The popularity of Sino-foreign joint ventures has fallen off in recent years. According to a study of European investors in China undertaken earlier this year by the consultancy firm Fiducia, only 37 percent of investors would establish a joint venture again if other legal structures were possible in their sector.
Even so, joint ventures still constitute a substantial amount of new investment in China. An accurate and thorough evaluation of the assets being contributed by the Chinese party is a prerequisite for the foreign investor.
The capital contribution of a foreign company in an equity joint venture is generally in the form of new equipment, cash and technical knowledge, while the Chinese party typically injects land, buildings and equipment. Intangible assets may also be provided, but frequently in the past no formal value has been put on these contributions.
The central government has long been concerned that state assets are being injected into joint ventures at low value. Possible legislation is therefore always under review and the whole issue of valuation in China remains a sensitive one. Government departments which should work together appear to be in conflict with one another. Market transactions, where they exist, are often suppressed and treated as 'classified.'
Until a hierarchical open market for land is developed and title clarified, land value will depend more upon its cost of production or related government premiums. Moreover, until industrial buildings are bought and sold openly, or leased to produce an income stream, their value will depend primarily on their depreciated replacement cost rather than on a unit market price.
In addition, until the concept of marketing becomes more sophisticated, and control of intellectual property rights is properly established, brand names and other intangiblesmay not realise their potential worth.
All of these factors make it difficult for foreign valuers to prepare reports in China. However, a few firms have been specialising in this area and have become adept at finding a path through the quagmire. Furthermore, a select group of these pioneers have the approval of the relevant sections of Chinese bureaucracy. From the joint venturer's point of view, an independent valuation can quickly highlight missing bits of the jigsaw puzzle, become an essential negotiating tool and save the foreign party considerable sums of money.
Appointing the valuer
There are now several thousand recognised joint ventures between overseas companies and Chinese state-owned enterprises (SOEs) or township companies. Although the rate of establishment of joint ventures has slowed, the amount of capital injected into China in this manner is far greater than in any other country.
The Asian recession has revealed many weaknesses in China's economic system. This has resulted in many foreign joint venture companies increasing their shareholding for firmer control of their joint venture. Under Chinese law, any dilution of a state enterprise in this manner will also require valuation of the assets before approval is granted.
The Administration of State Asset Valuation Procedures, effective November 16, 1991, governs the valuation of state-owned assets. These procedures specifically require a Chinese enterprise to have its assets valued when a Sino-foreign equity or cooperative joint venture is established. In 1995 they were endorsed by the State Asset Administrative Bureau (SAAB) – since absorbed by the Ministry of Finance – which stipulates that whenever there is an asset transfer from a Chinese party to a joint venture company, a valuation must be carried out.
The valuation must take place following preliminary approval of the project and it must be undertaken by an approved Chinese asset valuation institution. It is the responsibility of the Chinese party to initiate the valuation and to appoint the valuer.
Approval for this valuation is given by the Ministry of Finance and is generally granted to accounting firms, specialised valuation companies or financial consultants. Foreign capital valuation entities may also be allowed to participate in project valuation if their application for approval is submitted concurrently with the initial valuation application. However it is most unusual for the Chinese party to appoint, or the Ministry of Finance to permit, a single valuation performed solely by a foreign valuer. For practical purposes the initial valuation will be undertaken by an approved Chinese valuation company.
The foreign party to a joint venture often has cause to question whether the local Chinese valuation represents a fair market value – especially when land value is included in the transaction. As a result, the foreign party may attempt to influence the Chinese partner about the choice of an experienced Chinese valuer in whom both have confidence. However the choice of this local valuer will largely fall to the Chinese party.
An option open to a foreign party which is not comfortable with this procedure is to conduct an independent valuation by instructing a ?foreign' valuer to appraise the assets of the intended joint venture company. Many foreign valuation firms, normally Hong Kong-based chartered surveyors, have conducted valuations in China. This is despite the fact that the Ministry of Finance only ?recognises' a handful of foreign companies as having the necessary experience to value assets there.
