| Nicholas Andrews | ||||||
It has been a record year for equity and equity-linked issuance in the Asia ex-Japan market. By November it was clear that the $38 billion record set in 1999 was going to be broken by about $2 billion. “That’s another $1 billion in equity capital market fees,” says one banker grinning and rubbing his hands.
With Hong Kong and China responsible for 70% of the new issuance, issuers from these two markets are picking up most of the tab.
The foreign banks may be happy but the news for their investing clients and many issuers is a little less rosy. Being smug when the price of your stock has disappeared beneath the waves is something of a challenge.
“Nearly all deals have been performing badly, and most IPOs are underwater,” says Nicholas Andrews, managing director and head of equity capital markets at CSFB in Hong Kong. “There have been complete dogs,” adds another banker.
Philip Southwell, director and head of capital markets at Deutsche Bank in Hong Kong, agrees: “Many in the after-market have just not performed well at all. And I think this is an issue for banks across the region to consider.”
Shares in Sunday, the second-rank Hong Kong telecom floated on March 15, are down 79%. Chinese web portal Sohu.com, which came to market in July, has sunk 69%. And Netease, another Chinese web portal, has slumped 70% since going public in June. Admittedly negative publicity after a rogue user posted notices on Netease advertising human organs for sale did little to help its brand image or its share price.
“If the price of a stock has gone down 30% to 40% that’s considered pretty good,” says Christine Tan of Salomon Smith Barney’s equity capital markets team in Hong Kong. “And a decrease of 60% to 70% is not uncommon.”
“Look,” says the grinning banker, still rubbing his hands, “the banks just provide what investors are willing to buy. If you can find a buyer, then do the deal.”
Despite being on course for a volume record, the absolute number of deals hasn’t changed. According to John Simpson, managing director of HSBC’s equity capital markets team in Hong Kong, there has actually been a massive reduction in the number of issues. What is new is the unprecedented number of billion-dollar deals. The big slugs include privatization issues on the Hong Kong Stock Exchange from mainland companies Sinopec ($3.5 billion), Petrochina ($2.9 billion) China Unicom ($5.7 billion) and China Mobile (a $6.8 billion follow-on).
These privatizations have been a strong driver in the primary equity market, and the good news is that, in marked contrast to so many of the issues in the region in the past 12 months, they are trading at or above issue price. Market participants are in agreement that they have performed remarkably well in what can only be described as a bear market.
“The love affair investors have with China goes in phases,” says Andrews. “This year it’s been back on. Investors are dying for an excuse to believe in China and this year have been willing to give issuers the benefit of the doubt.”
Investors seem to have short memories. Three or four years ago many of them charged into red chips on the mere premise that China had a lot of people. Nobody wanted to miss out on a piece of such a vast market. But as Marcus Brown, director, equity capital markets at UBS Warburg in Hong Kong, points out: “All the investors seemed to overlook the fact that no restructuring was actually taking place. These companies were run by civil servants who didn’t have a clue. It’s not surprising that horrendous mistakes were made that cost shareholders a lot of money.”
Compelling but illusory
Sherry Lui, managing director, China investment banking, at CLSA in Beijing, gives the example of conglomerate Beijing Enterprises. “In 1997 investors saw this as a compelling company,” she says. “Its major shareholders were the Beijing municipal government and the vice-mayor of Beijing. It was believed to have great potential because the local government had the power to acquire stronger assets and then inject these into the company.” But, claims Lui, it was all an illusion: “Yes, investors saw a greater deal flow and a large amount of assets being pumped into the company that expanded the asset base, but they failed to look below the company’s surface.” Its core businesses and fundamentals were seriously flawed yet it had a price earnings ratio of 90.
The quality of stock on offer has definitely improved. “There has been a sea change in the way the Chinese have been going about privatization,” says Simpson. “Between 1993 and 1998 the Chinese basically listed small companies, between $50 million and $200 million [market capitalization], but they were in desperate need of restructuring. It wasn’t a case of ‘we have the equipment and we are now on the way up’, it was more a case of ‘give us the money from the IPO and then we’ll try to get the necessary plant and equipment.’ As a result the share price plunged.”
