The third module of Janus Henderson’s study on China investing looks at how corporate actions and local structures can be assessed to determine if they are intended to maximise shareholder value or otherwise.
‘The first favour is a favour, the second an obligation’
The ties that bind may be less clear than you think – Chinese proverb
Our core focus in the ‘Signals and Smokescreens’ series is to educate investors in identifying factors relating to the internal structures and external relations of Chinese companies. This can help to reveal the true intentions of a company’s controlling shareholders. While it is crucial for investors to be cognisant of these factors in making fully-informed decisions about investing in Chinese equities, it goes without saying that a crucial part of the investment process ultimately depends on the flow and circulation of money; where is it coming from and where is it going?
China’s ongoing and rapid transition from a planned economy to a hybrid system where market forces play a major role means that regulations have not yet had time to develop to the levels of international norms. This means that Chinese companies wishing to list domestically face an arduous listing process that is tightly controlled by multiple government agencies, resulting in low approval rates that are subject to minute fluctuations in government policy.
Image credit: iStock
In order to avoid these hurdles, many Chinese companies opt to list on foreign exchanges, which can generate added prestige and larger amounts of capital. Although, in the vast majority of cases, this arrangement has benefited both foreign investors and the Chinese controlling shareholders, it nonetheless creates a potential risk.
Proceeds from the listing can potentially be extracted onshore from the listed entity under the guise of value-generating material transactions where there are fewer impediments to these funds being misused.
Moreover, though transactions with related businesses can be problematic for companies in all jurisdictions, related-party transactions (RPTs) can be particularly challenging in China. This is because China’s business culture has been developed over centuries through reliance on trust built through deep personal business relationships – or ‘guanxi’ – rather than written contracts negotiated at ‘arm's-length.’
The two cultural and regulatory factors explained above result in much weaker protection for minority public shareholders against material and RPTs taking place at non-market valuations. Thus they warrant close scrutiny and targeted analysis by investors as they assess opportunities in China. The ‘Signals and Smokescreens’ study has examined more than 50 Chinese companies and material transactions that disadvantaged the minority shareholders were found in over half of these cases and approximately a third of those were between related parties. Additionally, many of the companies examined lacked transparency in their corporate structure, which raised the risk of misuse of shareholders’ funds through these transactions.
Here we describe factors that investors should consider when evaluating whether material transactions were intended to benefit the related parties involved or the whole of the shareholder group. Through our analysis, we have come across several cases where the transfer of an asset to a publicly quoted company was obviously completed at a non-market value; others were more subtle, but equally dangerous.
Material transactions - risks in practice
Some of the examples of material and RPTs that were detrimental to shareholder value that we encountered include:
- Spider’s web – the most important sign of potential risk – and one that can be easily identified – is the partial listing of just a fraction of a much larger, complex and interconnected China business under common control. In these sorts of structures, it is essentially impossible to verify independently whether transactions between the onshore entities and the offshore listed company have been negotiated at 'arm's-length.' One example disclosed in the Chairman’s Statement less than a year prior to its suspension from a major stock exchange that ‘38% of our sales in the year were transactions to independent third parties’ which, by implication, means that the remaining 62% were not. In another case, a company was able to book fictitious forestry assets through ‘authorised intermediaries’ who were actually acting in concert with the listed company’s management. These situations are not so difficult to detect as they often involve the acquisition capital assets without a corresponding cash payment. In both cases, the listed company was experiencing ballooning receivables from the related parties, who were essentially using the listed company as a bank. If there is no transparently rational reason for keeping substantial parts of an overall business out of a listed company, investors should be wary.
- Lack of independence by valuers – we noticed one Hong Kong-listed entity that purchased property development rights on the Chinese mainland from companies owned by the chairman of the listed company. The net asset value of the acquired entities was only slightly above HK$1 billion, however, the purchase consideration paid was over HK$5.5 billion. The transaction was supported by a report from a foreign valuer, who was different from the one that had been engaged in the past. The new valuation company was itself experiencing financial stress at the time and its holding company went into administration a few months after the deal completed. Given the materiality and conflict of interest regarding this transaction, the valuation may not have been truly independent and might have been used deceptively by the chairman to justify an artificial purchase price at the expense of the minority public shareholders.
- Placements for personal gain – a series of discounted equity placements were made by a Hong Kong-quoted company to outside companies owned by its own chairman. This resulted in mass resignations from the board and the chairman owning a huge majority of the quoted company. The chairman then sold the placements into the market at substantial premiums, netting a personal fortune of US$1.2 billion. These transactions all took place within a few years.