Ultimately, if any dispute between the two valuations arises and cannot be resolved, the ministry can be asked to arbitrate. It is therefore essential for an incoming party to understand that if the ministry requires an independent report for capital asset value justification, it should appoint one of these recognised foreign valuers, so that it may later rely on that report.
Where an entire business is being contributed by the Chinese party, an independent valuation should be conducted. Often, this valuation can only be performed with the full co-operation of the Chinese party and it may be suspicious of the motives for obtaining an independent valuation. Additional problems are also frequently encountered when the Chinese party claims that fundamental documents are confidential and cannot be examined.
Differences will certainly arise when two land valuations are undertaken. For example, the Chinese valuer will normally consider the value of land only with reference to its potential value compared with other similar land in the locality. Generally, it will not properly check title to enquire whether the Chinese party can actually show ?beneficial ownership' of the land by way of good title. In China, land which has been ?allocated' to a state enterprise cannot be assigned, leased or mortgaged until approval has been obtained from the Land Administration Department and a grant fee paid. It is frequently the case that the grant, nominally the land value, has not been paid.
The current interpretation of the Hong Kong Stock Exchange is that such land can only be considered to have ?no commercial value' unless and until the grant is paid. The exchange is obliged to take a stance in this matter as many state-owned enterprises seek to become listed in Hong Kong. In preparing reports for listing purposes, for example, the Hong Kong valuer must make a declaration, backed by a legal opinion in China, that the necessary premiums have been paid to enable the land to acquire ?granted' status. Only then can value be attributed to it.
From a joint venture's point of view, the important thing is that, though the venture itself may be capable of sale or transfer, the land on which it operates cannot be transferred unless the grant premium has been paid. Therefore incoming foreign parties should never pay cash for land unless it is legally proven to them that the necessary premiums have been paid.
A second difference is that buildings are normally valued on a replacement cost basis, which may lead to discrepancies of value due to overstating the expectation of remaining life when considering depreciation. Perhaps more important, however, is that the building covenants run with the land.
It is my opinion that the law in China requires that before any land improvement, such as buildings, can be transferred, a legal right attaching to the land underneath it must be capable of transfer. If the land can be transferred, then the buildings and structures would be also be transferable. However, if the land cannot be transferred then neither can the real property which sits on it. If the land and buildings cannot be transferred then they can have no ?value' to a third party.
Equipment valuation, essentially an agreement on the number and description of assets to be valued, is also performed in different ways. Although comprehensive asset lists may be produced, the Chinese valuer frequently spends little time checking these against the actual machinery on the factory floor, preferring to conduct an ?accounting exercise' in a convenient office. As a result, the actual condition of the machinery is often not taken into account fully.
Furthermore, machinery that may have been acquired some years ago but which has been little used, will have little or no depreciation levied against it by the Chinese valuer, and may even have had its original cost adjusted upwards for inflation. For foreign-made machinery, such equipment is likely to have been replaced by a superior model and may have little value in the international market. However, whether suffering from physical, functional or economic obsolescence, the Chinese valuer will have little idea of the current replacement cost of such equipment.
When preparing a valuation report, it is necessary to have an agreed basis of value which everyone understands and recognises. In China ?fair market value' is an appropriate definition for valuing land, buildings, and plant and machinery. Fair market value is defined as ?the estimated amount at which a property in its continued use might be expected to exchange between a willing buyer and a willing seller, each having a reasonable knowledge of all relevant facts, with equity to both, and contemplating the retention of the assets at their present location for continuing the operation as part of an on-going business.?
For a Chinese valuer operating in China, there is no defined basis of value. Therefore should the foreign party wish to query the report at a later date, there is no definition or basis of what the local valuer was trying to value in the first place.
The Ministry of Finance has approved three approaches to valuation.
The first is the market approach, which is preferred worldwide because it relies on comparable transactions which can be adjusted by the valuer to reflect the conditions applicable to the subject property. The more similar the comparables in type, age, size, location and date of sale, the less adjustment is required.
The problem in China is that there is insufficient market data to use this method reliably and information that does exist is not available through any public register. Eventually, this method will become much more commonplace, but for now it appears there is a marked reluctance to make public such information even when it does exist.
