Unlocking Chinas domestic stock markets a new era of public MA in Chna CAL2012110442100

Title: Unlocking China's domestic stock markets: a new era of public M&A in China. Asiamoney, 09589309, Asia-Pacific M&A 2007 Supplement, Vol. 18Last year was a watershed 12 months for A Share markets. Following four years of market declines, substantial progress in implementing structural market reform - combined with significant related regulatory reform, a surging domestic economy and unprecedented domestic liquidity - has led to a dramatic recovery in China's domestic stock markets and renewed foreign investor interest in acquiring stakes in A Share companies.A SNAP SHOT OF CHINA'S A SHARE MARKETSTHIRD LARGEST IN ASIA (EX JAPAN)China's A Share markets were the best performing equity markets globally in 2006. Total market capitalisation of the Shanghai and Shenzhen stock exchanges reached US$1 trillion by the year's end, and with more than 1,400 listed companies, the combined A Share markets rank third in Asia (ex-Japan) by total market cap and by number.BROAD SECTOR REPRESENTATIONAlthough dominated by large cap banks, steel companies and energy companies, A Share markets provide much broader sector representation, particularly to the consumer and industrials sectors (each having approximately 300 listed companies), than the Hong Kong market. Approximately 30% of companies have a market cap of between US$200 million and US$500 million and more than half have a market cap of under US$200 million.THE VALUATION DICHOTOMYPrior to the market consolidation between 2001 and 2005, A Shares traded at excessive premiums to H Share and red chip companies on the Hong Kong market. Significant price convergence occurred during that period, such that by the end of 2005, the average price-to-earnings (P/E) multiple premium of Shanghai A Shares to H Shares had fallen to 58% from 500% in 2001, and the average Shanghai A Share P/E multiple had fallen to 18.86 times, from 62.45 times at the end of 2000. However, A Shares remain largely polarised, with large cap blue chips (such as bank stocks) trading at a discount to the market due to the higher concentration of institutional investors and small/medium caps (often with limited profitability, higher risk and lower liquidity) subject to speculation by retail investors, trading at a premium. This explains the relatively low overall weighted premium of 33.2% for A Share stocks over their H Share counterparts (for dual listed companies) compared with the high average P/E multiple of 36 times for Shanghai A Shares generally (and more than 70 times for Shenzhen A Shares), versus 20 times for the Stock Exchange of Hong Kong (SEHK), each as at January 2007.However, the recent bull run in A Share markets has stretched A Share valuations beyond that which many foreign investors would be prepared to pay at present.STRUCTURAL REFORM: ELIMINATING THE NON-TRADABLE SHARE OVERHANG BACKGROUNDA legacy of China's previously socialist economic system, the so-called "non-tradable share overhang" stemmed from the fact that, prior to the recent market reforms, only shares issued to the public were granted a listing; all other (predominantly) state and legal person shares were illiquid and formed separate classes of shares, with no certainty as to when they might be listed. This liquidity overhang was a principal factor inhibiting A Share market recovery and development, as it resulted in a misalignment of shareholder interests, artificially depressed liquidity, a significant valuation disconnect between public and non-tradable shares and an inefficient public M&A market in which very few takeovers occurred.REFORM PROCESSDetermined to address these issues, in May 2005 the State Council and the China Securities Regulatory Commission (CSRC) introduced a pilot scheme to convert non-tradable shares into listed shares, which was subsequently extended to all listed companies in September 2005. Under the scheme, each A Share company is required to formulate its own reform proposal, with public shareholders receiving compensation in return for their consent to the proposals. As a rule of thumb, public shareholders have been compensated to the tune of three shares for every 10 shares held, largely justified based on the expected downward pressure on prices due to the increase in liquidity.The reform process is nearly complete, with almost 1,300 companies already having completed or commenced their reform process and the remainder facing trading restrictions and other regulatory sanctions if they fail to reform.Generally speaking, all stakeholders