MBOs (management buyouts) are once again at the center of controversy. Larry Lang, a well-known professor from the Chinese University of Hong Kong, recently criticized this method of disposing of state-owned assets.

“The MBO is the best way to rob the state of its assets”, Lang warned. “Harrowing losses are being incurred in state-owned assets.”

His critical remarks have triggered a hot debate on the future path of reform in the state-owned enterprises (SOEs). Insiders are saying that the relevant government departments are already actively discussing whether MBOs should be continued or not.

According to statistics from the State-owned Assets Supervision and Administration Commission (SASAC), half of the SOEs have already restructured their ownership through MBOs.

Last November Li Yizhong, vice director of SASAC, announced that the commission had carried out a survey of the SOEs in 23 provinces including 16 major cities. It showed that 85 percent of the restructured SOEs had successfully completed the process of transferring ownership.

The loss of state-owned assets during the MBO process is an emotive subject. However, SOEs usually return good results after their MBOs. In the past two or three years, MBOs have several times been given the green light only to be stopped again. Reappraisal in the light of experience, and the debate this gives rise to, will directly influence both the direction and the pace of future SOE reform.

Restructuring mostly successful

Zhou Fangsheng is a specialist who carries out research in the field of SOE reform. He would not support a complete veto of MBOs. The reality is that half of those enterprises that have restructured have done so through MBOs. The rest have attracted foreign investment or domestic private investment. Over 70 percent of SOEs have been able to achieve a successful ownership restructuring.

“There are no accurate figures available nationwide on the operations of the restructured enterprises. This is because they are no longer managed by government departments,” Zhou said. “However for example, in Baotou City of Inner Mongolia Autonomous Region and in Hebei Province, local officials say that some enterprises are still in difficulties after restructuring, but over 70 percent of SOEs have seen significant changes.”

“The goals set for reform are being achieved,” Zhou said. “Why are there so many MBOs and how do so many of the enterprises manage to achieve a successful outcome? We need to analyze the feasibility and appropriateness of MBOs for specific industries and different types of enterprise.”

The statistics show that over 30 percent of state-owned enterprises are in the red. Zhou said that for a variety of reasons including the type of industry or its products, together with considerations of profit, financial burdens and debt levels, many medium and small state-owned enterprises have found it impossible to attract either foreign investors or domestic private investors.

“For those enterprises that can’t be sold even at a much reduced price, it is only the enterprise management team that can offer a viable option for restructuring. This is the reality that I found in my research,” said Zhou.

The SASAC is directly affiliated to the State Council. It was set up early last year to deal with SOE reform and the operation and management of state assets.

Figures published by the SASAC last year showed that from 1998 to the end of 2002, the number of SOEs and state-owned holding companies dropped from 65,000 to 43,000, a decrease of 34 percent. However, during the same period, profits jumped from 74.3 billion yuan to 263.6 billion yuan. Since ownership of the SOEs began moving over to shareholders in 1999, the state-owned small/medium-sized enterprise sector saw an upturn in 2000. This followed six consecutive years of deficit. The state-owned small/medium-sized enterprises realized profits of 7.3 billion in 2000, 10.98 billion in 2001 and 28.69 billion yuan 2002.

“This is most encouraging,” said Li Yizhong when publicizing the SASAC research data at the end of last year, “The fact that reform was successful in over 85 percent of the enterprises indicates that the mechanisms of reform were well chosen for the local small/medium-sized enterprises. The results speak for themselves.”

However, Li Yizhong also said that the situation where some state assets had been undervalued and sold off cheaply, “makes people feel aggrieved.”

“It is a common international practice to use MBOs as a means of transforming an enterprise’s property rights. It is an option here too, but there have been problems due to gaps in the rules and regulations. One very controversial question is how large a single shareholding should be,” said Li. “If individuals hold too big a stake then what has happened in Russia might also appear in China and the reform of the SOEs would end up with the assets in the hands of just a few people. Therefore MBOs need to be further regulated, particularly as regards the size of individual shareholdings that can be acquired by employees.”

Zhou Fangsheng agreed that gaps in the regulatory framework had given rise to such malpractices as insider trading, lack of transparency, the same person acting as both buyer and seller, collusion, and deficit trading being contrived to ensure a bargain price. Consequently, state assets have been lost. It was because of all this that in March 2003 the Ministry of Finance abruptly froze MBOs by issuing a key document entitled Suggestions on Suspending Examination and Approval of MBOs. Insiders speak of a fierce debate at that time. They say the departments involved in the decision-making were divided on the issue of whether to stop MBOs altogether or merely to regulate their operations more strictly.