The red-chip bubble burst at the end of 1997. Five months after floating, Beijing Enterprises’ price fell by 60%. But it appears that the Chinese government of reformist premier Zhu Rongji has learnt some valuable lessons that it is now putting into practice.
First lesson: you can’t dump anything and everything onto the market in the hope of making a quick buck. The market is now no longer interested in seeing the insignificant regional road toll operator being privatized.
Second lesson: when you do a privatization, do it big and in a strategically important industry. Investors are, it seems, once again sitting up and taking notice.
Third lesson: price sensibly. The Chinese government has woken up to the fact that if it gets this part right, it can come to the market again and again in its quest to raise money. It is also important to note that jumbo transactions of the type seen this year have to be perceived as being successful.
Great possibilities
Michaël De Lathauwer, managing director and head of Asia equity capital markets at Goldman Sachs in Hong Kong, says: “If you look back five years and you think about the red chips, when the bubble burst there was very little there. There was no value creation in these companies. This time around it is very different. You have companies which are really very big which have very large revenues and also great possibilities.”
| Zhu Rongji | ||||||
Michael Carr, Goldman Sachs’ managing director and head of investment banking for Asia, enthuses: “Chinese corporates are now a very exciting investor story. Right now, if you are a fund manager you have to put your chips on China and Hong Kong because these markets are moving.”
Deutsche’s Southwell takes it further, explaining that for the first time there are now three or four companies of real significance. This allows the large institutional investor to move quite easily $150 million to $200 million into and out of these stocks. “Purely for liquidity reasons,” he says, “it makes them so much more attractive than smaller players.”
But before investors get too excited about the prestigious deals coming out of China, it would be wise to note that, as one banker puts it: “There is still a lot of birth pain to get through turning these corporates from state-owned enterprises to listed companies.”
He’s right. This is not like privatizing British Telecom, where a company is in reasonable shape but needs more commercial management and the spur of competition.
Chinese corporates are in need of a total structural overhaul. For example, Petrochina had 500,000 employees. It fired 50,000 on one day alone.
“Petrochina was the most difficult,” says Southwell, “because it was the First and it’s tough trying to sell a business of 500,000 plus employees.” Praise echoes around Hong Kong’s Central for Goldman Sachs and the job it did. But not everything went as smoothly as Goldman Sachs would have liked. The bank, according to one competitor, apparently expected greater retail demand and priced it to offer a 7% dividend yield. But Goldman failed to take into account that Chinese retail had yet to get into the habit of investing cross-border. Petrochina’s price dipped below the issue price. However since the middle of the year it has performed strongly, rising around 27%.
“Petrochina is the template for corporate restructuring,” says De Lathauwer. “The state-owned old economy stocks need more restructuring than the newer telecom companies like China Mobile and China Unicom.”
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The Petrochina of last year was a very different company to the one that was brought public. It was, claims Goldman Sachs, one of the largest industrial restructurings in the history of capital markets. The corporate was the fourth-largest oil company in the world and one year ago it was an integral part of the oil ministry. To spin off an entity of this size takes time, but what Goldman has helped develop is a commercial enterprise run alongside the ministry. “Petrochina has now got a very good operation,” says De Lathauwer. “It’s working out and building muscle.”
The success of this deal meant that the road ahead was cleared. Sinopec turned out to be a similarly successful capital markets transaction. Cynicism about Chinese privatization has apparently disappeared, with other deals following the successful ones mentioned.
Having a Chinese government that is now willing to subject state-owned enterprises to the disciplines of the capital markets has helped no end. “China has an interesting set of dynamics,” says Goldman’s Carr. “It has a government that really believes in reform and views the market as a vehicle to implement this reform.” Carr believes that the government has decided to open these companies up to investor demand and subject them to market forces because of a realization that it is a more effective method of change than pure political mandate. As a result the bigger, more growth-oriented enterprises are being put on the block.
But the question has to be asked: as these changes are happening so rapidly are mistakes being made that will come back to haunt the ever-optimistic investor in Chinese stocks?
The Goldman bankers think they have some answers. What is clear is that there are going to be winners and losers.
