Does 49% ownership of a Chinese securities joint venture (JV) offer more opportunity than 33%?
That’s the question international partners in the country’s securities alliances have been asking themselves following a May 4th announcement by the China Securities Regulatory Commission (CSRC) of more lenient rules on foreign ownership in these JVs.
The move followed US secretary of state Hillary Clinton’s visit to Beijing. Clinton had pushed for greater foreign access into China’s irrefutably closed capital markets, and urged regulators to ease control of trade and the renminbi.
Raising the foreign ownership cap in these securities JVs from 33% to 49% is progress, but it doesn’t exactly level the playing field. Control of the board, the direction of a firm’s daily activities and the crux of the profits earned are all tantalisingly out of reach.
But a stake so close to 50% in a rapidly developing market such as China is tempting; not least because it would become legally easier from there to gain full control.
“A 33% stake is clearly a minority position, and you have to be very creative and come up with some very funky structures to make the most of your stake,” says Li Qiang, managing partner of O’Melveny & Myer’s Shanghai office. “But 49% is so close to 50% – with the right contractual agreements, you can get control.”
Foreign partners that mix the right market aptitude and appropriate incentives have the opportunity to take charge of their ventures. That could help them acquire rivals, build market share and make them far more meaningful players in China’s securities industry.
Fragments and limits
The CSRC’s proposed new rules will strip away some of the handicaps under which the securities JVs have been operating.
Under the regulator’s old rules, almost all foreign securities JVs were restricted to underwriting domestic stocks and bonds for five years after incorporation. The only exceptions were UBS’s local JV UBS Securities, and Goldman Sachs’ Beijing Gao Hua Securities, which both gained a broader swathe of business licences from the get-go.
Being unable to engage in other activities left the securities JVs at a perpetual disadvantage to local businesses such as Citic Securities, Haitong Securities and China International Capital Corp. (CICC), which could invest and trade in securities and manage brokerage businesses and private banking customers too.
According to data from Guotai Junan Securities, the ability to trade is key. Local securities companies made 44% of their profits from securities trading in 2011. This was followed by investing, at 14% of profits, and underwriting, at 6%.
“If you look at the domestic securities firms, many of them heavily rely on their brokerage business,” says Jian Fang, a partner at Linklaters’ Shanghai office. “I would assume that for the local smaller ones their brokerage businesses could contribute anywhere between 70%-80% of their profitability.”
As a result of this limitation, the securities JVs are small fry in a fragmented market. Chinese financial data provider Wind Info states that 106 brokerages in China earned a total profit of Rmb80.9 billion (US$12.75 billion) in 2010. The foreign JVs comprised only Rmb1.9 billion, or 2.4%.
Profitability is thin outside the top few houses. China’s industry collectively recorded income of Rmb159.13 billion in 2011. Citic, the top securities firm by far, claimed income of Rmb25 billion in 2011, Haitong earned nearly Rmb10 billion, and Guotai Junan had nearly Rmb7.5 billion. This represents US$6.7 billion, or 26.2% of the entire market’s income.
Broker incomes drop dramatically after that, and none of the securities JVs fare well. UBS Securities was the highest-ranked securities JV by income in 42nd place, earning Rmb959.32 million in 2011.
Goldman’s Gao Hua Securities followed in 63rd place, earning Rmb526 million. Deutsche Bank’s Zhong De Securities ranked at 83rd, while Credit Suisse’s Founder Securities was 87th.
Many JVs are either loss-making or barely profitable for their foreign parents.
Welcome change
This situation should change under the CSRC’s proposed new rules.
A key change is that securities JVs need only wait two years instead of five before they can trade local equities and bonds.
This is a big lure for the eight foreign JV partners that lack the extra licences: CLSA, Credit Suisse, Daiwa, Deutsche Bank, Morgan Stanley, J.P. Morgan, Royal Bank of Scotland (RBS) and Citi.