In the absence of evidence of comparative transactions, a property's value for existing use can normally only be determined on the basis of depreciated replacement cost. This approach considers the cost to reproduce or replace in new condition the property appraised in line with current market prices for similar, property. Allowance is made for accrued depreciation on the basis of observed condition or present obsolescence whether arising from physical, functional or economic causes.
The depreciated replacement cost approach is the most commonly used valuation method in China. It can provide a bench-mark for buildings, machinery and equipment, but not for land. Where land-use rights are attached, their value may be added to the depreciated replacement cost of other assets to determine the underlying fair market value.
The income approach considers the present worth of future economic benefits to be derived from ownership. These economic benefits may either be discounted to their present value by using the discounted cash flow approach, or capitalised by using an appropriate year's purchase.
The income approach is not common in China, partly because it is often difficult to determine accurately the future net income flows from a particular project. The concept of value in China is also very much asset driven, and there is a general unawareness or lack of acceptance of discounted cash flow techniques and inexperience in profit and cash flow forecasting. Furthermore, current accounting principles in China do not lend themselves to accurate forecasting of net-income, making the income approach method less reliable. However as more long-term `leasehold' arrangements and infrastructural projects are approved, the income approach is becoming adopted more frequently.
The income approach also forms the basis for the consideration of intangible assets.
Under Chinese law there is no private ownership of land. All land is either owned by the state, especially in urban areas, or by collectives. Although individuals and companies cannot own land, they may acquire land-use rights which are tantamount to a leasehold interest in the property.
Under the present system all land-use rights must initially be granted by the state. As a result, collectively-owned land must be converted to state-owned land before land-use rights may be granted. Under the previous administrative system, land could be allocated to specific users without compensation.
In order to be granted a land-use right certificate, the acquiring entity must pay an initial premium plus an annual fee for the period of the grant. There are maximum terms specified in the legislation for land-use right grants, which apply to the intended use of the land. These include 70 years for residential users, 50 years for industrial users, and 40 years for commercial, tourist or recreational users.
The amount of the premium is now usually based on the established rates of premiums for different land uses in that locality. These rates are determined by the Land Administration Bureau. In many urban areas these rates have now formed a sort of benchmark for the market value of land. In rural districts, the premiums are based on the cost of land, after compensation has been paid for resumption, loss of crops and provision of services.
In September 1993 the Hong Kong Stock Exchange published Guidance Note 5 to the listing rules, now known as Practice Note 12. This note is particularly relevant to all valuations undertaken for listing purposes in China and is also significant for valuations prepared for joint ventures.
Although the note has no jurisdiction over joint ventures per se, in practice it has become a benchmark by which valuers may approach joint venture valuations in China. It would be a mandatory requirement if the joint venture were to list in Hong Kong, so valuers should be encouraged to accept the requirements of the guidance note as the minimum standard by which they would approach a joint venture valuation.
Among other things, the note deals with establishment of title and joint ventures.
The section in Practice Note 12 governing the establishment of title states that a valuation report must mention whether the relevant party has vested legal title to the relevant property. The section then deals specifically with the Mainland:
a long term land-use right certificate will be treated as the operative equivalent to the Hong Kong legal concept of vested title to the relevant property an opinion is required from an authorised Chinese lawyer stating whether such a certificate has been obtained by the relevant party.
Valuing intangible assets
Intangible assets have been defined as non-machinery assets without physical substance. They include brand names and trademarks, copyrights, franchises, intellectual property, licences, mastheads and patents, and established distribution networks.
The asset approach does not provide a methodology for valuing what may loosely be termed ?goodwill.? The Chinese are, however, becoming increasingly aware of the value of intangible assets which they contribute to a joint venture. Thus, it may appear to the discerning foreign party that the suggested value of a joint venture's tangible assets has been deliberately overstated to take account of these intangible assets. If the intangible assets had also been included as part of a total business enterprise, the suggested value for the tangible assets might appear quite reasonable. The valuation of total business enterprises is becoming more common, and a component breakdown of tangible and intangible value can be utilised for purchase price allocation.