have been winners in the reform process: public shareholders have arguably gained the most, receiving tens of billions of dollars of share value (mainly from the state) while enjoying all the accompanying upside from the ongoing bull market; holders of newly converted tradable shares have generally received good value (liquidity and valuation upside) for the compensation paid to public shareholders, while the state and regulators have achieved a major triumph in addressing a very thorny issue.FIRST REFORMED, NOW UNCHAINED: LOCK-UPS EXPIRINGTo manage the additional liquidity that was perceived to be created by the reform process, significant shareholders of previously non-tradable shares are subject to a staggered three-year lock-up, comprisingan initial 12-month lock-up, followed by a further 24-month period during which they are only permitted to sell a maximum 10% shareholding in the company on-market. However, after the initial 12-month lock-up, shareholders are free to sell shares off-market and deals are being structured accordingly; in the case of the proposed acquisition by Groupe SEB of a controlling interest in Supor, a cookware manufacturer, the transaction agreements were executed immediately following expiry of Supor's initial 12-month lock-up.Meanwhile, there is no restriction on the issue of shares by newly reformed companies; A Share placements re-commenced in mid-2006 and some of the recent M&A deals involve the issue of new shares: eg SEB / Supor (above) and Holcim's acquisition of a controlling stake in Huaxin Cement.REGULATORY REFORMS FACILITATING M&A DEALSWhile the non-tradable share reform addressed a major structural problem for the A Share market, it is the related regulatory developments that have facilitated the recent spree of in-bound cross border M&A deals.STRATEGIC INVESTMENT RULESIntroduced at the end of 2005 by five central government ministries, the Strategic Investment Rules remove the previous prohibition on foreign investors (other than QFIIs) acquiring A Shares. Key provisions of the rules include:• ability of foreign investors to directly acquire A Shares, subject to a minimum initial investment of at least a 10% shareholding, either by private placement of new A Shares or purchase of existing A Shares, subject to Ministry of Commerce (Mofcom)/CSRC approvals and filings;• qualification requirements for a strategic investor (or its parent): minimum overseas assets of US$100 million (owned) or US$500 million (managed) and not subject to any material sanctions in the past three years;• lock-up: the foreign strategic investor will be subject to a minimum three-year lock-up on the entire stake acquired;• FIE status: in line with existing FIE rules, a foreign shareholding of at least 25% will qualify the A Share company for FIE status; however, the foreign investor must undertake to hold the stake for at least 10 years.The following table sets out details of notable deals announced following the introduction of the Strategic Investment Rules; deals have involved a fairly even mix of private equity and industry investors, and a cross-section of sectors:DOMESTIC M&A RULESReplacing the interim M&A rules issued in 2003, revised rules governing the merger and acquisition of domestic companies by foreign investors were jointly issued by six ministries on August 8, 2006, and apply to acquisitions of stakes in both public and private companies, either via new share issues or acquisitions of existing stakes. For inbound transactions, notable provisions of the Rules include:• Regulatory approvals: the Rules impose central government approval requirements on two different, yet possibly overlapping, bases:(i) Central Mofcom approval is required for acquisitions of stakes in targets involving "key industries", "elements that may affect national economic security" or a change of control of a "famous brand". Although references can be found in other sources to help define these terms, their lack of specific definition in the Rules operates to give Mofcom broad discretion in considering deals.(ii) Anti-trust: pending the passage of the long-anticipated Anti-Monopoly Law, the Rules largely restate the anti-trust provisions from the 2003 M&A regulations. Thus, transactions can be subject to anti-trust review by Mofcom or the State Administration for Industry and Commerce (SAIC) where, for example, either party has a 20% market share of the China market, or the acquisition will increase one party's market share to 25%.