Zhang Xin has a Ph.D. in Finance from Columbia University and is a professor at the China Centre for Economics Research (CCER) at Beijing University. In this exclusive article he explains the benefits and background of the CSRC's new mergers and acquisitions proposals.
On July 27, 2002, the China Securities Regulatory Commission (CSRC) issued its 'Regulation on listed company take-overs' for public consultation. Based on international experience and designed to cope with China's special circumstances, the Regulation resolves a number of major problems that have prevented the emergence of an M&A market in China. What is the status of China's M&A market? And how should we understand the guidance provided by the measures?
A transitional and an emerging market
CSRC Chairman Zhou Xiaochuan has described China as an emerging market undergoing transition. The fact that China is an emerging market means that in many aspects--legal, economic, educational--it still has a long way to go before it reaches the standards of the developed world, but that it is moving fast towards them. And the fact that China is also in transition means that the economy is at the same time undergoing a fundamental restructuring from a planned to a market system. The challenges facing China are more diverse and complex than those that other emerging countries face.
A thriving M&A market would help in both aspects. It would support the transition to a market economy and it would boost growth thus helping to mature the economy. M&A could also assist the transition of ownership structure of Chinese firms from being heavily state-owned to privately-owned. And M&A could help China's industrial transition from traditional to modern industry. Because of the benefits it brings, M&A has a clear role in the government's development strategy. The 'Suggestions on Economic and Social Development 15th Five Year Plan' passed at the fifth plenum of the Communist Party's 15th Congress, backed 'the suitable use of international investment, and positive experimentation with M&A, investment funds and securities investments and other methods of using long-term foreign investment'. Premier Zhu Rongji has recently backed this stance.
Reform calls for M&A
China's listed companies should be the country's best. They should represent the most advanced and productive part of the economy. As such, they ought to take the lead in transforming the economy into a market-based system and in improving the industrial structure. M&A can play an important role in achieving this, by improving the allocation of capital and in helping these firms grow large and strong.
In terms of both their quality of management and of their financial performance, listed companies out-perform non-listed companies. The author has recently completed a comparative study of the results of 15,000 non-listed firms and 1,170 listed firms. From 1996 to 2000, the return on equity (ROE) of listed firms was 6.8% higher than that for non-listed firms.
The better performance of listed firms is due to a large extent to the stock market's regulatory standards and the pressure exerted by regulators and investors. Despite this, listed firms still give cause for concern, especially in terms of their ownership structure and the types of industry that dominate the market.
China has five types of firm, in roughly equal numbers: state-owned (guoyou), collective (jiti), private (minying), foreign-invested (waizi) and limited responsibility (youxian zeren) companies. For example, SOEs account for only 21.4% of all enterprises in China. But because of historical reasons, the stock market is stuffed with a disproportionate number of SOEs: Companies controlled by the government account for 78.4% of listed firms. And of course, the tiny numbers of listed collectives and private firms does not reflect their importance to the wider economy.
Amongst the five types of firm it is the collectives and private firms which are most efficient. As the chart shows, the ROE of SOEs is very low, typically just over 1%, while private firms give an average return of over 5%. The challenge facing China's stock market is thus huge.
There are two ways to improve the quality of companies listed. One way would be to list more private and collective firms. But since stock market expansion has to proceed gradually, there is an obvious limit to this approach. A second more practical way to improve the market would be to focus on restructuring, and improving the operations of firms already listed. This is where take-overs of listed firm could come in useful.
Does M&A create value?
But does M&A really help companies to use their capital better and to improve their efficiency? In other words, can M&A really create value?
One popular school of thought believes it does, holding that M&As, or at least the threat of a take-over, is a good way of disciplining a firm's management. If a firm under-performs, and its share price falls below what the market believes is its 'real value', then it will have a hard time avoiding a take-over attempt. Because of this threat, management will try to do better. If they fail, a new management will do its best to improve efficiency, and thus increase the value of the firm.
