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China SOE reform: No change?


When Jonathan Li approached Sinopec in 2013 about the partial privatization of its downstream unit - a deal that would allow private sector money into a nationwide network comprising thousands of gas stations and convenience stores - he did so as CEO of Bohai Capital. The firm amounted to a powerful door-opener: the first renminbi-denominated PE fund with strong state-owned backers like Bank of China and China Development Bank Capital.

However, Li was advised to wear the colors of BHR Partners, a cross-border unit created by Bohai Capital and several foreign investment groups. The business was only a few months old, it was set up for a different strategy, and this would be its first deal, but philosophically BHR was a good fit. "In their eyes BHR represents a mixture of private enterprise and SOE - essentially the kind of mixed-ownership structure advocated by the government's reform initiatives," Li told AVCJ earlier this year.

Sinopec Marketing was the test case in mixed ownership, a new approach to state-owned enterprise (SOE) reform intended to introduce private sector best practice without ceding government control. BHR was one of 25 investors that together committed RMB107 billion ($17.5 billion) for a 29.99% stake. Of this number, just over one quarter are recognized PE investors and only half of those have offshore funds, including Hopu Investment, RRJ Capital and CICC Capital. It could have been very different.

In the early stages, a consortium was formed with CITIC Capital, Boyu Capital, KKR, TPG Capital, GIC Private, and Canada Pension Plan Investment Board, according to sources familiar with the situation. However, enthusiasm softened due to the terms and timeline. Sinopec talked about a Hong Kong IPO in three years and 40% of net profit each year as a dividend, but the offer was take-it-or-leave-it: no discussion of corporate governance, reforms, and due diligence.

The foreign investors were uncomfortable. "They have over 30,000 stores, 20,000 of them with points of sale. If the idea is to improve that aspect of the business, then you need to do due diligence. There's not enough time, so how do we know what's wrong, and can we fix it," one source recalls.The real game-changer, though, was the arrival of domestic insurers and asset managers, all willing to put in substantial sums with lower return expectations than private equity. The combination of a fast turnaround time and an ever-rising entry multiple caused the consortium to buckle; investors were told to come back with another bid, but it never happened.

Industry participants offer somewhat conflicting explanations of what went wrong: foreign investors were used to create competitive tension and once the deal got momentum they were no longer welcome; civil servants were so paranoid about the personal consequences of making a mistake and bringing the wrong person into the deal that they made the situation unworkable; or the process was just poorly timed and poorly managed.

Reform in context

This opacity is characteristic of dealings with the Chinese state and has long been considered a cost of doing business with SOEs. Yet mixed ownership presents a different dynamic. It is a formalized approach to change that involves the traditional challenges but without the payoff of control over one's own destiny. Not all transactions will match Sinopec Marketing for size, but has China redrawn the reform blueprint in a way that means GPs will struggle to get it past their investment committees?

"If the SOE already runs efficiently there's no problem, but most of them are bloated and inefficient," says Chang Sun, founder of Black Soil and previously managing director at Warburg Pincus. "The purpose of mixed ownership is reform, but if you don't have the power to make personnel decisions that will get rid of big issues like nepotism and favoritism, you can't made a fundamental difference. I am cautious about the next wave of SOE reform because I haven't seen any evidence of real impetus to reform, which means to cede control to market-oriented forces."

SOE reform is not a new concept. Xingdou Hu, a professor of economics at Beijing Institute of Technology (BIT), identifies three distinct waves of reform prior to the current one that have in turn seen the government release and rein in state-backed companies. They have largely been driven by economic expediency and the need to resolve growing debt burdens, with intermittent reassertion of central control when it was politically expedient to do so.

The origins of mixed ownership in an SOE context can be traced to a meeting of the Communist Party central committee in 2013. The communique outlines a comprehensive vision for reform in which "a unified, open, competitive and orderly market system is the basis for the market to play a decisive role in the allocation of resources." Using the adjective "decisive" in place of the more conservative language of previous statements was seen as a significant nuance.

Gradually, more flesh was added to these bones. In mid-2014, six SOEs were chosen for pilot programs intended to boost efficiency. Two of those, China National Pharmaceutical Group (Sinopharm) and China National Building Materials Group (CNBM), would introduce private investors under the mixed ownership model; control of another two would transfer to state-owned holding companies designed to be one step removed from political interference and one step closer to market orientation; and two would switch to a system whereby their boards, not regulators, would appoint senior management.

While this was happening at SASAC (State-owned Assets Supervision & Administration Commission) level, provincial and municipal governments across the nation announced programs to list or sell-off assets in up to 70% of the SOEs under their jurisdiction by 2017. Chongqing, for example, set a target to increase the proportion of SOEs with mixed ownership from 47.4% to 66%.

In addition to the Sinopec Marketing deal, financial and strategic investors, both foreign and domestic, participated in similar transactions involving two asset management corporations, Cinda and Huarong. Several other SOEs, led by CITIC Group, the country's largest conglomerate, also claimed to be engaging in reform by injecting state-owned assets into their Hong Kong-listed subsidiaries. These preceded the publication of an implementation program for SOE reform in September 2015.