• Shares as consideration: the Rules ostensibly permit the use by a foreign acquirer of shares (existing or new) in an overseas company as consideration for a stake in a domestic target. The overseas company must be a publicly listed company in a jurisdiction with a well established securities trading system, the shares must be traded on a lawfully established stock exchange and the shares must have had a stable price over the past year (although what might be regarded as stable by A Share standards could be interesting). In addition, central Mofcom approval is required and the target must engage an M&A adviser to prepare a report.As the receipt of foreign shares by the target constitutes an overseas investment, further layers of approval and registration are required from Mofcom, the State Administration of Foreign Exchange (SAFE) and SAIC. Not surprisingly, no deals have yet sought to take advantage of this payment method.2006 TAKEOVER RULESIssued by the CSRC, the new Takeover Rules came into effect on September 1, 2006 and apply to all takeover situations involving companies listed on China's domestic stock markets, whether a domestic or foreign acquirer. The Rules contain some helpful developments:• Partial Offers (Mandatory and Voluntary): an acquirer of more than a 30% shareholding in a target company may now elect to make a partial offer only for the stake that it is interested in acquiring, rather than a general offer for all shares as was previously the case. In addition, an investor holding less than 30% (including no interest) may also make a partial offer. Partial offers must be for at least 5% of the company. By way of illustration, upon obtaining a 30% interest in Supor through a share purchase and subscription, SEB Groupe proposes to launch a partial general offer that would give it a maximum 61% shareholding in Supor.• Conditional Offers: the Rules also contemplate that offers may be conditional, although no guidance is included as to what conditions may be acceptable to the CSRC.• Waiver from bid obligation: the Rules provide for waivers from mandatory obligations where an acquirer's shareholding exceeds 30% as a result of the issue of new shares by the target, provided that the issue of the shares is approved by independent shareholders in a general meeting, the acquirer undertakes not to transfer its shares within three years, and the waiver is also approved by shareholders. The Rules also enable a 30% shareholder to seek a waiver from the CSRC for increases in shareholding of not more than 2% during each 12-month period.• Share consideration: the Rules include detailed provisions regarding the use of securities as consideration for share purchase, and where the securities are unlisted, the acquirer must provide a cash alternative.• Pricing: reflecting the reforms in relation to non-tradable shares, the Rules no longer distinguish between tradable and non-tradable shares for pricing purposes and require that the pricing must be higher than the highest price paid by the acquirer during the previous six months. Pricing is now no longer referable to the net asset value of the shares acquired.KEY CHALLENGES FOR FOREIGN INVESTORSWhile the market reforms and new regulations represent a major milestone in the development of a public M&A market in China, they also present challenges to foreign investors seeking to acquire majority stakes. Key issues include:• regulatory approvals: delays in obtaining approvals can undermine transactions where share prices rally in the intervening period, which may lead to vendors seeking to renegotiate or withdraw from agreed deals;• target identification and selection: with intense competition for the most attractive targets coming from both private equity funds sitting on huge amounts of capital as well as industry players, first mover advantage is up for grabs; a focused target identification process and early stage due diligence that can address regulatory and other risks is crucial;• valuations: as A Share valuations continue to expand, deals are becoming increasingly difficult to justify to acquirer boards, particularly for financial buyers lacking strategic business imperatives for a deal. However, for industry players looking to gain market share and able to add value to the target (for example in terms of technology or overseas distribution channels), then valuations may be easier to justify to acquirer boards based on strategic grounds;• deal structuring: deals need to be structured so that they fall within the comfort zone of regulators to gain approval; where a controlling stake is not available, structuring a deal to allow maximum flexibility and participation in the