Another school takes the opposite view. It holds that M&As usually bring little value, and that purchasing firms are usually only motivated by vanity and/or a desire for a sense of security. In short, take-overs have nothing to do with creating shareholder value. The recent scandals involving Enron and Worldcom in the United States give much weight to this thinking. Both companies expanded rapidly through the 1980-90s via M&As, and their internal management structures became a mess as a result. Grub and Lamb (2000) argue that 'in reality, only 20% of M&As are succesfulàMost take-overs erode shareholder value'. Meeks (1997) looked at 233 M&A deals in the UK and found that profits at the purchasing firm tended to decline after the take-over.
Of course, regulators are also concerned. For example, the Securities and Exchange Commission (SEC) in the United States established an 18-person committee in 1983 to examine US take-over regulations. After examining M&A activity in the US, the committee decided that there was not enough evidence to support the claim that M&A creates value, and so revised US regulations to neither encourage or limit take-overs.
In the last 30 years, the question of whether M&A adds value has attracted endless academic research, but to no avail: a conclusive answer is still out of reach.
Of course, in developed markets the fact that M&As may not create value is not really surprising. Since market competition is intense and capital markets are efficient, companies' shares are usually priced at fair value. As such it is very difficult for a potential purchaser to be sure that he has spotted an undervalued asset. But in China, a transitional economy with an inefficient industrial structure, it is much easier to find under-valued companies, and under-performing assets. As such, in a country such as China, it should be easier for M&A to add value.
M&A helps listed company performance
An examination of the 1,176 listed firms that have undergone some form of takeover during 1990 to June 2002 backs up this claim. First of all, consider the share price movement sixty days before and 30 days after the announcement of an M&A deal. Financial theory would predict that if the market expects the deal to add value to the company, the share price will rise, especially in the three days preceding the announcement (as news leaks out). Even taking account of price manipulation, the chart below shows clearly that the share price in China does tend to rise before and after such a deal.
Alternatively, look at the accounts of these companies in the three years after a take-over, especially the results from their main operations. The below chart shows an obvious improvement in performance after an M&A deal, even allowing for the decline in the third year.
In conclusion, it appears safe to claim that M&A in China creates value.
What prevents M&A in China?
The first thing that holds up the development of the M&A market in China is the restrictions that apply to the management of state assets. 70% of listed company equity is controlled by the state, 80% of all listed companies are controlled by the government. Current policy can be described as 'state ownership, different levels of management' in that different levels of government control listed companies. Any transfer of this equity must be approved by the Ministry of Finance (MoF). The government has made it clear that it intends to encourage the transfer of ownership to private and foreign hands. But it is as yet unclear when the procedure to implement such a policy will be issued. Second, the rules governing listed company take-overs are still incomplete. The legal framework for mergers, acquisition and restructuring is made up of a large number of laws, rules and regulations governing different aspects of the market for corporate control. Among them, the 'Regulation on Listed Company Take-overs' is concerned with listed company sales, and stakes out a practical set of rules to govern general offers and negotiated take-overs. The 'Notice Related to Large-scale Sales, Purchases and Asset Restructurings of Listed Companies, (Document No. 105) set out the rules to govern the asset restructuring of listed companies.
The only regulation that has been implemented so far to cover large-scale M&A deals is this notice û Document 105. Because of the lack of other rules, those involved in the market inevitably face a lot of uncertainty. The new regulations on takeovers will go a long way to help clarify their rights and duties.
Third, the instruments available for taking over companies have been restricted. China's commercial banks are banned from getting involved in investment banking activities. Because of this commercial banks will not finance the purchasing of the shares of the target company. Since banks cannot help, purchasing firms currently must use their own cash and this of course limits the scale of the deals they can do.
Finally, the professional standard of the intermediaries involved in arranging M&As--the lawyers, accountants and investment bankers--is limited. Most securities companies do not have a dedicated corporate finance department to handle M&A work, and in fact pay the sector little attention. One of the reasons for this is that corporate-related work is still a low fee generating business. Moreover, the M&A market is still subject to much manipulation. A rumour about a restructuring deal, or a fake deal, can send a company's share price sky high, and many securities companies have been involved in arranging such scams. Much of the time, the corporate advisory staff within securities companies do little more than support those involved in manipulating a listed firm's share price.