In total, four of the existing securities JVs will immediately be able to apply for such licences, and three more can within 12 months.
Additionally the securities watchdog looks set to allow JVs to conduct asset and wealth management, proprietary trading and derivatives trading for the first time.
The new licences matter just as much as the ability to trade. Institutional broking, asset management and proprietary trading are the bread and butter of many Western investment banks.
All the international partners in the securities JVs look keen to expand their businesses. Sources at five banks that responded to Asiamoney inquiries – Credit Suisse, Deutsche Bank, Goldman Sachs, J.P. Morgan and RBS – say their institutions are considering their strategies following the proposed rule changes.
“Anything that goes toward 50% is a good thing in the board room,” says a banker at one Western bank that has a securities JV.
David Li, managing director, chairman and country head of UBS China, adds that any motion to liberalise China’s market is a step in the right direction. “We welcome the Chinese government's move to allow foreign investors to raise their stakes in joint-venture securities companies, which signals the further opening up of the financial markets,” he tells Asiamoney.
Credit Suisse’s China chief executive Zhang Liping told media on May 8 that he was keen to explore upping the bank’s stake in Founder Securities. The Swiss bank is reportedly applying for its stock trading licence, which is now feasible as its JV launched nearly four years ago.
And CLSA’s chairman Jonathan Slone confirmed on May 28 that Fortune CLSA Securities would begin offering securities broking services after receiving business permits from the CSRC on May 21.
Linklaters’ Fang says that the eight banks will take the CSRC up on its new licences, and should do well.
“Local firms have no advantage on the institutional side of the brokerage business; it’s still a very underdeveloped market. The international banks will have an opportunity to lead in this space once they obtain licences,” he says.
Securities JVs such as Zhong De and Founder Securities may benefit from the rules changes too. The fact that the two respectively ranked 83rd and 87th in Guotai Junan’s 2011 industry rankings without full broking businesses suggests both should markedly improve once they expand their services. Both JVs’ relationships with their onshore partners also seem solid.
Power shift
Despite its announcement, the CSRC has yet to reveal its regulatory changes in their entirety. But many of the foreign partners of these JVs have long been preparing for the chance to ramp up their stakes.
According to several lawyers who worked on the contracts of the 10 foreign JVs, nearly all foreign JV partners have a built-in call clause in their joint-venture contracts that gives the foreign partner automatic right to negotiate for a higher stake in the JV if Chinese regulators ease control rules.
Typically, the registered capital of a new securities JV is around Rmb800 million, and one-third of that amount, or Rmb266 million, is contributed by the foreign investor. This suggests that the price of raising a stake from 33% to 49% could be Rmb120 million.
This is where the game of earning de facto power comes in. The power in these JVs lies in a partner’s ability to name the general manager, the legal representative – typically the chairman of the board – to win seats on the board of directors and to veto strategic decisions.
It isn’t necessary to have a majority stake in a JV to earn these rights. UBS, for example, only owns 20% of its JV but is the largest single shareholder. But with a 49% share, gaining such control becomes more viable for foreign JV partners.
The fact that both UBS and Goldman already have management control of their JVs suggests that they may choose not to raise their stakes in these subsidiaries. However, the level of control the other foreign institutions can anticipate all comes down to how cooperative their local partner is prepared to be.
“If you [a local securities company] wanted to give your foreign partner real power over [the securities JV’s] operations, then you could have done that at 33%. And if you don’t want to give it, a local partner doesn’t have to give it to a foreign partner at 49%,” says the head of strategy of a China-based securities firm not participating in a foreign JV.
Power struggle
If the foreign banks choose to trigger the clauses to gain more control, it could lead to some potentially uncomfortable conversations.
That will be when partnership dynamics are truly tested. The best outcome for the foreign bank is that the local partner recognises the value in the foreigner’s experience in new areas where the JV can do business and so lets the foreign partner pick managers, improve its board seat representation and gain veto power in addition to raising its stake.
