Regulators and entrepreneurs in China are caught in a tug-of-war over the issue of management buyouts (MBOs).

Regulators are wary of the practice, which, in developed markets, is just one way of carrying out corporate restructuring and boosting executive incentives. It is often abused in China due to legal loopholes and an immature State-owned assets management system.

Many Chinese state-owned enterprises (SOEs), however, still support MBOs, carefully manoeuvring around policy obstacles during their restructuring and privatization drives.

Some senior executives are able to purchase minority shares in the companies through incentives like stock options. Some later get controlling rights and turn the SOEs into private companies of their own.

"MBOs could benefit the development of enterprises, but the market mechanism is still not ripe in China now, so many strange things have occurred," said Hu Ruyin, director of the research center of the Shanghai Stock Exchange.

MBO refers to the management purchase of all outstanding shares of a company, clearing the way for privatization.

It is more suited to small- and medium-sized companies, where it is easier for the executives to get sufficient funding to purchase the shares, said Hu.

If used properly, MBOs can help enterprises get the right people to take over the ventures and further develop them. The managers who buy the shares are also encouraged to do a better job.

However, in China, flaws within the system of the State-owned asset management serve as obstacles to MBOs, Hu said.

Though the State Council established the State-owned Assets Supervision and Administration Commission (SASAC) last April as a specialized agency to manage State assets, so far the commission only monitors the 189 central and biggest SOEs.

Local State assets supervisory agencies are still being formed, and many local SOEs are yet to be covered by the new system.

During an SOE buyout, it is often unclear who should act as the State owner during the transfer of shares to the organization's managers, Hu said. Many enterprises do not have a properly-functioning board of directors and the general manager is actually in charge of the company.

If the managers make all the decisions, then they may be able to evade supervision and set the price of the assets they then buy, said Zhang Mingxing, a researcher with the State Information Center, an influential government think tank.

Such conflicts of interest have been a major concern for authorities because State assets may be underestimated, resulting in losses for both the State and the minority investors.

By the end of 2002, China's State-owned assets totaled 11.8 trillion yuan (US$1.4 trillion), SASAC sources said. By that date, the number of State-owned or State-controlled enterprises was 159,000, down more than 8 per cent from 2001.

To curb irregularities during the restructuring of the SOEs, SASAC issued a guideline document in December on SOE reforms, for the first time explicitly setting criteria for MBOs.

It allows SOE executives to conduct MBOs, but forbids them to directly manage the transfer of State-owned assets and equities. The MBO project cannot be conducted by the executives themselves, it says, but by the real owner of the assets and equities or authorized intermediaries.

The management buyers also cannot get financing for the purchase from pledges or mortgages of their enterprise assets. Those liable for any decline in the company's performance cannot take part in the MBO.

Some analysts say the rule lifts the ban on the review of MBO cases imposed by the Ministry of Finance last April. But it also increases supervision, creating a sounder regulatory framework that supports long-term development of the market.

Zhang Chunlin, a World Bank economist based in Beijing, thinks that SASAC is trying to set up an equal baseline for all potential buyers of SOEs, and the new rules are aimed at encouraging fair competition.

Without competition, it would be hard to assess the actual value of the State assets to be sold and clinch reasonable prices, he said.

Such risks during MBO transactions make strict supervision very necessary.

A SASAC spokesman also said that even with the existing regulation, smaller businesses are more suited to MBOs. Big enterprises should pursue other measures like the introduction of strategic investors to diversify their shareholder structure.

Li Rongrong, SASAC chairman, has said earlier that some of the central SOEs, especially those in the high-tech sector, would be encouraged to give their executives more incentives like stock options this year.

The commission has been drafting a special rule regarding MBO, which is expected to give more details and set up more standards on such buyouts. But until the rule comes out, much policy uncertainty remains.

In China, where privatization is still a sensitive issue, some entrepreneurs have been treading a thin line to gradually or partially privatize SOEs. Some have performed well and helped their enterprises grow rapidly.

For example, executives of TCL, one of China's top consumer electronics producers, owned a quarter of the firm's shares, with another 17 percent owned by other staff, prior to its public listing in January.

Though the ratio is now diluted following the group's 1 billion A-share offering, many executives, including Li Dongsheng, chairman and chief executive officer of TCL, were made millionaires or billionaires after the listing.

But Li insists that TCL's practice is not an MBO because there was no selling of the original state holdings or management purchase. Instead, the shares acquired by the executives and other staff was rewards for their contribution that were approved by the authorities, he said.

As early as 1996, Li signed an agreement with the municipal government of Huizhou in South China's Guangdong Province, where the TCL is headquartered. It said Li should guarantee a minimum 10 perhttp://www.sasac.gov.cn/eng/eng_index.htmcent return on net assets for TCL each year. If the ratio exceeded 10 percent, then TCL's staff and executives could acquire part of the corporate holdings out of the excess asset growth. The growth rate has surpassed 30 percent each year since then.

MBOs do need sounder regulation and legislation to develop faster in China, but will inevitably become more popular as economic reform progresses, Zhang Mingxing said.

But it is crucial to appoint competent managers.

"It is unwise for some domestic enterprise leaders to just think of their short-term gains through MBOs. They should learn to focus on the long-term development of the enterprise," said Hu Ruyin.

The authorities also have much to do to consolidate the regulatory framework, improve transparency and encourage market competition.

It is not just about bans and restrictions, but deeper reform of the property rights system, he said.

But like many other reforms in China, it will be a gradual process.

(China Daily February 9, 2004)