such “green energy” projects a national priority. More energy was probably consumed forging the steel and building factories and equipment to produce LED assemblies, solar panels and wind turbines than has been saved by lowering overall energy use in China. A lot of these LED, solar and wind projects are now mothballed, due to losses and falling demand.

Part of what SOEs exist to do is to take government economic policy and turn it into hard, if sometimes not very productive, assets. That outlook, of course, also impacts the way SOE staff work. Their pay isn’t linked to profits any more than company-wide strategy is.

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.

 

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.