The worst case would be that the local securities company will not allow the foreign partner to have any more sway over the business even after it invests money to raise its stake.
This is a real danger given the minority position of the foreign partner, even at 49%. Just ask Morgan Stanley, which sold its 34.3% stake in CICC – which represented the first-ever securities JV, dating from 1995 – to private equity partners in 2010 because it lacked any management control.
The US bank instead created a new securities JV with Huaxin Securities, whose minnow status presumably gives Morgan Stanley much more say in the JV’s operations.
The bottom line is that Western players offer value for these securities JVs, particularly given their substantial offshore experience in securities trading, asset management and broking – all areas where new licences will enable the JVs to participate. Add to that their information technology knowhow and experienced manpower.
Such business advantages should encourage more local securities companies to seek partners, especially as the JVs of their existing rivals begin to benefit from broader licences. And willing foreign partners still exist. Barclays, Bank of America-Merrill Lynch and HSBC are all circling the market, and the promise of 49% control is only likely to whet their appetite.
“Forty-nine percent is an additional lure,” says a source close to Nomura, which is said to have been holding talks with potential mainland securities partners both before and after the CSRC’s rule was announced.
Meanwhile, Barclays is said to be considering more than a dozen securities firms as possible partners, including Chongqing-based Southwest Securities.
“It’s not just the terms that have to be right, but everything has to be right – the relationship and the dialogue,” says a source close to Barclays. “You don’t go into a wedding because your pre-nuptial agreement is strong. The two teams need to work together.”
Consolidating your position
The CSRC’s regulatory shift is also likely to foster market consolidation.
Previously it was almost impossible for a securities JV to consider consolidation with another broker because the target would have had to agree to give up the businesses in which the JV could not engage – a remote prospect given how much equity trading dominates broker revenues. Now this stipulation has been erased for JVs with a two-year track record, it’s possible for the securities JVs to pursue M&A. That should accelerate a consolidation trend that has already begun.
“There may be more than 100 securities houses in China at the moment but for a few years around 2005 it was probably 150. Quite a few went bankrupt and that led to consolidation, and more consolidation will happen,” says a Beijing-based lawyer. “A lot of securities houses in China aren’t making big money and in terms of M&A activity it may be a good time for foreign firms.”
Acquisition can be an easy option, as seen by Guotai Junan Securities. In August 1999, Guotai Securities – which already gained strength after merging with J&A Securities – merged with Junan Securities, which sought to rebuild after suffering reputational damage when its then chairman and CEO was penalised for mishandling company assets. Following the merger, the combined company was the largest brokerage in the market.
It’s uncertain whether the CSRC would allow the securities JVs to conduct acquisitions. Regulators haven’t yet prioritised China’s securities sector as an industry in need of consolidation, which would be a major driver of the process. But allowing more activity and foreign participation in the market does suggest that the CSRC is looking for a securities-sector makeover – and if that’s the case, there’s no reason why these JVs wouldn’t be invited to join the action.
They are still, after all, majority-owned by their Chinese parent.
A unique opportunity
The CSRC’s rules changes mean that foreign JVs may become a more meaningful influence in China’s securities markets.
It’s an opportunity that foreign firms within China, and those about to enter, should not pass up.
True, none of the JVs will threaten the likes of Citic or CICC any time soon. And it is far from clear exactly what business they’ll be able to conduct. But the regulatory changes make it possible for some foreign JVs to become top-20 brokers.
“Once these foreign-backed firms have the opportunity to expand their business, they’ll automatically be Tier I players,” says an executive within a Chinese securities firm not involved in a foreign JV. “With their pay and their culture, a securities firm more led by their overseas partners would be competitive in the market.”
Ultimately if the foreign partners of securities JVs believe the firms can build market share by delving into new areas, pumping more capital into the JVs may seem worthwhile.
China’s securities JVs may be poised to come of age.