“The more China has grown private and market oriented, the more it has grown. The parts of China that have grown, are the parts that were private and market oriented. The model that people talk about of alternative capitalism in China is something that China grows, despite, not because of.” — Adam S. Posen, President, Peterson Institute for International Economics
A fundamental paradigm shift has just begun, as private ownership advances, and state ownership retreats within China. Strategic investment opportunities for private investors seeking to capitalize on first-mover opportunities for shareholdings in Chinese state-owned enterprises (SOEs) previously closed to outside investment are anticipated to emerge as of early 2015. China Petroleum & Chemical Corp’s (Sinopec) US$17.44 billion spinoff of part of its retail unit is a harbinger of more privatization to come as key SOEs undergo sweeping mixed ownership reform. Whilst domestic private capital has played the dominant role, over time, foreign capital may enjoy more opportunities to invest in mixed-ownership enterprises (MOEs). Early awareness of, and subsequent positioning for, capitalizing on China’s mixed ownership renaissance will require sophisticated understanding of investment entry points, exit strategies, and the surrounding policy and regulatory regimes within China and abroad.
A New Direction: Mixed Ownership Reform
At the Third Plenum of the 18th Chinese Communist Party (CCP) Central Committee in November 2013, China’s leaders endorsed the concept of a mixed ownership economy: “We must ensure the decisive role of the market in allocating resources and… eliminate different forms of monopoly.” The Plenum’s sixty-point communique (Communique) called for rapid development of mixed ownership, defined as “cross-holding by, and mutual fusion between, state-owned capital, collective capital, and nonpublic capital.” In short, not 100 percent state ownership, not 100 percent private ownership, and definitively not 100 percent foreign ownership. Asset sales at centrally governed financial and industrial conglomerates have steadily followed suit post-publication of the Communique; a roadmap of Chinese economic imperatives over the next 8-10 years.
The P.R.C. State-Owned Enterprise Footprint
The ongoing transition from state ownership to mixed ownership represents a fundamental paradigm shift to China’s economic landscape. The presence of SOEs within the Chinese economy is profound. China has more than 100,000 SOEs, with combined assets of roughly US$13 trillion. The largest SOEs in China—the 113 central SOEs—fall under the purview of the central State-owned Assets Supervision and Administration Commission (SASAC). They comprise entirely state-owned group corporations or holding companies with multiple subsidiaries, some of which may be listed (largely in Hong Kong). Many of these companies (which are at the forefront of the shift from SOE to MOE reform) are in industries deemed to be strategic, and as such, operate within a more politically sensitive regulatory framework. Within the energy sector, these include: power generation and distribution (China Datang, China Guodian, China Huaneng, State Grid, and Southern Grid); and oil/gas (China National Offshore Oil Corporation (CNOOC), PetroChina, Sinopec and Sinochem).
Nicholas Lardy of the Peterson Institute for International Economics has advanced that SOEs (relative to their private sector peers) have been, and continue to be, outperformed across a spectrum of metrics that have buttressed the rationale in favor of SOE to MOE reform. The Economist posits that putting SOEs right is “the most critical reform area for China in the coming decade.”
Challenges with the Status Quo
Of the numerous challenges facing SOEs, this article identifies four central dilemmas. First, SOEs’ return on assets have been extremely low relative to the cost of capital. In industry, for example, the gap between private and state firms has widened significantly over the past six years and is now almost at a ratio of 3:1. Moreover, return on assets of private firms is around 15 percent versus less than 4 percent for state firms. This equated to less than half the cost of capital, which hovered around 6.8 percent.
Second, the private sector’s utilization of credit in proportion to their contribution to output exceeds the performance of SOEs. Between 2010 and 2012, private firms received, on average, 52 percent of loans going to all enterprises. But the private sector produced between two-thirds and three-quarters of China’s GDP. Moreover, on average, the ability of private companies to repay loans is more than twice as great as SOEs.
Third, from a domestic standpoint, SOEs’ perceived preferential access to subsidized energy, land and capital inputs is leading to market distortions that have resulted in rampant overcapacity in some key sectors. From an international perspective, external pressure is being placed on China’s government as SOEs seek to integrate more fully into the global economy by investing and competing abroad. China’s trading partners have for years complained about the preferential treatment enjoyed by SOEs.
Fourth, about half of all SOE assets are sitting in non-strategic sectors, such as restaurants, retailing and low-end manufacturing. There is increasingly little justification for SOEs continuing to attempt to compete with private firms in non-strategic sectors. This “non-strategic” group of SOEs is large. It comprises over 90,000 individual enterprises with about RMB37 trillion (US$6 trillion) in assets, according to the Ministry of Finance. In October 2013, SASAC Vice Chairman Huang Shuhe, remarked: “We are determined to clean up and dispose of inefficient and inactive assets in order to stop the bleeding. We will strictly supervise investments by state-owned enterprises to control investments that exceed their financial capacity or go into non-core businesses and excess capacity sectors.”