Like other tangible assets, the value of intangibles should be their value in the marketplace at the relevant date. It is appropriate to use ?fair market value' as a basis of value.
The most common approach to determine the fair market value of intangible assets is to first establish the ?business enterprise value' of a company. Business enterprise value is defined as ?the combination of all tangible and intangible assets that comprise a going business concern, the value of which is equivalent to the fair market value of the company's total stockholder's equity plus long-term debt obligations.?
The value of intangible assets as a whole can be derived by first estimating the total business enterprise value based on foresee-able income-earning prospects, which are then capitalised by either using a suitable risk/rate of return for the industry, or an appropriate price-earnings ratio. From this figure can then be deducted the value of the net tangible assets, such as land, buildings, plant and machinery. Whatever remains after the deduction of net working capital required to support turnover is then attributed to the intangible assets.
Further tests can then be conducted depending on which intangible asset is required to be isolated. Quite frequently this will be a service mark – for example Tsingtao beer carries a high intangible value as it is the only beer available across China and known internationally. Other tests can be utilised, such as the ?freedom from royalty' approach which considers the different margins that might be paid on branded and unbranded products, and hence can suggest a value for brand names.
By performing these tests, a more accurate valuation of the intended joint venture entity may be obtained, providing the under-lying information is accurate. It is not uncommon for Chinese valuers to conduct an intangible valuation as part of their general valuation of a company. However, their cur-rent methodology varies from adopting a certain percentage of the share capital of the company, which not surprisingly produces illogical results, to a cost approach basis, whereby the cost of developing a distribution network or brand name is considered to rep-resent the minimum value of this asset. This can only be correct if the return on the investment produces a yield in line with market expectations.
Increasingly, discounted cash flow valuations are used to appraise the present value of infrastructure schemes, such as power plants and electrical distribution networks, telecommunications, toll-roads, ports and water supply schemes. Due to their complexity, many of these are joint ventures. Sallmanns, for example, is increasingly involved in business valuations for information technology and website projects. By their very nature of being start-up projects, a discounted cash flow valuation via computer modelling is the only practical means of valuing such schemes.
The equity joint venture has now become well established and the mechanism for instigating the initial valuation is commonly known to the Chinese party. As Chinese and foreign valuers work together more closely, a better acceptance of commonly used techniques has developed. Valuation methodology will become more sophisticated, meaning that the possible diminution of state asset values by inadequate valuation will generally cease. The two-valuer system for the joint venture is in principle a good one, as it should mean that a fair compromise can be reached – valuation is not an exact science and to reach a negotiated settlement is, after all, the purpose of the exercise.
?Foreign' valuation companies are effectively precluded from forming joint ventures with their Chinese counterparts due to capital, manpower and other restrictions placed upon them by Ministry of Finance. However in the foreseeable future this obstacle is likely to be overcome, enabling a single entity to be instructed by a foreign party that wishes to enter into a joint venture in China. Currently, only a handful of foreign valuers? reports are accepted by the ministry, so foreign companies wishing to appoint an independent valuer should determine beforehand whether or not the valuer's report will be accepted.
Sallmanns is a Hong Kong-based valuation company with offices throughout Asia. It offers comprehensive consulting in the fields of real estate, plant and machinery valuation, and financial and business valuations. It is the leading international valuation company active in China, and has been appointed as valuer to many Chinese enterprises which have sought an overseas listing. Paul Brown is a chartered surveyor who has lived in Hong Kong for 20 years. He is chairman of the Sallmanns group. Tel: (852) 2169 6000, Fax: (852) 2528 5079, email: email@example.com
UK brewer Bestbeer Ltd had held preliminary negotiations with a Chengdu-based brewery, Chengbrew, to form a joint venture. The two parties reached agreement in principle and Chengbrew appointed a local firm of valuers, Chinaval, to prepare a valuation of their assets.
Chengbrew's original brewery had been extended onto adjacent land on which new brewing facilities had been partially built. Chengbrew claimed it was the beneficial owner of this land and Chinaval had valued it at Yn40m. This figure was based on the considered value of a commercial site nearby. Chinaval had also valued all buildings and structures, machinery and equipment, and suggested a total tangible asset value for the brewery of Yn240m.
