Ties That Bind - Bay Area Council Economic Institute

Investment: Building Global Businesses in a New China
This interest in investing abroad by U.S. venture capital firms represents a sea change for an industry
that has historically invested all of its money domestically.
Investors see particular upside potential in the fact that many of China’s traditional industry
sectors are highly decentralized with no distinct industry leader. For example, Shanghai Baosteel
Group, a conglomerate formed in 1998 from 11 iron and steel companies, is the world’s 6th
largest steel producer, yet it holds only a 7% market share among China’s 134 steel companies.
This is in part the result of Maoist Cold War security policy to disperse steel production
throughout the country in case of attack. Poor highway and transportation infrastructure,
balkanized regional and local political interests, and local preferences have contributed to a
similar fragmention of China’s consumer market, leading to regional markets and products without
national reach. This can also pose challenges for foreign investors seeking to operate at a
national scale.
Still, the scale and growth of China’s market is stimulating deal flows, reflected in growing M&A
activity. Draft rules issued for comment in May 2006 by the China Securities Regulatory Commission,
which oversees the Shanghai and Shenzhen stock exchanges, propose to reinstate IPOs
for listed companies, allowing them to convert their non-tradable shares so they can use their
own equity for mergers and acquisitions. As of late September 2006, 1,169 of the 1,343 listed
companies on the two exchanges had started or completed plans to make their previously nontradable
shares publicly tradable. These plans have typically involved combining various classes
of non-tradable and restricted shares, along with government-guaranteed issues to compensate
existing domestic shareholders for potential dilution of their interests, into a single, tradable class
of stock known as “G” shares.
So far, the combining of share classes has eroded G share values. Listed companies have tended
to trade at very high multiples at the time of an IPO and then decline in value as earnings and
fundamentals becomes more apparent. Internal management and accounting reforms and reporting
transparency are proceeding, but slowly. Add in exchange rate concerns, and investor
reticence continues to limit trading on the Shanghai and Shenzhen exchanges. A successful ICBC
listing on the Hong Kong and Shanghai exchanges, however, is expected to provide a jump start
for new Chinese listings.
It should be noted that, despite its market economy elements, much of what happens in China
is still administratively determined by the government, introducing a factor of political as well as
commercial risk for foreign investors. Less than a year after issuing clarified rules encouraging
private equity and venture capital investment to go forward, Chinese regulators have imposed
new measures to re-exert partial control. In the telecommunications/internet sector, where
direct foreign ownership is tightly restricted, the Ministry of Information Industry (MII) adopted
rules in July 2006 to more closely regulate contractual relationships between foreign-owned offshore
entities known as special purpose vehicles (SPVs) which hold specific technology, trademarks
and domain names, and the “Restricted Companies” that actually provide those services
under Chinese telecom licenses. In September 2006 the Ministry of Commerce and three agencies
overseeing state-controlled assets and securities transactions adopted tighter controls on
share swaps where a foreign entity acquires a domestic company for eventual overseas
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