De Lathauwer says: “It’s clear that restructuring will lead to massive retrenchment but American industry had to go through it and US unemployment is now at an all-time low.”
Ronald S Lee, Goldman Hong Kong’s executive director, debt capital markets, quickly takes up some positive aspects of the story. “It’s not so much the pace of change that is precipitating mistakes,” he says, “but more a case of us uncovering mistakes that were already there. But from an investor’s point of view, they are now the arbiter in this whole process. They will ultimately decide.
Investors’ dollars will evaluate whether the pace of change is too fast. But from an investor’s point of view the changes can’t go fast enough.”
De Lathauwer agrees, pointing out that the success of China Mobile, Sinopec, and Petrochina are all closely monitored by fund managers. “If they do something wrong in terms of shareholder value their price will go down.
Winners and losers are being decided by competitive forces, which was never the case before this whole process started.”
Not everybody is convinced that the companies coming to the market are as world class as some western investment bankers would have us believe. The simple reason for industrial investors to own shares in these Chinese companies is to get a toehold in the Chinese market and show solidarity with the government.
Licences to conduct business within China are hard to come by. Daniel Conklin, head of global corporate banking, China, at Standard Chartered Bank in Shanghai, explains: “Oil companies such as BP and Mobil have been getting into non-profitable business just to get their feet on the ground. Companies are being pushed into China because the US domestic markets are so mature and growth rates are so low. This is really the underlying creator for demand for these shares.
“They are not so much an investment but more like a club membership, because 15 years down the road China is going to be the only game in town.”
Brown agrees, saying that investors are buying a piece of China rather than the stocks themselves.
Whether these Chinese companies are truly quality operations in their own right or mere entry points to the market, with $1 billion in fees on the table the banks are having a great scrap to win mandates to lead the coming wave of privatizations.
“Winning mandates for privatizations requires longer-time relationship-building,” explains Colin Stewart, managing director at Morgan Stanley Dean Witter in Hong Kong, described by one banking competitor as Hong Kong’s most knowledgeable white-faced banker on China. “China needs a longer lead-in and the longer you know the decision makers, the better. The coverage starts earlier, making time getting to know the client before the mandate really exists. Yes, it’s personal, but the credentials of the institution are important as well.”
But the deals now in the pipeline are, it seems, far too high profile for banks to rely on individual relationship managers.
“What China is looking for is real expertise, both from a sector and distribution standpoint. You need coverage guys who have a regular dialogue who can deliver the firm. And the Chinese are really becoming smart and sophisticated,” says CSFB’s Andrews.
This wasn’t necessarily the case a couple of years ago when wining, dining and entertaining government officials was perhaps a little too important.
In an attempt to deal with criticisms that the decision-making process was perhaps slightly tainted, an edict was passed banning decision-makers, company directors and bankers playing golf together. “Yes,” says a banker in Beijing, “golf has officially been banned between those attempting to secure business.
But unofficially,” he pauses, “they play a game of golf and then talk business when they get home.”
To be truly successful, it is important for banks to get in early, assist in the restructuring and, most important, get the capital markets execution right. Unfortunately for some it doesn’t always go right, and one failure can have profound effects on a firm’s prospects for winning China business. Salomon Smith Barney can vouch for this.
It was the lead manager in a planned privatization of China National Offshore Oil Corporation (CNOOC) worth $2 billion. In the words of one banker close to the deal, it turned into a comedy of errors. “The execution of the deal when launched was mispriced and badly handled. At the last minute, SSB tried to down-price it and then tried to down-size it in an attempt to get a smaller deal done.
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[Citigroup vice-chairman, Robert] Rubin was even sent out to fight their corner.”
The Chinese were apparently not impressed by the former US treasury secretary’s intervention. CNOOC slung SSB out of the deal and asked CSFB to join Merrill Lynch and the Bank of China International at the table.
Sympathy for SSB in Hong Kong is notable chiefly by its absence. One high-profile banker says: “SSB has done a lot of damage to itself and rightly so. I’m surprised they weren’t Fired earlier.”
Another banker says: “SSB’s whole China strategy has unravelled due to this CNOOC deal. “It has effectively been shut out of all China’s new issues. It’s quite interesting really because it had a good year last year, and it pitched a good deal in every market. But if you get it wrong once in China, nobody invites you back to the table.”