- Keeping it in the family – we noticed a NASDAQ-quoted China stock that disclosed an acquisition for US$15.3 million. Several months later, in a separate disclosure, it became apparent that the vendor of the acquired business had itself only purchased it a month beforehand, and that the price paid by the vendor was US$6.1 million. The unreasonable capital gain in such a short time is cause enough for suspicion, but a third disclosure revealed later that the vendor company that enjoyed the gain was owned by the wife of a controlling shareholder in the NASDAQ purchaser. It also stated that ‘the contract did not cover indemnification regarding the improper payments to foreign government officials by employees of the target company.’ The suspicious nature of the transaction could have been revealed by a desk-analysis of the original seller, whose identity had been disclosed, and whose US-quoted business had sold its Chinese subsidiary due to the discovery of illegal payments.
- Unexplained pricing differences - the management of a NASDAQ-listed cable television and GPS equipment manufacturer prepaying for the equivalent amount of office space on the third and fourth floors of the same unfinished building. According to the notes to the financial statements, the third floor had been purchased for US$1.7 million and an identical space directly above on the fourth floor had been purchased for US$8.1 million. A brief search on the Chinese internet showed that both of these prices were above market rate, implying that the discrepancy may have been due to the payment of kickbacks.
- Self-dealing – In 2014 a Hong Kong-listed producer of natural gas in China announced it had agreed to purchase two of its parent company’s wholly-owned entities situated in North America for a total purchase consideration of US$200 million. The issue was that the controlling shareholders of the Hong Kong-listed entity were also controlling shareholders of the parent entity and that both of the acquired North American subsidiaries were making significant net losses.
Natural evolution, intentions and foresight
In the US, the Securities and Exchange Commission was established more than eighty years ago, whereas in China, the comparable regulator, the China Securities Regulatory Commission, was empowered by the China Securities Law that was enacted less than twenty years ago. As mentioned above, this means that the regulatory oversight regarding material and related-party transactions is much less developed in China than in more mature markets. However, it must be stressed that this does not mean that the presence of highly material or RPTs necessarily signifies nefarious activities. These transactions are essential to the functioning of many businesses. As China’s market continues to evolve, these sorts of transactions in the form of capital expenditure, mergers and acquisitions and changes in block ownership are to be expected and are, in many cases, vital to the long-term viability of companies.
Notwithstanding all of the above, our focus here has been on interpreting information surrounding material and related-party transactions to provide insight as to whether the transactions were intended to maximise shareholder value, not whether or not they actually do. For instance, in the above example of the discrepancy in purchase considerations for two floors of office space in the same building, real-estate prices might have subsequently sky-rocketed. Nevertheless, we can use the unexplained discrepancy in the price paid for essentially identical assets to understand the management’s intention at the time. In this case, the stock price collapsed about a year later due to issues that arose regarding the company’s auditors. By examining the property transaction and reaching the correct conclusions about the management’s real intentions in seeking foreign investment in the first place, global investors would have been able to avoid a loss.
What are the main corporate actions and structures in China that facilitate the misappropriation of shareholders’ funds, and how can it be determined whether these actions and structures are intended to maximise shareholder value?
The table below shows the flags that were most instructive in our analysis of companies.
|Red flags||Green flags|
|A corporate structure where the listed entity is a small cog in a much larger machine, leading to numerous RPTs between related subsidiaries which can easily be manipulated.||Simple and transparent corporate structure with management clearly articulating the methodology and basis for related-party transactions.|
|Use of shareholders’ funds to purchase subsidiaries in which management hold stakes or personally benefit and where it is almost impossible to determine whether these are at 'arm’s length.'||Clearly defined reasoning for the assets being acquired and the benefit to minority shareholders.|
|Transactions involving capital assets that result in ballooning receivables.||Clear business rationale and transparent disclosure of the need to structure the capital transactions in the way chosen.|
|Excessive use of SPVs/SPEs (special purpose vehicle/special purpose entity), creating a complex corporate web with multiple RPTs between subsidiaries.||Low related customer concentration (i.e. majority of sales are to independent parties).|
|Share trading or decreasing management stakes that are not proportionate to share dilution.||Material transactions should be ratified by an experienced board with no personal financial interest in the transactions.|
|Purchase of loss-making or non-revenue generating entities.||Material transactions only occur when ratified by an experienced board where there is clear evidence of adequate financing from a solvent balance sheet|
Investment team perspective
Mike Kerley, Director of Pan-Asian Equities and Portfolio Manager at Janus Henderson Investors:
“Material and related-party transactions are a regular part of corporate life in China and are common in both the state and private sectors. It is imperative to understand the nature of these transactions, the value at which they are undertaken, and whether they are in the best interests of minority shareholders in order to make an informed investment decision.’’