Small may be beautiful for investment banks in China

CLSA's equities boss Tim Ferdinand is a firm believer that smaller, less extravagant investment banks are well placed to profit from the opportunities available in China, while bulge bracket firms could suffer from a lack of big deals.

In an interview with FinanceAsia, Ferdinand points out that China-related primary issuance deals raised a total of $2.2 billion during 2002, but only three deals raised more than $200 million: China Telecom at $1.43 billion, China Oilfield Services at $287 million and battery manufacturer BYD Co at $183 million. "In the first two cases," he says, "the bulk of the fees had to be shared by three and two bookrunners respectively."

And those four deals were still an improvement on 2001, when China-related main board primary issuance came to just $1.97 billion, of which CNOOC Ltd and Aluminium Corp of China contributed $1.02 billion and $351 million respectively.

In fact, a lack of jumbo deals is a recurrent characteristic of Asia ex-Japan, according to figures from local stock exchanges. Of some 642 international deals from August 2001 to July 2002, only 69 were bigger than $50 million, representing 85% of the money raised. China also falls behind Korea, Hong Kong, Taiwan, Singapore and Malaysia in the numbers of deals over $50 million.

At first sight it seems a curious paradox, considering China is the largest economy in the region, and twice as big South Korea. Yet the latter accounted for 33% of total issuance, the single biggest component, for the period. The reason is that although China's domestic issuance was large, at 21% of the Asian total over 2001/02, many of its companies are simply not yet ready to meet international regulatory or investor standards.

"The evidence of corporate capital markets activity out of China to rescue Hong Kong-based investment banks simply isn't there if you look at the deal flow over the past three to four years," Ferdinand adds.

Nor will M&A help to fatten margins. Most the deals which inflate the statistics are not genuine M&A and therefore don't pay genuine M&A fees he continues. They mainly relate to listed mainland companies, such as China Mobile, steadily absorbing mainland assets from their parent companies, starting with the healthiest one.

He notes that returns on the big deals need to be huge before the biggest investment banks even reach break-even point, since bankers can spend years chasing these deals, and then have to spend another year or two restructuring the company for the listing.

The difficulties of getting deals are well illustrated by the experience of a former international banker now based in Beijing who spoke to FinanceAsia a few weeks ago.

"It was quite funny really. First, you had to throw a lot of money around on entertaining people at the China Club (one of the swankier clubs in Beijing, a traditional courtyard house filled with antiques). Secondly, you had to win the battle of the 'pi tiao'," he says.

The 'pi tiao' is an 'instruction note' from an official which tells the giant SOE (state-owned enterprise) listing prospect precisely which investment bank to use. But if a rival investment bank gets a document signed by an even more senior official, the deal goes to that bank. Hence the frantic wooing of senior government officials.

The upshot is that if you put the shrinking issuance figures together with the record number of issuance last year in terms of the number of companies listing - 117 in Hong Kong on both the GEM and the main board - you end up with a trend to smaller, although more numerous, companies listings.

That should play into the hands of mid-cap specialists such as CLSA, Core Pacific Yamaichi, BNP Paribas Peregrine, Nomura and ABN AMRO.

But things can only get more competitive with the 500 pound gorillas such as Goldman Sachs and Morgan Stanley trying to justify their cost structures and get involved in the smaller deals.

Corroborating this trend, Goldman's most promising deal so far this year, for example, is SOHO, a well-regarded Beijing luxury property company which is set to list in Hong Kong for some $100-200 million.

On paper the PRC's privatization plan, as set out by China's cabinet, the State Council, should allow the big investment banks to rest easy. According to the schedule, about 60 giant SOEs and a handful of private entities such as insurance company Ping An, are to list abroad by 2005.

However, Ferdinand says such a plan is hopelessly unrealistic given the time to takes to prepare these companies for the public markets and the market's ability to aborb such deals. After all, there have been no more than three or four Chinese privatizations bigger than $100 million each year since 1998.

Sinotrans' roughly $500 million IPO went, but few see many other similarly sized opportunities other than Ping An Insurance, which might list towards the end of the year. HSBC's acquisition valued the company at roughly $6 billion, so an IPO could be as large as $1.5 billion. However, the company faces problems relating to the acceptable level of foreign investment, since Morgan Stanley and Goldman already own 15% combined and HSBC 10%. The limit on foreign ownership in the industry is 25% for the time being, until further WTO-mandated ownership relaxations kick in.

That's one reason why the likes of Morgan Stanley and Goldman Sachs have focused on China's $500 billion of non-performing assets. With assets on sale for as low as nine cents on the dollar, the area could be a goldmine, since many of the loans and companies could be relatively easy for financial experts to turn around.

However, China's state-owned sector is poorly organized, making any sell of state assets, however poorly performing, quite onerous, observers say.

A single SOE can have half a dozen ministries in Beijing overseeing separate functions within the company, making effective cooperation almost a lost cause.

In addition, of course, there is the politically sensitive point of flogging assets to foreigners at knock down prices. And there's no bankruptcy law.

So it's not surprising the Morgan Stanley joint venture with Huarong, the asset management company working with ICBC, has still not been finally approved, despite being announced over a year ago.

Ferdinand suggests this could also be an area well suited to boutique investment banks, which are sprouting in the wake of the 2000-odd investment bank lay offs over the past two years in Hong Kong.

"A niche for a small boutique firm with a low cost, mainland-based team, is to act as adviser on the debt restructuring of SOEs which have fundamentally sound businesses, but excessive debt or short term liquidity problems," he says. Ferdinand reckons that since the adviser gains a close understanding of the SOE's cash flow prospects, he could, if the prospects are good in the medium term, acquire a portion of the debt to help push through restructuring.

"Returns on such NPL acquisitions could be as high as 100% to 200% over two to three years," he says.

Precisely this kind of small scale, time-consuming intensive work is not be worthwhile for the high-cost bulge bracket firms - hence their attempts at cooperation with AMCs on the much larger NPL portfolio acquisitions.

It's a cliche the bulge bracket firms are about building a franchise. But will be interesting to see how for how much longer they can ignore profitability.