Chinese buyouts

When China’s State-owned Assets Supervision and Administration Commission (SASAC) issued an announcement (approved by the State Council) earlier this year paving the way for a slightly more relaxed treatment of management buyouts of the country’s state-owned enterprises (SOE), a SASAC official was keen to stipulate a number of caveats for any potential deal. Essentially, what it boils down to is that any MBO of an SOE would be “rigidly controlled and canonically operated,” according to this nameless official.

This is one of the great stumbling blocks for the concept of a buyouts market in China. While by their nature buyouts are about taking control of a business and exiting the investment with a tidy profit in hand, there appears to be state-sponsored resistance to embrace this investment ethic. Much as China wants to attract outside capital and the managerial expertise that comes with the big buyout funds, there is a sense among international investors that China’s multi-tiered government approach is not ready to cede control to foreign capital for a number of reasons.

An investment manager at one of the big buyout funds looking for China deals says while there are obviously certain industries that remain restricted investments for foreign capitalists, China is all about maintaining face. “You find a real sense of reluctance in at least one tier of government when you talk about buyouts,” explains this well-connected investor. “The Chinese certainly don’t want to see headlines about foreign capital making tremendous profits on the back of restructuring their industry. Perhaps a bit more sensitive an issue is that there is a real sense that Chinese industrial champions should be Chinese managed: real homemade success stories. But good enough managerial skill sets are lacking in many cases.”

It is understandable that China wants to avoid a privatisation process where state-owned assets are carved up by politically appointed managers who have no other interest but to make a quick buck. The experiences of the Russian economy must be fresh in the minds of the many government departments and commissions controlling the process in China.

For the time being, China is just too complicated a proposition for some investors who are taking a back seat as far as the buyouts market is concerned. “In China we see a lot of potential for state-owned enterprises (SOEs) being privatised. There is also some activity for some generational changes for some privately owned businesses,” says Stephane Delatte managing director of MezzAsia Capital in Singapore.

“With an SOE, you’re not buying one neat company,” says Delatte. “There are pension fund issues, tax liabilities, greater social considerations and much more to consider.”

“There’s no doubt China wants to divest its stake in some of its assets and businesses. When you buy an SOE in China they are often not run as a business: it’s more like buying a government department,” says Jean Salata, managing partner of Baring Private Equity Partners, Asia in Hong Kong. “The amount of effort involved versus the reward is not worth it. Generally, I would rather wait to see how the market develops,” says Salata. “There’s a lot more examples of growth equity success stories than there are of buyouts.”

Some funds have been negotiating potential buyouts for a long time. But as agreements are nearly reached, the regulatory framework changes may have an impact on the whole process meaning even more negotiations are needed. One of the highest profile attempts at a deal so far has been Carlyle Group’s attempt to finalise an 85% buyout of Xugong Group Construction Machinery Co Ltd (XCMC), the largest construction machinery manufacturer and distributor in China, for US$375m in cash. Although Carlyle announced the signing of a definitive agreement last October, the final closing has been delayed. Investors in China think the sticking point is Chinese government insistence that Carlyle does not exit within a certain time. It is not clear what that timeframe is.

Carlyle has noted the agreement follows a lengthy and rigorous auction process, with two rounds and six international bidders. The auction was conducted under the guidance of the Xuzhou Asset Exchange Centre in accordance with central and local government regulations on the transfer of state owned assets, which emphasise open, equitable and impartial principles. As of last October, the transaction had obtained Xuzhou government approval and was in the process of completing Jiangsu provincial government approval and appropriate central government regulatory approvals. The transaction is the culmination of a restructuring process under the guidance of the Xuzhou city and Jiangsu provincial governments. The aim of the restructuring is to expand XCMC’s leading national brand internationally. Carlyle has structured the buyout as a pure equity investment with no mention of any leverage finance. However, private equity investors are trying to develop a leveraged buyout market, of sorts.