The guidelines divide companies into two categories: those that can operate on a fully commercial basis, with the level of state control dependent on the sensitivity of the industry; and those that must remain wholly owned by the state. While there are references to preventing the appropriation of state assets and strengthening Communist Party leadership at SOEs, the guidelines also highlight IPOs and employee stock ownership plans (ESOPs) in the context of mixed ownership.

"We knew there would not be an ideal program. Instead, China's leadership has adopted a reform agenda that reflects the new economic ideology and reality and contains concrete implementation detail," Xingdong Chen and Jacqueline Rong, economists at BNP Paribas, wrote at the time. They concluded that the program, if executed properly with other reforms, would improve SOE productivity and efficiency.

According to Terence Foo, head of China PE at Clifford Chance, the notion of incentive-based compensation is significant for two reasons: first, it is hard to see SOEs becoming more market-oriented without alignment with management; and second, it has always been a carefully regulated area due to concerns about abuse. "Encouraging equity incentives for SOE managers is quite revolutionary, but we have yet to see any clearer implementation rules and it is not yet being adopted on a widespread basis," he says.

Neither, for that matter, has there been the level of deal flow many were expecting. Referring to the six SOEs - including Sinopharm and CNBM - slated for reform, Xin Wang, managing partner at BHR, notes that implementation appears to have been delayed. She puts it down to the government "refining the granularities surrounding the reform exercise" in terms of tax, legal and regulatory issues to optimize the investment environment.

An alternative explanation, put forward by several industry participants, is the continually shifting sands of the Chinese political landscape. "SOEs are in a dilemma," says BIT's Hu. "On one hand, the government wants to reform them; on the other, it fears that the reform will have a negative impact on the economy. Therefore, the government is advocating reform, but there is no real action." Coupled with an ongoing crackdown on corruption that has claimed some high-profile scalps, this has made officials fearful of retribution should they push ahead with a deal and it doesn't turn out as expected.

"A lot of companies were working on similar proposals [to Sinopec Marketing] but we have not seen any other deals concluded. Quite a few big SOEs are watching and waiting for clearer signals from the central government on what direction to take. So far the signals haven't been strong enough to encourage companies to engage in substantial mixed ownership reform," says Black Soil's Sun.

Middle market matters

Move down a few rungs from the large cap players to the middle market, and the picture changes. For many SOEs, the past decade was one of consolidation; this is likely to continue as part of the efficiency drive. In 2013, two thirds of the 150,000 companies that fall under the reform guidelines were classified as local rather than central players. Each group was roughly equal in terms of assets - RMB100 trillion between them - and in headcount, debt, and equity, but the central SOEs were much bigger revenue and profit generators than their local counterparts.

While a steady trickle of mergers has left a select group of SOEs in a more commanding position than before - enabling them to compound their advantage still further thanks to deep pools of bank and capital markets funding - this does not remove the private equity opportunity. Some SOEs are still under the control of provincial governments that want to be rid of them, perhaps especially now given the slower growth environment. Others can be plucked from the large SOEs.

"The central SOEs are larger as a result of the consolidation but the subsidiaries still exist - like a lot of potatoes in one bag," says a senior member of the CITIC Capital team, who asked not to be named. "There are a lot of subsidiaries, maybe hundreds of businesses, and some are more market-oriented and management is more aggressive. That's what you try to identify. You never target the parent; they are too big, too complex, and you can't change anything."

CITIC and Hony Capital are perhaps the only two GPs in China with long track records in the SOE space. These track records suggest there is no such thing as an identikit SOE transaction: Hony in part made its name restructuring smaller companies at the provincial level, but the GP also classifies its minority investment in listed hotel and tourism behemoth Jin Jiang Group as an SOE reform deal; CITIC has in recent years participated as one of many foreign groups in the Cinda transaction as well as working with smaller companies as the lead investor.

Where once manufacturing was the primary target sector, now the focus is on services. Many manufacturers have already been privatized or gone out of business, and those that remain tend to be beyond the wit or will of private equity. Also, the services sector has seen rapid growth in line with the broader rebalancing of China's economy, and companies that were previously too small to be considered or simply unavailable for reform have become viable targets.

Mixed ownership has also taken hold in the middle market, and the typical deal structure CITIC describes is reminiscent of a management buyout: CITIC approaches an SOE about the potential carve-out of a division; the parent holds on to 40% of the business, satisfying its requirement to remain the single largest shareholder; CITIC takes 35%, deemed large enough to push through reforms; a second external shareholder owns 20%; and management has skin in the game with 5%.

Universal Medical, though actually a precursor to the government's formal endorsement of mixed ownership, is a case in point. The GP acquired a 41% stake in the medical equipment leasing business in 2012 while a management-linked entity took 8%, leaving state-owned China General Technology Group with 51%. CITIC also got to appoint the chairman. There was a partial exit in 2014 ahead of a Hong Kong IPO the following year. Between 2012 and 2014, revenue and profit rose by more than 2.5x.

