In December 1998 one of the Hong Kong investment community's favourite red chips – Shanghai Industrial Holdings – buckled under market pressure and was forced to scrap its planned purchase of a Hong Kong hotel from its parent company. Its roller coaster share performance and the management humiliation of a public climb-down served as a warning to the company and other Mainland Chinese entities whose expectations of overseas investors might have hinged on fantasy.
Shanghai Industrial, arguably the most sought-after China play on the Hong Kong bourse,, announced its plan in late November to purchase two hotels for HK$1.47bn (US$190m) from its parent company Shanghai Industrial Investment Holdings (SIIH). One of the hotels was in Hong Kong and the other in Shanghai. Institutional investors were outraged as the HK$880m price tag for South Pacific Hotel in Hong Kong represented a demanding 20 times 1999 estimated pre-tax earnings – and this during a tourism slump. The hotel in Shanghai – itself awash with luxury hotels – will not be completed until 2000 and is unlikely to yield any profits in the first few years of business.
Fund managers believed that the whole purpose of the deal was to bail out the company's parent, instead of enhancing share-holder value. Shareholders responded in protest by starting to dump their shares. In the 10 trading days following the announcement on November 22, the share price slumped by nearly 20 percent from HK$18.80.
Commonly regarded as a core holding of a portfolio, Shanghai Industrial is held by heavyweight institutional investors such as US-based Montgomery Asset Management, ING Barings Greater China Fund, Jardine Fleming's China Fund and Merrill Lynch Asset Management. They tend to hold their positions for the long term.
The parent company which holds the majority stake of 60.5 percent was not allowed to vote on the deal, which meant that strong opposition from the minority shareholders could scupper its plans.
To make matters more complicated, the Hong Kong government at one point was being forced into an awkward position of making its first corporate decision since it purchased stakes in Hong Kong-listed companies during its autumn market intervention. The controller of the government's portfolio, Exchange Fund Investment, has an 8.49 percent stake in Shanghai Industrial. It later emerged that the company management did sound out directors of the fund before finally amending the spending plan.
The important question of this saga was why the company's management agreed to such a glaringly expensive price in the first place. To understand the reason, one has to look at the parent company.
SIIH, set up in Hong Kong in the early 1980s, was designed as a commercial arm of the Shanghai municipal government. Its remit was to help channel foreign investment into the city in the shape of joint ventures. The city's top-ranking investment and trade officials are typically sent to oversee operations. Over recent years, SIIH has accumulated a diverse portfolio of assets in Shanghai including toll roads, hotels and cigarette manufacturing. In May 1996 it created a listing vehicle on the Hong Kong Stock Exchange so that some of its assets could be cashed in and the money raised through equity sales could be ploughed back into other infrastructure projects which the city badly needed.
An instant success
The listed subsidiary Shanghai Industrial became an instant success due to its diversity of assets and high growth potential of the city. Demand for its shares was such that its price soared to nearly HK$60 in the bull market of 1997 on a price of over 45 times the year-end estimated net earnings. This represented an appreciation of 690 percent from its initial public offering price of HK$7.28 in a matter of just 14 months. The parent was able to sell off more assets to its listed company at what seemed to be reasonable prices to the market. However its latest foray revealed a failure to appreciate changed market sentiment.
"The management miscalculated badly this time," said Mr. John Li, a fund manager with Framlington Asset Management which sold its entire stake in the company immediately after the announcement. "They thought they could stuff the minority shareholders [with the poor deal] and get away with it."
To avoid an outright defeat at an extraordinary general meeting scheduled to seek approval of the minority shareholders, the company scrapped the purchase of the Hong Kong hotel and persuaded its partner Four Seasons Group to invest jointly in the Shanghai hotel.
"This is a lesson for us, especially on how to treat minority shareholders," the company's chairman Mr. Cai Laixing was quoted as saying after announcing the revised plan. The company had consulted ‘investors, social elite and professionals' and admitted the importance of ‘communicating with' and ‘respecting' the wishes of minority shareholders.
Market practitioners believe that this high-profile incident has more far reaching implications than just a successful show of strength by the institutional investors.
"They [Chinese companies in general] have to learn to behave in a marketplace now that they're listed and subject to market scrutiny," says a broker from Robert Fleming. "It's up to the management to make commercially viable decisions." The state has a controlling stake in almost all the companies listed in Hong Kong. A transaction between a listed company and its majority shareholder is by no means unique.
Analysts believe that government officials running companies like SIIH will have realised by now that there is a limit to their power of control, even though senior company managers are still commonly appointed by the government. Their plans to maximise the value of state assets through equity sales have to be in line with market expectations.
In the case of Shanghai Industrial, which plans to expand in the hotel and tourism industry designated as one of its six core areas of operation, the market expects the company to pick up bargains during a business downturn. Had the company not revised its original plan, the competence of the management would have been questioned and the damage to its reputation would have made future fund-raising much more difficult.
In reality, the news of the revision was welcomed by the market, with its share price rising by two percent to HK$16.50 in a falling market.
Market observers are optimistic that given the sophisticated legislative framework in Hong Kong, institutional investors have begun to exert their influence on company governance in China and that time will come when they can make or break a company, as is common in more developed markets.