Another high profile buyout to encounter problems in China was the 55% stake in Harbin Pharmaceutical Group Holding Co Ltd the parent of Harbin Pharmaceutical Group Co Ltd that Warburg Pincus, CITIC Capital Markets and Heilongjiang Chenneng High-Tech Risk Investment Company, a local Harbin-based fund, bought early last year. The remaining 45% would stay with the municipal government of Harbin. Warburg and CITIC bought a 22.5% stake each.

The equity investment in China’s largest drug maker was to be funded by the investors taking out a US$282m loan underwritten by Citigroup. But by March of this year the loan was cancelled following a poor response from the bank market, which was concerned repayment would be uncertain and the debt would be subordinated to existing debt facilities at the parent level.

It is thought Citigroup was able to syndicate just US$85m of the five-year loan facility. This despite the fact that it offered 322bps over Libor in fees for banks taking at least US$50m. Some banks did not like the idea of being repaid from the proceeds of a relisting of Harbin Pharmaceutical, which was previously listed on the Shanghai exchange but was delisted following the buyout last year.

The unofficial line from Citigroup in Hong Kong is the Harbin deal was not pre-funded and Citigroup did not lend the funds. It provided an underwriting commitment, which has lapsed given the change in the deal structure.

In the wake of closing the Harbin buyout, China ended a requirement that investors owning more than 30% of a listed company make a general offer to purchase a 100% stake. This is being interpreted as a useful measure that will help reduce the cost for buyers who only want to gain majority control of a listed company rather than taking it private. The general consensus is that regulators in China have put a temporary hold on fresh mainland listings while the country’s stock markets, mainly Shanghai and Shenzhen, recover and a new regulatory framework is put in place and the domestic securities market improves.

The Xugong and Harbin buyouts are very different deals but they appear to have been lumped together as reflective of how difficult a buyout is to close in China. Even investors with a keen eye on the Chinese market think the buyout process in China equals headaches. One Hong Kong-based investor says: “When you look at buyouts in China, you’ll always be faced with deals like those two.”

“The trend appears to be an increase in buyouts but with the potential there are some issues to consider such as leveraging deals. The level of leverage tried so far has been modest,” says Delatte. “It is very difficult for overseas lenders to lend.” There is, however, proof the leveraged buyout market in China can work. The one LBO completed so far in China, seemingly with no real problems, was Pacific Alliance’s US$122.5m acquisition of Goodbaby Group, one of the world’s largest makers of baby strollers and children’s products. The deal closed early this year. Goodbaby Group, headquartered in Shanghai, is one of the largest suppliers of baby goods to Europe, in China and to the US. Goodbaby makes roughly one-third of the pushchairs and baby strollers sold in the US and has about a 30% market share in baby goods in the expanding Chinese domestic market.

Using leveraged finance debt pre-funded by Taipei Fubon Commercial Bank Co Ltd, (long-term credit rating by Standard & Poor’s is single A-minus) the sole mandated lead arranger Pacific Alliance acquired the interests of existing shareholders, including First Shanghai Investments Limited and SB China, an affiliate of Softbank Corporation. After the transaction, management has a continuing role in the business. “The ability to structure the transaction as a leveraged buyout demonstrates private equity investors now have a greater set of options when investing in China and we expect to see more such transactions in future,” says Chris Gradel, Pacific Alliance’s managing partner.

“Following China’s accession to the WTO, the retail and services sectors have been opened up. They appeal to financial investors because they are traditionally cash generative businesses,” explains Seung Chong, a partner at White & Case in Hong. The law firm advised Pacific Alliance on the deal. It is thought there is a hold clause requirement for Pacific Alliance, but just how long the investor needs to wait until it can exit has not been announced.

As close as the deal is to the start of an LBO market in China, the offshore structures foreign investors use to invest in Chinese businesses mean a true Chinese LBO is still some way off. “A true LBO would mean Chinese bank debt being lent to a Chinese acquisition vehicle taking security in China,” says Chong. “However, domestic banks are not internally resourced or incentivised to lend into these deals at this stage.”