Though Bestbeer did not dispute this, it wanted a second opinion and appointed a Hong Kong firm, Profvals, to prepare a report. Chengbrew eventually agreed to this.
Chengbrew gave Profvals a copy of a red line plan issued by the local economic development zone relating to the land. On inspection, however, it was found that this had been issued to Chengwheels, a motorcycle manufacturer which had ties to Chengbrew but was a separate legal entity. A construction planning permission certificate had been issued by the local township, but was also issued to Chengwheels and gave permission for an automotive plant to be developed on the site.
Chengbrew also produced a state-owned land-use certificate issued by the local land administration bureau. However, although this appeared to relate to the site, it was granted to Chengland, another affiliated but separate company which had once applied to build a hotel on the site. This document showed the land zoned for commercial purposes. Chengbrew claimed that three years earlier it had paid Y 15m for the right to an assignable title to the land. Profvals requested copies of the receipts of payment but was told by Chengbrew that these were confidential.
Profvals advised Bestbeer that the land could only have commercial value if the title was clarified, the planning permission related to a brewery and Chengbrew could clearly show that it had paid the full premiums necessary to permit the land to become transfer-able. Moreover, Profvals mentioned that Chengbrew was entitled to transfer the land into the joint venture. This would require a Chinese lawyer's letter to that effect.
Furthermore, Chinaval's opinion of value was based on land use as a hotel, and as the site was now to be used for light industrial purposes, this basis was not valid. Once proper title had been established, the land might be valued based on current industrial premium, suggesting a value of Yn20m. Until then, it could only be ascribed `no commercial value'.
Most of the buildings and structures on site were relatively new and were valued by Chinaval at Yn50m. Profvals did not disagree with Chinaval's approach and a compromise on the depreciated replacement cost basis of valuation could have been reached at Yn45m. However, Chinaval had included in its valuation a large building on-site which was used for the production of soft drinks. Bestbeer had indicated that as a dedicated brewer it was not interested in this structure, which should be excluded from the joint venture. This immediately reduced the value of the buildings by a further Yn5m.
Chinaval had valued the machinery and equipment of Chengbrew at Yn 150m. Due to the fact that a splendid lunch had been arranged on their last day of inspection, Chi-naval did not have time to inspect the fermentation plant in the old section of the brewery. It therefore relied on the asset list prepared by Chengbrew's financial controller, who was allergic to barley and had never actually been inside the factory. This list showed four sets of fermentation equipment – whereas two sets had actually been closed down a year earlier when the second fermentation plant was opened on the extension land. This made a difference of Yn15m.
For its extension plant, Chengbrew had acquired a semi-new bottling line from a brewery in Switzerland facing liquidation. Unfortunately, Chinaval had little idea of the fair market value of this line and based its opinion on the cost of a Chinese model. The Swiss model, however, was able to fill three-times as many bottles as its Chinese equivalent and simultaneously cap and label them. It was far more reliable and worth several times more, as it relieved a bottleneck in the production process. Profval's eventual value of machinery and equipment was Yn110m, after a suitable deduction had been made for the equipment in the soft drinks plant.
The two valuations were therefore Yn240m versus Yn150m, or Yn170m if Chengbrew rectified its land title. This it was prompted to do by paying Yn5m – the out-standing balance of the required premium, which the previous town mayor had apparently waived indefinitely for a lifetime supply of beer. It was then quickly able to reprocess the application and obtain the necessary Chinese legal opinions.
Sensing its commitment to the deal, but frustrated by the large differences in values, Bestbeer instructed Profvals to consider any intangible value in the trade name Chengbrew. Based on stable profitability and the fact that Chengbrew beer was well established and appreciated in the locality, Provals valued intangibles at Yn25m. In tense negotiations, the value of Chengbrew Brewery was eventually agreed at Yn200m, a figure which was approved by the SAAB.
For reasons of confidentiality, this is not an actual case study. However it is drawn from several real events.