The reigning champion at winning mandates is without doubt Goldman Sachs. It has set a blazing pace, being involved in many major deals, including China Mobile’s $6.8 billion follow-on issue, the largest offering ever in Asia ex-Japan. It’s a record that leaves the banking community in Hong Kong looking on in awe.
Goldman took the view, before others, that there was a need to focus on large important deals and those take a while to come to the market. It realized it needed to invest heavily in the investment banking side of its Chinese business. That is now really paying dividends.
Lee explains: “Resource allocation is important. Greater China is the game for us rather than spreading ourselves too thinly throughout the region.”
Perhaps the trap other banks have fallen in to is that they have their fingers in too many different pies and as a result cannot bring the same focus.
Carr continues: “China has seen the investment we have made in terms of our build-up and commitment. That’s important to the Chinese.”
He says that it was invaluable that Goldman Sachs was there at the start rubbing shoulders with the captains of Chinese industry. “If you aren’t in the same room, you can’t have the same knowledge,” he says.
Simpson at HSBC doesn’t deny that the credentials of a bank are important when pitching for business, but he says that unfortunately the Chinese fascination with listing in New York greatly benefits US players. “The Chinese have been persuaded by the Americans that this creates demand. The reality is that it certainly doesn’t. If you have a dual listing the volumes always come back to Hong Kong. The Chinese have been conned into thinking that it’s a great idea.”
Simpson backs up his argument with the example of China Mobile. Although the company is triple-listed – in New York, London and Hong Kong – 80% of its shares are now held outside New York. “There may be some truth that there is some prestige attached to a New York listing, but there is no truth in the idea that you get more demand by listing in New York simply because US retail investors can buy it.” Another senior banker agrees strongly: “I believe the Chinese have been brainwashed and are just paying more in fees to the US banks.”
All banks are carefully refining future strategy in an attempt to deal with further Chinese issues.
When CNOOC finally goes public, China will have cleared its privatization backlog and there will be fewer jumbo transactions. And it’s not obvious where they will come from.
But all banks, perhaps SSB excluded, are optimistic. Andrews at CSFB points out that: “The taps can be turned on very quickly in Asia, so it’s important is to go with the flow and have good penetration on the ground.”
Another analyst discusses a company visit in October. “We went to see a company that we had never heard of, and it’s worth $5 billion. And there’s a lot more like it to come. China is a big place, and there are sectors that nobody has done anything with, and it could easily amount to over $100 billion.”
China has now worked through two sectors: oil and telecoms. The next link in the chain is the financial sector and bank shares may eventually be floated. One analyst says: “That will come, but a hell of a lot of work needs to be done.”
Southwell from Deutsche has the last word: “You have to focus on the opportunities and not the problems associated with restructuring. Call it right, and the benefits are huge. If you genuinely think it’s going to happen it’s going to be an exciting ride.”
Marriages of convenience and necessity
The prospect of earning huge fees from Chinese privatizations and financing on the capital markets is a powerful attraction to foreign investment banks. But they will find Chinese investment banks muscling in and trying to learn all the tricks quickly.
| John Simpson | ||||||
Unfortunately for the international banks, it’s not simply a case of being able to wander around China, cherry-pick the privatization mandates and keep the spoils for themselves.
That $1 billion in fees – with the promise of more to come – has to be shared with local institutions. Culturally-challenging investment banking joint ventures are in vogue.
“It’s inevitable that all of us are going to have to go to bed with the domestic banks. It helps us win the mandates. There is a need for ever-closer partnerships, be they formal or informal. And everyone will be working towards that,” says John Simpson, managing director of equity capital markets at HSBC in Hong Kong.
The local investment banks bring the contacts and the foreign banks bring the experience. But one foreign banker in Hong Kong seems slightly put out by the arrangement. “Yes they have contacts. But we do all the work and they take half the money. And they load up on our experience.”
The local securities firms disagree. They say that they bring just as much market savvy to the table as the bulge-bracket global investment banks. Their view is that the foreign banks don’t yet fully understand the complexities of China. “The foreign banks provide the technical knowledge about the international markets and we help them with local knowledge,” says Tang Shisheng, vice-president of Beijing-based China Galaxy Securities Company.