In all, SOEs are grossly inefficient relative to private sector actors. According to the World Bank, China’s SOEs are “dying dinosaurs that continuously absorb resources from the economy but produce little economic value.” This underperformance is beginning to act as a drag on the economy’s potential for growth just as broader structural changes are shifting China’s economy onto a slower growth rate.
Oil and Gas SOE Privatizations: Actively Developing Mixed Ownership
Since the Third Plenum of the 18th CCP Central Committee, China is likely to incrementally intensify the transformation of its SOEs into MOEs. China’s four oil and gas leviathans—CNOOC, PetroChina, Sinopec and Sinochem—have been reported to be looking to eliminate efficiencies, improve governance, and to a certain extent, embrace private capital (the bulk of which, to-date, has been domestic). The case of Sinopec’s spinoff of part of its retail unit may be a harbinger of enhanced appetite for mixed ownership opportunities within China’s oil and gas SOEs.
In September 2014, Sinopec announced it had sold a 29.99 percent stake in its retail unit to 25 investors for RMB107.094 billion (US$17.44 billion) in cash. International companies including KKR & Co. and the Ontario Teachers’ Pension Plan were invited to bid. The foreign bidders, however, were predominantly overlooked. Sinopec’s auction gave 24 out of 25 stakes to Chinese companies. The only international investor to win a stake in the business was RRJ Capital Ltd., an Asia-focused private equity fund. Whether this represents a longstanding policy sentiment across China’s key oil and gas SOEs remains to be seen.
After completion of the capital injection, Sinopec now holds a 70.01 percent stake in the company. The new investors have three board seats. The sale of the stake in Sinopec’s retail unit, which includes more than 30,000 petrol stations and 23,000 convenience stores, showcases China’s efforts to realize mixed ownership and increase efficiencies1. Analysts have estimated that an IPO, if pursued, could raise US$50 billion.
Whereas in the past, P.R.C. energy SOEs were focused on outbound investment, there is now an emerging focus on restructuring and integrating past acquisitions. Chinese oil and gas SOEs are consolidating sprawling assets, putting related assets together and seeking listings for units. However, Zhang Cunxiao, a senior official working for SASAC, stated in the China Daily, that companies in the resources sector are likely to still be majority state held. This reform process to mixed ownership presents an uncertain regulatory context amid what is expected to be a flurry of SOE transitioning to MOE activity.
Therein the Opportunities Lie?
The need for financing is driving large oil and gas SOEs to seek private capital: “Introducing private sector ownership at the parent group level is unprecedented, which could potentially allow entrepreneurs to run SOE groups,” said Steven Sun, head of China equity strategy at HSBC in a research note. Strategic investors can help establish a new management incentive plan and make oil and gas SOEs more market oriented. In addition to seeking private capital, the government is encouraging Chinese companies to exploit financing on a standalone basis, as opposed to depending on their parents for discounted financing. Other potential deals include asset injections and divestitures of non-core assets. For instance, within the realm of oil and gas:
- In 2013, PetroChina formed a joint venture with Chinese investment company Taikang Asset and the Guolian Fund through which the two funds channeled RMB60 billion (US$9 billion) in exchange for a 50 percent stake to develop pipeline assets in the western part of China; and
- In May 2014, Hong Kong-listed PetroChina announced that it plans to establish a subsidiary called PetroChina Eastern Pipelines and sell a 100 percent interest through a public tender on an equity exchange. China Enterprise Appraisals valued the net assets of the pipelines at RMB39 billion (US$6.3 billion) and Fitch said in a May report that it expects the transfer proceeds to be higher than the net book value.
By de-monopolizing oil and gas assets vis-à-vis the transition from SOEs to MOEs, the market is likely to witness more mergers and acquisitions, private placement, and restructuring activity. Whilst to-date the overwhelming source of private capital injected into SOEs has been derived from domestic investors, it should be noted that the experimentation of MOE reform will be a long-term undertaking. Foreign capital, over time, is likely to incrementally play a more active role in the MOE renaissance. In crossing the river by feeling for the stones, a fundamental paradigm shift is underway as private ownership advances, and state ownership retreats.
Sidley Austin’s Asia Pacific Energy team will continue to closely monitor the policy and regulatory opportunities (and complexities) accompanying China’s mixed-ownership enterprise reform.
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1 The Chinese investors included affiliates of Bank of China, China Cinda Asset Management, private equity fund Hopu, Haier Electronics, ICBC, Credit Suisse Asset Management, China Asset Management, Harvest Fund Management, Fosun International, Sino Life Insurance, ENN Energy Holdings, China Pacific Insurance Group and China Life Insurance Company.
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