Two more deals, with similar ownership structures, are currently in CITIC's pipeline. The firm is clearly confident that even without an outright majority position - and in some of these situations the state-owned parent, though in the minority, is said to retain final say over personnel decisions, major asset disposals, and the timing of other investors' exit - it can wield sufficient influence on operations.

When asked a similar question about BHR's capacity to ensure reform takes place as a minority shareholder, Wang lists areas in which the firm shares its experience, from marketing to corporate governance to M&A opportunities. There is a channel for such communication of, although it is up to the company's board and management to decide what to implement. "The rationale behind this round of reform is not to repurpose the SOE regime and the government is not looking at wholly privatizing SOEs, the purpose is to increase efficiency and productivity, maximize output, enhance returns, and eradicate corruption and mismanagement," she adds. "The key is not private capital but a comprehensive and hospitable investment ecosystem which allows private capital and public capital to co-exist and to thrive."

Stick or twist?

Vice Premier Ma Kai announced in April that China would push ahead with SOE reform as part of efforts to restructure the economy. The announcement was followed by reports that Communist Party cells within SOEs are moving to tighten their grip on major operational and strategic decisions, which could undermine aspirations for a more market-oriented approach. From the government's perspective, these goals are not mutually exclusive; for private equity, the question is whether firms are comfortable participating in transactions on these terms.

The private equity role in SOE reform is certainly evolving. Partnerships intended to help state-backed groups pursue assets overseas are increasingly classified under reform, while many of the larger SOEs rely on the arm's length nature of private equity structures to enter new business areas without overstepping their strict remits. The common theme is that rather than serve as the architect of SOE reform by leading restructuring efforts, private equity is a participant in them.

Levels of involvement will vary according to the size and sensitivity of deals, but it remains to be seen how quickly, and how much, this approach turns laggards of the Chinese economy into commercially savvy pioneers. The numerous reformist drives over the years are often described as waves, and the progress will likely continue to see crests and troughs, depending on the policy environment at any given time.

"There is no clarity on what SOE reform means," says John Gu, a partner at KPMG. "Some people interpret it as reforming companies to become more commercially oriented, so they are managed more efficiently in the same way as any publicly listed company, with a focus on generating shareholder value. Clearly the government wants SOEs to be managed more efficiently and commercially, but it appears such reforms lost their momentum as you don't hear much about such stories nowadays."

SIDEBAR: SOE deals: Minutiae matter

Having seen its attempted buyout of Xugong, a state-owned construction equipment manufacturer, grind to a halt in 2005, The Carlyle Group decided that using investment professionals for government relations in China was not enough. The firm appointed a dedicated individual to this role and also stepped up its engagement efforts with local media.

The Xugong deal came a time when China was less familiar with private equity, and it faced stern opposition - including a misinformation campaign - from local companies that wanted the asset for themselves. All this was fed back to a regulator that had never even sat down with executives from Carlyle to hear their side of the story. "Before that all the communication was through Xugong management and they had their own agenda," says a source familiar with the situation. "You can't just work with a company in China, you have to engage the government as well."

As such, state-owned enterprise (SOE) reform is not for everyone. Indeed, it is often claimed that only private equity firms with very deep local ties can realistically hope to initiate control deals in the space. Hony Capital and CITIC Capital are good examples. Both are independent-run affiliates of SOEs - Legend Holdings and CITIC Group, respectively - and this is said not only to help open the door but also to reassure leadership teams that often fear the potential political fallout of a poor decision.

Beyond relationships, private equity investors must come equipped with patience and a detailed understanding of the regulatory process. Deals that involve the transfer of state-owned assets require approval from the Ministry of Commerce and the State-owned Assets Supervision & Administration Commission (SASAC), or one of the latter's provincial equivalents. SASAC is obliged to follow various time-consuming procedures, not least a third-party valuation appraisal of the asset being traded.

While the CEOs of SOEs must undergo an exit audit - which no doubt contributes to concerns about retrospective disciplinary action should a deal go wrong - the appraisal firms can be held indefinitely accountable for their reports. This means they tend to play safe and overvalue rather than undervalue assets. Black Soil has seen the completion of its acquisition of a state-owned potato processing company delayed because the appraisal firm used replacement cost rather than the discounted cash flow method to come up with a much higher valuation than that agreed by the transacting parties.

"How can one assign an increased value for a company that has been losing money for four consecutive years? Based on this logic, every company in the steel industry will increase its value as its replacement cost has surely increased its value," says Chang Sun, founder of Black Soil. "It's crazy, but what can you do?"

Speaking at the Hong Kong Venture Capital & Private Equity Association's China forum earlier this month, Vivian Lam, a managing director at RRJ Capital, warned that investors must leave enough time to remove any potential obstacles. It is relatively straightforward to get to the memorandum of understanding (MOU) stage, but whereas foreign investors like to have all the details in place at this point, the local counterparties may still have other procedures to complete.

"You need to understand the approval or review process with the SOE parent," she said. "In some situations you don't have much control, so even when you have written agreements, you need to focus on what it actually means in practical terms."


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