Michaël De Lathauwer, managing director and head of Asia equity capital markets at Goldman Sachs in Hong Kong, agrees: “We are very respectful of local knowledge. You can’t go in there and pretend to know everything.”
The process of finding the right partner is certainly challenging for all concerned. Sherry Lui, CLSA’s managing director of China investment banking in Beijing, describes it in terms of marriage. She points out that although a potential partner may look beautiful, it doesn’t necessarily mean the relationship will work. She goes on to talk about the fact that CLSA is eyeing up some of the top 10 securities Firms based in Beijing.
But she says: “Some may have the largest market share in particular areas but they have the traditional problems. Lack of transparency and too bureaucratic.”
China is supposed to have moved beyond a time when guanxi (connections) especially in the government, were the main requirement for business success. The local knowledge that foreign banks seek from Chinese joint venture partners can perhaps be translated to their local connections. These contact lists still take precedence over everything, despite claims to the contrary. “A bad Firm with connections within the government is so much better than a good Firm without,” acknowledges one banker.
One Chinese Firm that everyone is trying to dance with is China International Capital Corporation (CICC), the joint venture set up Five years ago between China Construction Bank and Morgan Stanley Dean Witter. “MSDW wanted Construction Bank because Construction Bank has clout with the government. They have the best connections. Why else do you think CICC is involved in all the big deals,” says an analyst in Shanghai.
CICC has indeed built an impressive record of high-profile deals: Petrochina ($2.9 billion IPO); China Telecom ($4.9 billion IPO); China Unicom ($5.65 billion IPO); and Sina.com ($68 million IPO listed on Nasdaq) to name but a few.
But in the MSDW-CICC marriage bed not everything is functioning perfectly. In fact MSDW seems to have a headache. CICC is – in the opinion of some investment bankers anyway – getting ideas above its station. It’s started to go it alone in some deals and has even been seen courting the opposition – Goldman Sachs.
Colin Stewart, Morgan Stanley Dean Witter’s managing director in Hong Kong, attempts to clarify the position: “Go back and look at the raison d’être of CICC – to be China’s First international style investment bank. At the beginning there was a misconception in the market and to some extent in Morgan Stanley that CICC would be Morgan Stanley in China.
The Chinese believed that CICC must be independent and should grow through advice and technology transfer from Morgan Stanley.
Originally when it was set up CICC was more focused on domestic business in China, but this market has not matured, expanded, or deregulated as fast as CICC would have liked. So to maintain their position they looked to opportunities in the international capital markets.”
Both entities are trying to come terms with this shift in philosophy. They have become competitors and partners in the same market.
It’s something that can only be described as a double-edged sword. Who do you go with – CICC or MSDW? When they have worked together it’s often been a successful and profitable partnership.They won the mandates together for two jumbo IPOs, Sinopec and China Unicom.
Shawn Xu, managing director of CICC’s research department in Beijing, has his own opinions: “There is a conflict of interest which we will have to eliminate. If we don’t we will just have to come to some sort of gentleman’s agreement. But let’s not pretend it doesn’t exist. At our formal meetings everyone seems so happy.” Maybe the expressions on the faces of people at those meetings are more grimaces than smiles. He goes on: “People compare us to Bank of China International but we have the competitive edge. We have the infrastructure and management to support teams to reach international standards. We can’t do that without Morgan Stanley.”
So is this be a pattern of things to come? As the Chinese investment banks become more savvy, will they become less dependent on foreign banks and start taking the lead in more deals?
Guocang Huan, managing director, and co-head of investment banking for Asia Pacific at Salomon Smith Barney, certainly doesn’t believe so. “The evolutionary process of globalization is very aggressive. Chinese banks will not be able to compete without foreign banks,” he says.
Goldman Sach’s Carr doesn’t believe so either. He says: “The best thing that could happen to the Chinese investment banks is for them to gain experience. And the more we do together, the better will be the results for issuers and the market.”