Offshore deal structuring can be a minefield of uncertainties. For example, if there is a default on the debt repayment schedule, how does the lending bank enforce security if the whole LBO is offshore but the business in obviously onshore? “The security is in the shares of the offshore entity (or entities because often there will be intermediate companies) and the offshore entities, of course, own the onshore business through a domestic entity. Of course, it is better also to get a charge over the fixed assets onshore but there is where you run into the problems of taking onshore security,” explains Chong. This deal is a considerable development for China LBOs because it features a lender, a Taiwanese one at that, willing to lend to a domestic business while all of the security is offshore. Generally, China is addressing the concept of management buyouts and issued interim provisions on the transfer of state-owned property rights in enterprises to management personnel last year. Although probably best left to legal counsel interpretation, interested parties could read the details of the document called Circular of the State-owned Assets Supervision and Administration Commission of the State Council and the Ministry of Finance on the Printing and Distribution of the Interim Provisions on the Transfer of State-owned Property Rights in Enterprises to Management Personnel (State-owned Assets Supervision and Administration Commission Document No. 78 of 2005.) This MBO circular basically outlines the provisions for investors to structure quite easily an MBO of a small-to-medium-sized enterprise (SME) but it is restricted for large companies.

“You have to be aware of what the definition is of a small, medium or large state-owned company, which is determined on an industry by industry basis,” says Andrew McGinty, a partner at Lovells in Beijing. (See boxed item.)

By the end of 2005, SMEs accounted for 99.3% of the total number of Chinese enterprises, 55.6% of GDP and 74.7% of industrial output growth. They employ 75% of the working population and have helped China’s economic growth in the last two decades. Their contribution to the economy is expected to continue to increase in tandem with China’s soaring manufacturing and exports volume as well as the burgeoning service sector.

As the Xugong deal demonstrates, attempting a buyout of a Chinese SOE can take years rather than months. The market generally agrees there is interest but what is debatable is whether this investor demand will be attracted from private-sector deal demand in China.

“The SOE route has always been a minority approach. People have always found it easier to get their head around private enterprises because they are less complicated,” says McGinty. “If you buy state-owned assets in China you have to accept a mandatory state valuation. There’s a floor price below which you can’t go so that means there is no room for the buyer to negotiate the price. Before being sold, assets have to put on Property Rights Exchanges in Beijing and Shanghai, for example, where they can be bid for, meaning the original buyer has wasted time and resources completing the due diligence,” says McGinty.

It is worthy of mention that the Xugong transaction has been subject to scrutiny at the Xuzhou Asset Exchange Centre.

“It’s a question of finding the mechanism that works to get the best price which is fair to the Chinese government without making it unfair to those that have done all of the groundwork,” says McGinty.

The Chinese government has experienced some bad times in the past where companies have been asset stripped and the proceeds flipped into offshore structures.

“China wants state-owned assets to be restructured with foreign capital, but it is an extremely complicated balancing act,” says McGinty.

Some of the most basic, yet resounding, advice to investors looking at buying or structuring MBOs of SOEs is you can’t just walk into China, take over a company and fire hundreds of people. Also, privatisation is not a popular word in China.

“The buyout market will develop gradually. I don’t think there will be a big bang.” The idea is that this will feed into trade sales in the future, with fewer anticipated IPOs, says Chin Bay Chong of Actis in Beijing. Chin says the big buyout funds are starting to look at China with US$100m-plus deals on the horizon.

“Looking at the examples of Korea and Taiwan, you can imagine the similar levels of economic development in India and China,” says Salata. “I would be surprised if there were no buyouts in China.” China attracted in the region of USD8.5bn in private equity investment in 2005, of which not much more than 5% was for buyouts, market participants generally agree.