The Chinese government has finally realized that simply owning a wealth of business assets does not necessarily mean they are productive.

In China, the State used to own almost everything. But as economic reforms have introduced new equity holders into the system, State assets have been gradually withdrawing from centre stage. To shape State-owned enterprises (SOEs) into veritable businesses with strong market orientation, the State has decided to pull even further out of the equity arrangement of China's economic juggernauts. One estimate puts State equities in publicly listed companies alone at 6 trillion yuan (US$725 billion).

And who will take over this giant stake?

Management, proclaims a chorus of advocates. Of all the companies listed on the Shanghai Stock Exchange, only 0.08 per cent of the equities are currently in the hands of management. There seems to be interest as well as room for growth in this area.

China's business press touted management buyouts (MBOs) throughout 2002. And they heralded 2003 as "the year of the MBO". From 1999, when the first MBO took place in China, to 2002, 16 equity transfers of this nature were sealed.

However, in early 2003, the Ministry of Finance issued an edict that temporarily brought MBO activities to a halt, citing legal imperfections as the cause for possible "new forms of trading that some insiders can use to obtain improper financial interests".

But the buzz surrounding MBOs did not stop there. Rather it morphed from a trumpet blast into a subliminal hum. Management has put on a collective facade of endurance, replacing its erstwhile flamboyance and euphoria. But by all accounts, the MBO show is still going on, just in new formats.

Pros and Cons

The see-sawing arguments tipped mostly towards MBO advocacy last year, while this year they have favoured the opposition. But the arguments remain the same.

Hu Ruyin, director of the Shanghai Securities Development Research Centre, pointed out several benefits of MBOs. When management is truly the master of its own universe, efficiency in decision-making is much higher, creating a perfect harmony between the interests of the company and those of management. The management team will work harder, as a result, and be more cohesive. In a word, the MBO combines the best of both worlds -- that of the entrepreneur with that of the professional manager.

Zhong Wei, professor of finance at Beijing Normal University, is an ardent MBO promoter. MBOs will further clarify China's cloudy corporate equity structure and rid a business of the major investor who does not have the knowledge or inclination to be an active part of the operation, he said. "Many of these SOEs are simply a burden. Why do we worry about the erosion of State assets? I worry that nobody will take them."

Very few are against privatization per se, but the process of the big sell-off, if not tightly regulated and closely monitored, could cause a plethora of problems that might fundamentally undermine any potential benefits. Opponents like Gao Huiqing, director of the planning office for the research department of the State Information Centre, emphasizes fairness.

Because the assets are not open to bidding from all parties, but only to management, there is sure to be a lot of insider manoeuvring to make huge profits by simply tossing them onto the public market. And small investors left out of the loop will end up paying for this. "It's like asking the down-and-out to subsidize the well-heeled," says Gao.

Ba Shusong, deputy director of the strategic development office of the China Securities Association, refutes the oft-repeated argument that because MBOs work in the West, they've got to be good for China. In Western countries, the MBO usually works for the spin-off of a side business or as a deterrent against hostile takeovers, and it takes place in an open, transparent system where there are rules to follow every step of the way. China, Ba says, is different. Here, the whole process is designed for insiders to make a quick buck, or millions of quick bucks, by playing two markets -- one for tradable stocks and one for non-tradable ones.

Zhong Wei is not convinced. Regulation in China often lags behind practice, he says. "We can improve the system by working on it. If we don't go into this dark forest, how do we know what kind of beasts are lurking inside?"

Hua Sheng, an economist, contends that the modern management model is to separate investors from managers, not the other way round. Investor-managers are more suitable for small and medium-sized firms, he says. Using stock options as a stimulant does not infer that one has to be the sole or majority owner in order to operate a business.

Price and Payback

Several key issues involving MBOs point to the potential of mass abuse. The first is the pricing of State equities for sale.

Since senior executives know their companies better than anyone else, it is easy for them to manipulate and undervalue the enterprise for the sake of buying equities at a bargain price. Assets might be concealed and profits deliberately minimized to present a bleak prospect.