Another banker adds: “We don’t think for a minute that US banks are going to dominate this market so we look to grow with them. If we get pushed out, its because we weren’t on our game.”
There’s little pressure to issue
Chinese companies have begun flocking to the international equity markets but issuers have been far less prominent in international bond markets. The last large sovereign bond was launched in December 1998, and though rumours periodically surface of another sovereign deal, bankers in the know dismiss these as little more than wishful thinking on the part of mandate hunters.
| Patrick O’Brien | ||||||
China has substantial foreign exchange reserves and little need to boost these with additional foreign currency liabilities. “The sovereign is smart enough not to be too frequent an issuer,” says one banker. “The Chinese tend to be very cost-conscious and have a good sense of when to come to the market. They won’t push a deal for the sake of doing a deal. They don’t have the same funding pressures as other countries. And they can issue domestic bonds whenever they want. The savings pool is massive.”
But other market observers are more critical. They argue that China has not done a good job of building a following for Chinese credit among international institutional fixed income investors. Rare Chinese bond deals often Flow back into the hands of Chinese-funded institutions. Patrick O’Brien, managing director, joint head of debt capital markets at UBS Warburg in Hong Kong says: “It’s a prestigious but sporadic borrower. By being sporadic, it has failed to engage large international pools of capital. And that may be a problem when the time comes that Chinese companies could quite sensibly access the international market. For a country of its size and economic importance, one big deal every couple of years is not enough.”
One reason why China might launch more deals would be to provide a benchmark sovereign yield curve for domestic corporates to pitch their own issues against. US and European capital markets might provide longer-term funding that would be attractive to those Chinese companies with significant foreign currency earnings. But it seems that, for now, Chinese corporates are no more inclined to launch foreign currency bond deals than the government.
Partly that’s a reflection of the doubtful credit quality of many Chinese companies and of the tight restrictions on foreign currency borrowing. SAFE (the State Administration of Foreign Exchange) has to give individual approval for foreign currency borrowings by Chinese entities. Although large numbers of these have been granted to Chinese infrastructure projects – which are huge spenders – the Chinese banks closest to these projects and likeliest to co-lead international bond deals seem to have lost confidence in their commercial viability and certainly in their ability to convince foreign investors of their credit quality.
Additionally, these projects are not generators of foreign currency earnings, so international bond deals would bring unnecessary currency risk. Many official licences for foreign currency borrowings are going unused.
Aside from the sovereign, those Chinese borrowers that have come to the international bond market tend to be intermediaries, such as China Development Bank, which might eventually channel funds raised to local borrowers. This arrangement reflects the structure of the domestic market. The Chinese bond market is large but direct corporate issuance makes up only a tiny fraction – as little as 3%, says O’Brien at UBS Warburg. Banks account for perhaps 10% to 15%, with the government still by far the biggest issuer.
“China is not disintermediated in the same way as US and European capital markets,” says Adrian Khoo, director at SSB in Hong Kong. “You don’t have a separate loan market and distinct bond markets.” This may change as the Chinese government encourages one or two of the larger banks to foster a local bond market. In the meantime, according to Lucy Fan,vice-president debt capital markets at Salomon Smith Barney: “What is apparent is that domestic sources of funding are substantial.”
Bigger banks may become issuers, but foreign investors will worry about their credit quality for some time to come.
Despite all the NPL problems of Chinese banks, the local renminbi market remains a liquid and plentiful source of low-cost funding.
Borrowings are based off the one-year deposit rate, now 2.2%. That makes the additional premium required on foreign currency interest rates look prohibitive. As NPLs have built up in China, so has bank liquidity. There aren’t enough quality borrowers to lend to. Certainly those Chinese projects that can show decent credit fundamentals have access to large volumes of cheap local renminbi funding. China Mobile recently raised a domestic syndicated loan of almost $12 billion equivalent.
Ultimately, developing efficient means to channel domestic savings to productive users of capital – through banks, domestic bond markets or both – is more important to China than keeping happy the debt capital markets teams at international banks. Khoo at SSB says: “To have a fully-functioning, self-sustaining economy in a developing world, you’ve got to have fully functioning domestic capital markets. And guess what? China has a market, and an internal market, that’s big enough.”
