The privatization of China's economy is gathering speed

Private companies have been taking over listed entities by stealth to access badly needed capital Now new M&A proposals aim to legalize and boost the process.

According to the official line in China, the 1160 companies listed in Shenzhen and Shanghai are the country's finest. In fact, most of the companies are badly managed and show poor returns, as Caijing Magazine documented in its most recent issue. On an Economic Value Added Basis, listed companies as a group destroyed value of about Rmb16.6 billion in 2001 ($1.9 billion), or around Rmb14.4 million per company, the magazine reports.

They succeeded in listing in the booming 1980s and 1990s thanks to strong provincial and city support, based on good connections more often than not.

In contrast, it's no secret that the country's private sector has been booming, accounting for between one-third and one-half of the country's GDP, according to the World Bank, even though it suffers from severe restrictions in accessing capital, especially the capital markets. Banks prefer to lend to state owned entities which have some assurance of the government bailing them out in a crisis. Credit information in the private sector is scarce and unreliable and the coveted listings are awarded to SOEs.

Consequently, the private sector gets forced into shady areas in their search for funds. Companies wine and dine banking officials, raise money on the black market and generally make themselves vulnerable to government crackdowns. Their difficulty in accessing capital also means their growth prospects are gravely hampered, resulting in very few high profile genuinely private Chinese companies, especially in capital-intensive industries.

Yet the chairman of the CSRC, Zhou Xiaochuan recently mentioned at a domestic press conference that some 200 companies are in fact privately owned, or at least that their major shareholder is a private company or individual. Nobody quite knows where Zhou got his figure from, although an influential Chinese business magazine, New Fortune, published a study this month estimating that around 10% of listed companies, or around 160 companies have undergone de facto takeovers by private companies.

How did this extraordinary reversal come about? For years, analysts have been urging the authorities to provide more credit to private companies and to allow them better access to the capital markets. And it seems as if the government is finally realizing that it's time to let the private sector off the leash.

In contrast to today's new government philosophy, in 1995 Japanese car market Isuzu acquired a stake in a Chinese car component manufacturer. The government 'went ballistic' at the loss of state assets, according to one contemporary witness, and vowed that nothing similar would happen again. Yet many are predicting now that once the logjam caused by the 16th party congress is lifted, even foreign companies will be able to pick up majority stakes in listed Chinese companies.

So far, takevers of listed state companies by private companies have worked like this:

Listed companies in China normally have a third of their shares as free float, one third of the shares owned by state entities such as other state owned enterprises (legal person shares) and one-third owned by state asset management companies, whose main function is to preserve state assets.

The transfer of legal person shares has become increasingly straightforward, simply requiring approval by the State Development and Planning Commission. In contrast, the transfer of state shares from the asset management companies is still a very difficult process given the government's reluctance to lose assets. The relaxation in the transfer of the legal person shares is a recognition that a grey market has been underway for years.

What happens, say analysts, is that private companies buy up the legal person shares in listed companies in the expectation of acquiring mangement control - which New Fortune defines as acquring 20% of the shares. Often the private company will buy the legal person shares by using a separate SOE as a front to expedite the approval process. Buying the free float shares would be too expensive, since at the whiff of a takeover the shares in the target company soar. Even without the threat of a takeover China's shares are quite expensive since demand outstrips supply and the market as a whole has an unrealistically high price to earnings ratio. The free float shares can be four to five times as expensive as legal person shares.

The only price restriction with legal person shares is that they cannot be sold below net asset value. In practice, acquiring companies pay a 20% premium to this, say analysts. There are usually sufficient legal person shares for the acquiring company to take effective management control, or the acquiring company may enter into an alliance with another shareholder.

The upshot of this activity is a situation where 10% of China's listed companies are effectively privately owned and this should have a beneficial effect on these cash starved companies, who are now in a position to access the capital markets.

However, New Fortune makes the point that not all these de facto listed private companies outperform other listed companies in a number of key metrics.

New Fortune points out that many of the listed shell companies which were taken over by private companies were going cheap because they were facing severe business problems, which the acquirors are still struggling to improve. On the other hand, private companies, such as Shenzhen-based health products manufacturer Tai Tai, which have directly accessed the stock market, show substantially better business results than the other listed SOEs.

All this activity means that M&A is booming in China, with analytics company Dealogic estimating that in the first half of this year, China was the world's 10th largest M&A market, behind the Netherlands and Australia, and the top emerging market.

To regularize and promote this M&A market, the China Securities Regulatory Commission came out with some far reaching proposals on the M&A market in July. These must still be accepted by China's cabinet, the state council, however.

Under the new regualtions, companies would be allowed to acquire other companies by selling or exchanging shares. Previously, the only way to acquire companies was to use huge sums of cash, since banks are prevented from lending funds which are used for stock market activities. In addition, the CSRC has now recognized the de facto takeover process by private companies of listed companies by abolishing any distinction into what type of company can engage in takeover activity. State and private firms, as well as individuals can all engage officially in M&A. And there are now more situations in which Chinese companies can request an exemption from the CSRC from making a general offer, thereby reducing the capital required for a takeover.

Everything indicates that foreign companies will be allowed sooner rather than later to acquire stakes in SOEs. The government, by tolerating and now regularizing takeovers by private companies, seems to have understood the need to sell off state assets. China's economy could finally live up to its long-standing promises to frustrated foreign investors. In particular, its impressive headline GDP growth figures will finally be translated into well-run, profitable listed companies.

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