Encourage the market, and make sure its fair
China's listed companies need to undergo major restructuring. A strong M&A market would help, and thus needs to be strongly encouraged. There are a number of measures that need to be taken to bolster the market. For instance, the government bureau that are currently in charge of managing the state's assets need to change their approach. They ought to recognise that the only way for the assets they control to gain in value, and to be put to productive use, is if they can be traded. The regulatory organs responsible for the capital market ought to quickly loosen the regulations governing M&As and provide more tools for purchasers. For instance, bank loans should be available to support corporate purchases.
But while the market is developed, it is also important that proper regulations are implemented, that all shareholders, large and small, are protected, and that the market develops on the basis of equity.
If M&A deals are not fair, or are perceived as being unfair, there will be an adverse public reaction. For example, people might see M&A deals involving state assets as a form of theft of state assets. Such a public reaction would feed back into the market since if those firms and individuals involved in M&A come under pressure they may well decide to take a short-term approach. They would start to buy up companies and sell off their assets as fast as possible, and then escape abroad with the funds.
For example, in the former-Soviet Union and Eastern Europe, economic policy makers thought that the only thing that mattered was clarifying property rights as quickly as possible. And so they organized a rapid privatization process which completely ignored issues of justice. Unsurprisingly, as state assets were sold into a very few private hands, often involving corrupt payments, there was an adverse public reaction. This then resulted in short-term investment strategies and large volumes of funds fleeing abroad. Economic development in the region was undermined. The lesson we learnt here is that the success of any significant reform is path dependent. Not only the transition itself is important, but also the path of the transition is key to the success.
The government of the PRC must do its best to create a fair and just M&A market. In China at present, one important trend is for private entities to become majority shareholders of listed companies. But because the official rules state that state shares cannot be sold to non-state organs, the people currently involved in these deals have to bend the rules. Faced with the huge uncertainty and risks involved in such deals, investors will not be keen to organize substantive, long-term take-overs, and may well be encouraged to leave China altogether.
Thus, rules need to be clarified. If the M&A market is built to be efficient and fair, however, there will be no adverse public reaction and investors will have the confidence to invest for the long-term.
What changes do the new takeover measures bring?
The CSRC's new measures combine international experience with the special needs of China's own stock market. Together with the Securities Law, they create a comprehensive and stable legal basis for the M&A market, which will undoubtedly stimulate its development, and will thus trigger a dramatic consolidation in China's industries.
The new measures break new ground in a number of areas:
- There are no limits on what type of entity can engage in the take-over of a listed company. A state or private firm, an individual or a legal person, can all now get involved. By lowering the entry barriers, the rules should allow a larger and more diverse crowd of players to become involved.
- More financial tools are available to purchasers. For example, a firm can now use shares or assets to buy a listed firm's shares, whereas before only large sums of cash could be used.
- The pricing problem is resolved. The split between floating and non-tradable shares (the ones owned by the state and legal entities) in China means that it is impossible to use market mechanisms to value the equity of listed firms. The new regulation allows for buying different types of shares at different prices.
The measures also increase the exemptions to a general offer, and thus should decrease the cost of take-overs. In many other jurisdictions, a general offer--an offer to buy all shares at the best price within a fixed time period--is mandatory once an entity controls a certain proportion of the firm's shares. Previously, the only exemption to the general offer rule in China was when the transfer of shares was carried out administratively between state shareholders, since in such a situation there was in fact no real transfer of control rights. The new measures extend the exemptions to when shares are obtained unvoluntarily as well as when a takeover rescues a listed company from a financial crisis.
The measures also promote protections for all shareholders. For example, they guarantee that all parties must make extensive disclosures. They also ensure that once the purchasing party has reached an ownership stake of 30%, it must then make a general offer to all other shareholders, unless excused by the regulator. This offer is designed to protect the interests of all shareholders. The principal is that when corporate control is being transferred (and in legal terms this is a 30% stake), medium- and small-sized investors should have a chance to profit from the upward price movement and have the opportunity to exit before their company gains a new owner. Only the United States, and a small number of other countries, do not adopt a general offer system. As China has a much weaker legal system and a less efficient disclosure environment, it needs a more powerful and clear tool such as the general offer to protect small investors' rights.
Zhang Xin has a Ph.D. in Finance from Columbia University and is a professor at the China Center for Economics Research (CCER) at Beijing University.