business, including joint venture arrangements, board/management participation and options that may provide a future path to control, can make a vital difference;• management incentive: particularly with A Share companies, the majority of which remain state-controlled, providing incentives to management which will generally have very little, if any, shareholding in the target, is challenging; investors need to work with controlling shareholders and targets to adopt performance-based remuneration schemes and ensure that key executives are appropriately rewarded; this can be highly sensitive when state shareholders are involved;• financial adviser: selecting a financial adviser with international experience, substantive on-the-ground capability and a domestic licenced entity to make bids for listed companies and advise on domestic regulations, as well as having access to regulators to assess the likelihood of gaining approvals and other concerns, can play a major role in helping to ensure a transaction's success.CONCLUSIONThe recent reforms demonstrate a serious attempt by People's Republic of China (PRC) regulators to achieve a comprehensive overhaul of the A Share market and establish the necessary conditions to facilitate public M&A transactions.Industry consolidation, pressure on foreign investors to enter or increase their operations in China, a rapidly emerging domestic fund management market and stock markets largely populated by small cap companies create ideal conditions for a sharp increase in the volume of public M&A activity in China.However, the new regulations themselves, and their application by regulators, reflects the sentiment frequently expressed by senior officials that China seeks "quality" investment that will bring research and development, management skills and offshore expansion opportunities to PRC companies. As a result,industry players that are able to deliver on these items and for whom acquisitions can create synergies, cost savings and market access for their existing business, may have the greatest chance of taking advantage of the new opportunities.There is also an unavoidable sense of deja vu with the A Share markets at present; while some may argue that buying opportunities have passed, it may just be that now is the time to be preparing for the inevitable correction that will lead to the next wave of reform and opportunities.NOTABLE DEALS ANNOUNCED FOLLOWING THE INTRODUCTION OF THE STRATEGIC INVESTMENT RULESLegend for Chart:A - ACQUIRERB - TARGET (MARKET CAP)C - STAKE ACQUIREDD - DEAL VALUE & CONSIDERATION METHODE - SECTORF - STATUSA BCD E FSEB Zhejiang Supor CookerwareCo Ltd (MC: US$464m)Between 52.74% and 61%Approx Consumer PendingUS$300m MOFCOM and(Cash) CSRC approvalsCarlyle Xugong Science & TechnologyCo Ltd (MC: US$708m)50% of Xugong Machinery, whichowns 43.06% of Xugong Science& TechnologyApprox Machinery PendingUS$225m MOFCOM and(Cash) CSRC approvalsGoldman Shineway Group (& indirectly:Sachs/ CDH Henan Shunaghui InvestmentInvestment & Development Co Ltd)(MC: US$2.05bn)35.72% from local SASAC(thecontrolling shareholder) and 25%from Luohe Haiyu (the 2nd largestshareholder) through a biddingprocessUS$252m Consumer Obtained(Cash) MOFCOM approval in Dec 2006 and pending CSRCapprovalHolcim Huaxin Cement Co Ltd(MC: US$412m)Subscription of 160m A Shares tobe newly issued, increasingHolcim's shareholding to 50.32%from 26.1% currentlyApprox Materials Pending CSRCUS$100m approvalMittal Hunan Valin Steel Tube andWire Co Ltd (MC: US$1.394bn)36.67%US$338m Steel Completed(Cash)Arcelor Laiwu Steel Corp(MC: US$4.543bn)38.41%US$225m Steel Pending govt(Cash) approvalsMorgan Anhui Conch Cement Co LtdStanley & (MC: US$4.543bn)IFC14.33%US$159m Materials Pending govt(Cash) approvalsSOURCE: BLOOMBERG AND COMPANY ANNOUNCEMENTSGRAPH: RANKING OF REGIONAL STOCK MARKETS BY MARKET CAPGRAPH: RANKING OF REGIONAL STOCK MARKETS BY NUMBER OF LISTED COMPANIESGRAPH: COMPARISON OF A SHARE AND H SHARE VALUATION MULTIPLESGRAPH: A-SHARE MARKET PERFORMANCE SINCE 2001PHOTO (COLOR): Robert Reid Managing Director of Investment Banking, Head of Mergers and AcquisitionsPHOTO (COLOR): William Yeung Executive Deputy General Manager (CESL)PHOTO (COLOR): Philip Gregory Director of Investment Banking, Head of China Execution©Euromoney Institutional Investor PLC. This material must be used for the customer's internal business use only and a maximum of ten (10) hard copy print-outs may be made. No further copying or transmission of this material is allowed without the express permission of Euromoney Institutional Investor PLC. Source: Asiamoney and .。