The moratorium on MBOs remained in force until December 2003 when the General Affairs Office of the State Council issued the Opinions on Regulating Reform of SOEs. “This was interpreted as lifting the total ban on MBOs and giving limited consent to proceed,” said Zhou Fangsheng.

Regulatory issues

“In fact, besides the guidance effectively regulating MBOs contained in these Opinions, other documents including Measures on Managing the Procurement of Listed Companies issued by the China Securities Regulatory Commission also limit and regulate MBOs,” said Zheng Peimin, chair of the board of the Shanghai Rongzheng Investment Consulting Company.

Zheng has been involved in the detailed operation of and research into MBOs for six years. He said, “There are two sides to every story and this includes MBOs. The malpractice of the same person acting as both buyer and seller could be avoided completely just by adhering to current policies and standard procedures. It would be ridiculous to prohibit MBOs or even abandon property-rights’ reform just because of some cases where the proper procedures were not followed.”

Zhou Fangsheng was personally involved in drafting the Opinions. He said, “We have plugged the MBO regulatory loopholes with the policy contained in Article 10 of the Opinions. However, even where there are strict laws in place there are bound to be some criminals prepared to break these laws. In practical terms, non-compliance with standard procedures cannot be eradicated completely. There are real difficulties in implementing some of the measures.”

Zhou Fangsheng explained that the Opinions now require the principal operational features of MBO schemes to be determined by the investors. Organizations acting as intermediaries must be appointed by the investors not by the management of the enterprise as had been happening previously. Similarly, the management cannot set up the detail of the scheme themselves and must not interfere in any part of the entire buyout process. Meanwhile, the management cannot purchase the company with the company’s own funds or with finance that has been guaranteed with the company’s own funds. Nor can they use funds from other SOEs or other state-owned shareholding companies. Furthermore, where a company shows a sustained under-performance in the years leading up to reform and this can be attributed to poor management, then that management is not considered qualified to take part in the buyout of its own company.

“In fact, these measures do prevent the management acting as both buyer and seller or running the company into deficit to get a low valuation enabling them to buy it at a knock down price. However, we carried out research around the regions and we did find some cases where the Opinions were not strictly followed,” said Zhou Fangsheng. “For instance, some enterprises still develop the details of the MBO in collaboration with the investors and fail to distance themselves completely from the process. This is mainly due to practical considerations where the investors cannot complete the details of the scheme independently without the help of the management. They need access to the professional expertise, experience and detailed knowledge of the company that exists only inside the enterprise. Therefore, there are some real difficulties in the full practical implementation of the Opinions. Nevertheless, it represents a major step forward that schemes are now mainly guided and decided by the investors. The managements can no longer take control of everything like they used to.”

To standardize or suspend?

“The ongoing MBO trend in China is totally different from what happens in Western countries,” said Zhou Fangsheng. “So you can’t look at MBOs in our country in the same way as in others.”

In the wider world, the MBO is the purchase of a company by its existing management. The ownership changes but it is not a wholesale transformation of the corporate system as is happening with the SOEs in China.

MBOs in China usher in deep systemic changes in an economy that is itself in a state of transition. Single ownership by the state is being transmuted into multiple ownership by shareholders. In addition, the property rights transfer is flexible and foreign partners, private individuals and corporate management can all participate.

There have been some MBOs, where incomers have been brought in to run the company and they have turned out to be more effective than the old management. However, this does not mean that all existing managements are in some way inferior to outsiders.

“It’s true there are some cases where state-owned assets are lost when ownership is transferred,” said Zhou. “But most state-asset losses occur because of commercial factors. Price should not be the only criteria used when considering these assets. Long-term development and social benefits should be the ultimate goal of enterprise reform.”

“The decision to reform the ownership structure of the SOEs’ is a correct one, however we should be more specific about the rules for MBOs,” added Zhou. “For example, we might prescribe which industries were appropriate for MBOs.”

However, it is no easy matter to deal with the detail of regulating SOE reform in China. It is a massive undertaking being carried out in the context of complex national conditions.

Zheng Peimin, chair of the board of the Shanghai Rongzheng Investment Consulting Company, and managing president Li Wei of the Beijing Wanmeng Investment Consulting Co, believe that the reform of the enterprise system shouldn’t be stopped just because there have been some inappropriate cases.

Both have studied many examples of MBOs in practice. They are of the view that there is no need to bring in additional detailed regulations since individual MBOs can differ so much. “We only need to regulate the overall operation of MBOs,” said Li Wei.

“We can’t just apply an inflexible formulaic approach to complex social mechanisms,” said Zhou Fangsheng.

(China.org.cn September 22, 2004)