ECM 2005 - Banks look to Chinese JVs
International investment banks have long pondered how to break into the huge Chinese domestic equity market and tap into what is a potentially huge investor base. Recent moves to clean up the country's banks – and a relaxation of foreign ownership restrictions – are providing a route into the local market for international firms, which are increasingly looking to establish joint ventures with domestic firms. Nichole Chan reports.
Foreign investment banks are expected to see more opportunities this year to set up joint ventures in China, with the country now stepping up efforts to clean up securities firms which have long been strangled by losses resulting from poor internal controls and proprietary trading. And joint ventures are increasingly seen by foreign firms as a way to break into domestic China ECM activity.
With its entry into the WTO, China has committed to open its closely-regulated financial sector to international players and has allowed foreign shareholdings in mainland financial institutions to be raised to 49% by the end of this year and to 100% by the end of 2006.
Of the 132 securities firms in China, analysts believe that as many as 60% of them are sub-standard and should be closed down or consolidated within the better-performing firms. Of the remaining 40% which are better-performing, some of them would be capitalised and restructured to be the future model houses.
Central Huijin Investment and the Ministry of Finance are said to have injected a total of Rmb7bn (US$865m) into Galaxy Securities, while Guotai Junan and Shenyin Wanguo are likely to receive about Rmb3bn each. Moreover, Citic Securities has teamed up with CCB Investment (an entity controlled by Huijin) to reform the troubled Huaxia Securities.
But other than funding from the government, some observers suggest that international investment banks – which are eager to have a presence in the mainland capital markets –could play a more active role in reform in China by setting up JVs with the financially-troubled domestic securities houses.
“Regulators and industry participants previously saw that co-operation with international investment banks could benefit the local players via their international know-how and expertise," one mainland bankers said. "Other than encouraging best practice, the regulators also see foreign capital as constructive throughout the reform. And this will benefit both the mainland government and the foreign banks, as the former will get cash to pay off the bills while the latter will get the licence or the JV they have been looking for.”
Also, foreign banks’ position as white knights providing additional capital to domestic banks will give them more bargaining power and a more advantageous position when negotiating options to lift their stakes when regulations allow, another banker suggested.
One example was Goldman Sachs’ donation to defunct domestic brokerage Hainan Securities when setting up its JV, Goldman Sachs Gao Hua Securities. When establishing the JV, as a gesture of goodwill to mainland authorities, the US bank made a US$62m donation to a fund which reimbursed investors caught out by the collapse of Hainan Securities.
This donation, however, was widely viewed as being effectively a payment to the mainland government in order to secure a licence for the JV that Goldman subsequently set up with China Gao Hua Securities.
China Gao Hua Securities was set up by veteran mainland banker Fang Fenglei and other corporate investors including Lenovo. The JV has a start-up capital of US$100m and Goldman contributed US$50m, taking a 33% stake in the JV, the maximum allowed under existing regulations. The US bank also lent US$100m to a consortium led by Fang, which then invested that money in the JV. The loan gave Goldman the flexibility to raise its stake in the JV to secure majority control when regulations permit.
The JV structure is a novelty for foreign investment banks in the sense that Goldman has control, unlike the case with its direct rival CICC. CICC was the first ever JV set up in China, established 10 years ago by Morgan Stanley and China Construction Bank. Morgan Stanley has a stake of about 34% in CICC but its role is merely that of a passive shareholder, with management and control rights resting with its Chinese JV partner.
Other than CICC, three other JVs have been established and one more announced. CLSA and Xiangcai Securities set up China Euro Securities two years ago; then came BNP Paribas Peregrine with Changjiang Securities to create Changjiang BNP Paribas Peregrine; and finally Daiwa partnered with Shanghai Securities to form Daiwa SMBC-SSC Securities. Earlier this year, Merrill Lynch announced its plan to set up a JV with Hua’an Securities.
Many others, including ABN AMRO, Deutsche Bank and UBS, are now keenly eyeing JV opportunities in China. According to some mainland bankers, UBS is looking to inject capital into Beijing Securities, which is currently seeking funds both domestically and internationally for a restructuring.
If it took its permitted stake of 33%, UBS would – before any investment commitment – need to restructure the liabilities and contingent obligations of the mainland securities firm, and then its internal control and risk control procedures.
But it is rumoured that the Swiss firm wants to take a similar approach to Goldman, by taking the licence without taking on the potential liabilities of the domestic firm. Some suggest that UBS could team up with domestic bankers (possibly Beijing Securities' existing management) and external mainland corporate investment to buy out the whole brokerage and make a similar donation to set up an investor compensation fund with the government.
What complicates the deal with Beijing Securities compared to that with Hainan Securities is that the latter was already insolvent and it was easier to ascertain its liabilities. Beijing Securities’ contingent liabilities could vary significantly.
The next steps
Establishing a JV is just the first step to going into China: learning how to make a profitable business out of it is the next. Recognising the immense effort and investment required in setting up a JV, some bankers are wondering if it is genuinely worthwhile and whether the mainland capital markets will indeed prove to be a goldmine.
The A-share market has recently tumbled this year to an eight-year low and fund-raising activities were stopped as a result of the authorities’ efforts to push ahead with non-tradable share reform.
In April this year, the China Securities Regulatory Commission (CSRC) issued guidelines for domestically-listed companies to resolve the market's spilt-share structure. About two-thirds of the market capitalisation of the A-share market is not freely tradable in the open market. Under the new guidelines, holders of non-tradable shares are required to negotiate with public shareholders in order to seek their approval to make non-tradable shares tradable.
In order to understand the impact of the pilot scheme on the market, the CSRC has temporarily halted the IPO review process. It is rumoured the CSRC will soon allow the resumption of deals from companies which have successfully proceeded with their reforms.
But the move has highlighted the high regulatory and policy risks inherent in the mainland market. A Guotai Junan banker admitted the market is highly influenced by policies from the state, provincial and city government. “No one can expect or predict what will be coming… and fund-raising is always stopped for one reason or other,” the banker said.
Regulatory risks aside, the mainland securities industry is expected to see more intense competition, with more JVs coming in as well as the re-birth of the state-owned investment banks following government recapitalisations. Galaxy Securities, for example, may seek an IPO for itself, to strengthen its capital base. This could position Galaxy, now already one of the biggest firms, for larger fund-raising transactions.
According to data from the Securities Association of China (SAC), Galaxy was ranked number one in terms of the size and number of transactions underwritten in 2004 (Rmb17.22bn from nine deals). Set up in 2000, Galaxy Securities was a state-funded securities company formed by China’s Big Four banks – China Industrial and Commercial Bank, Agricultural Bank of China, Bank of China and China Construction Bank – and with China Life Insurance.
Unlike CICC, which is focusing more on international deals, Galaxy's background has pointed it more in the direction of deals from larger domestic state-owned enterprises. That may be wise, since the JVs have generally not completed much business, with the exception of CICC which has been in the market for ten years. The SAC data shows that in 2004 CICC was ranked number four in terms of underwriting (Rmb5.39bn from three deals), while China Euro ranked number eight (Rmb2.99bn from seven deals).
Bankers still remain hopeful that the mainland capital market will become one of the biggest in the world. “There will be challenges but the growth potential will be worth the effort for the early movers,” said one JV banker. “Despite corporate fund-raising activities now being in moratorium, follow-ons or block-trades from domestic companies will come. Also, we believe that cross-border M&A and other resulting corporate finance and capital market activity will be the next big hit in the near-to-medium term. This is where the JVs will have advantages over the domestic banks.”