According to a recent survey, public companies in China average a net-asset-to-net-profit ratio of 30.75. As net assets are often used as a yardstick for evaluating MBO equities, the price/earnings ratio (PE) for such transactions is about 15. But on the open stock market, this PE ratio generally hovers around 40-60, meaning that MBO prices can be undervalued by 63-75 per cent compared with market prices. That, according to experts, is the main reason for the rush on the part of corporate heavyweights.

The rationale for such low prices is the amount of liabilities that most SOEs carry on their balance sheets. Some companies even have negative assets. However, many companies on the MBO bandwagon are actually profitable; it is the bad reputation of SOEs in general that tends to help them drive down the price.

Even if the per-share price is often artificially pushed down below market level, the total price for a controlling stake is still significant. Executives at Midea, a Guangdong-based home-appliance maker, twice bought out stakes invested by the local government, in 2000 and 2001. Now they control 22.19 per cent of all equities for a total of 321 million yuan (US$38.8 million). When the 22 managers bit off the first big chunk, they paid 10 million yuan (US$1.21 million) as a down payment and took out a loan of 90 million (US$10.9 million), which was parcelled out in instalments.

As a matter of fact, most MBO funds come from loans, which raises the spectre of high dividends down the road. Only by paying themselves, now the principal investors, high dividends, can the executives possibly pay down the loan within a short period of time, normally 10 years. This will impede a firm's long-term growth, argue some experts, because a company always needs to plow back earnings to fuel growth. Another possibility is that management may divert funds raised on the public market for the payment of these loans.

Experts point to the below-average performance of many post-MBO companies as a sign that the MBO is not the panacea it was intended to be. While Midea slid a bit in earnings, a Founder-invested company, also a MBO-baptized firm, saw its earnings plummet 48 per cent and, subsequently, into the red. There are now very few cases of MBOs boosting profit margins.

Another possible consequence of MBOs is the social cost. If management reduces staff on a large scale to raise efficiency, the problem of surplus labour simply shifts back to society at large, which may add to social instability.

The Black Hole

Regulators' discouragement has not stopped the thirst for MBOs; it has merely driven MBO activities underground.

By most accounts, the MBO is alive and well but taking on more complicated forms. Executives are no longer at the forefront fielding reporters' questions. Instead, they lie low and set up a trust company to do the job for them. According to 21 Century Economic Report, a business weekly, Jinxin Trust helped transfer 14.33 per cent of Yili's equities from the State to its management. Even though management at Yili, a leader in the country's dairy industry, is keeping mum, the transfer price of 10 yuan (US$1.2) per share, which is close to 8.938 yuan (US$1.08) in net earnings per share, is still a bargain in light of the company's solid fundamentals and above-average financial performance; therefore, it hints at an MBO coup, said the paper.

Many of these trust companies have popped up out of nowhere in the last few years, and some of them have bought into more than one company.

"The management is definitely behind these machinations," said Tu Songhua, a partner at Longce Consulting. "One needs the approval of the Ministry of Finance to transfer State equity to private hands. But no such approval is needed to move it from one private hand to another."

In addition to trust companies, "shadow firms" are another way to use a third-party to get State assets into management control. The equity structure of these shell companies is so convoluted that authorities have a hard time cracking the "shell".

Almost all experts agree that there should be a mechanism that ensures a fair and transparent process of any sell-off or transfer when public interest is involved. When a deal is conducted under the table, the general public will undoubtedly view it cynically.

In one MBO deal for a food processing company in central China, the intangible assets of the brand, valued at 5.2 billion yuan (US$628.22 million), were conveniently ignored. Another company in Hunan Province bought a 3 million-yuan (US$362,440) stake in an MBO transfer then, six months later, sold it on the open market for 32.84 million (US$3.97 million).

"The MBO, as it is being implemented in China right now, violates the principle of fair competition," comments Huang Zemin, director of international finance research at East China Normal University. No wonder some people want a piece of the pie before any law or regulation blocks their way.

(China Daily HK Edition September 24, 2003)