RBS, Merrill and KS Li buy into BOC

Investor group buy a 10% pre-IPO stake in Bank of China for $3.1 billion.

The news became official yesterday (Thursday) that the Europe's third largest bank RBS was investing $1.6 billion for a 5% stake in Bank of China. Co-investing with RBS for a slightly smaller stake for $1.5 billion are a consortium comprising Merrill Lynch and the Li Ka Shing Foundation, the personal holding company of KS Li, Asia's richest man. Other investors are understood to be in the deal but their identities have not been revealed.

RBS has committed to hold onto its stake for three years and has stated that it does not plan to invest any more in Bank of China. The price values the bank at 1.15 times its net asset value as of end 2004. The investment is understood to have come with certain protections against issues such as any delay to the IPO and any deterioration in Bank of China's asset qualitry. Quite how these protections work is unclear at this stage.

For RBS the investment comes with a host of strategic co-operation agreements with Bank of China. The two will cooperate on credit cards, wealth management, corporate banking and personal insurance, using RBS' product skills and Bank of China's distribution strength. RBS will also get one board seat and help Bank of China with its corporate governance, risk management, HR and IT systems.

While the market had been expecting RBS to come clean on its investment into Bank of China for a number of weeks, the news that Merrill and KS Li were matching RBS's investment was something of a surprise. Most industry chat had been that UBS and Temasek were the most likely co-investors. Sources at UBS confirm that the firm is still looking to invest up to $500 million in Bank of China and its investment is likely to be tied to certain other strategic co-operations in investment banking and risk management.

However the most interesting aspect is the presence of Merrill Lynch. Officially the firm is not saying how much it is paying for its investment, only that it is part of a consortium with The Li Ka Shing Foundation, which together are investing the $1.5 billion. Sources confirm that the investment is purely financial and does not herald an imminent tie up with Bank of China in, for instance, a domestic Chinese securities venture. Certainly no strategic cooperation agreements were officially revealed, although Merrill does already own 16.5% of Bank of China Internatioal Investment Managers, BOC's domestic asset management arm.

Nevertheless when one looks at the China connection of Merrill's China Chairman Erh-Fei Liu and the close relationship between its Asia Pacific chairman KL Wong and Li Ka Shing, the deal starts to take shape. Moreover, Merrill has a definite appetite for Asia at the moment and is enjoying considerable success across many products. Putting its own capital on the line to secure a deal like this is just another example of banks doing deals for their own account rather than just for their clients. It also gives great comfort that as adviser to the deal, Merrill is willing to back it up with its own money.

In a way it is a throw back to the old days of merchant banking, when banks actually took risks on behalf of their clients. The structure of the deal addresses the concerns of RBS shareholders who did not want to see the bank spend the full $3 billion on the stake as well as Bank of China that wanted to get s much co-operation from RBS as possible. By putting the consortium, together Merrill has allowed both parties to meet their goals.

Sources suggest that Merrill's investment is not tied to the forthcoming IPO mandate, as Bank of China is scheduled to undertake an IPO in 2006. Market talk had suggested that UBS, Goldman Sachs and HSBC would get the mandate having successfully completed the IPO of Bank of China's Hong Kong subsidiary in 2002. It would be remarkable however if Merrill did not manage to get in on that transaction after this investment.

Merrill is advising RBS on this deal however, and is handling the sale of 135 million shares of Santander Central Hispano bank for $1.6 billion. The proceeds of that sale will be used to buy the Bank of China stake.

For Li, the purchase is the latest in a long string of investments he has made in Chinese SOE privatizations. However, most of the previous investments have been made through his listed companies, Cheung Kong and Hutchison Whampoa. This investment is being made through his charitable trust. It is not clear whether this means it is an act of charity, or just a sign that the investment is perhaps too risky and non-core for his listed companies. Whatever the reason is, it does give his personal endorsement to Bank of China.

Temasek is also said to be planning a $1.5 billion investment in Bank of China and there is nothing to say that that deal is off. Indeed there is still room for UBS and Temasek to invest their combined $2 billion and come under the ceiling of 20% foreign ownership, if they invest at the same valuation as RBS, Merrill and KS Li. There might be less strategic joint ventures to go around however.

Undoubtedly the biggest winner in all of this is Bank of China. It gets stamps of approval from one of Europe's best run retail banks, one of the best global investment banks and one of Asia's most admired business men. Not bad for a 10% stake.

The investment will also undoubtedly make its IPO path a lot smoother as jittery investors get comfortable with the presence of such well-regarded strategic investors. Indeed with the recent IPO of Bank of Communications, many investors just took the view that it was a leveraged and slightly more risky play on HSBC, which owned 19.9% of BoComm.

"I am delighted that an investment agreement has been reached with RBS," said Xiao Gang, Bank of China Chairman. "With its experienced management, outstanding business strengths, well-established internal control mechanisms and prudent management style, RBS is an ideal partner. The co-operation with RBS is a key step in our joint stock reform, and is crucial to transforming the operational structure, enhancing the internal management, improving the competitiveness and promoting our profitability."

The deal is also clearly sanctioned at the very highest levels of the Chinese government. This adds to the certainty that the Chinese government will not let Bank of China, nor indeed any of the big four banks fail.

"Bringing in international strategic investors is an important step in the deepening of the reform of state-owned commercial banks in China," says Wang Jianxi, Vice Chairman of Central SAFE Investments, the major shareholder of Bank of China. "Through strategic co-operation with RBS, Bank of China will be able to further enhance its corporate governance and internal control. We are confident that the strategic cooperation between Bank of China and RBS will produce positive results for both parties."