A dizzying circle game

PUBLISHED : Monday, 03 October, 2011, 12:00am
UPDATED : Monday, 03 October, 2011, 12:00am


Cross-shareholding structures are widely used to enable controlling shareholders to control large listed companies with very little shareholdings and capital, and protect them from hostile takeovers. They are quite common among chaebol in South Korea and keiretsu in Japan, although they are increasingly frowned upon and unwound.

Let's pick an example closer to home, the Jardine Group, to illustrate how it works.

The Jardine Group is a major conglomerate that has been operating in Hong Kong since the 19th century. Most of its major assets, such as Dairy Farm (78 per cent owned), Hongkong Land (51 per cent), Mandarin Oriental (74 per cent), Cycle & Carriage (70 per cent), Astra (35 per cent) and Rothschild (21 per cent), are held by Jardine Strategic.

Jardine Matheson is the group holding company, owning 81.7 per cent of Jardine Strategic, which in turn holds a 54.5 per cent equity interest in Jardine Matheson, hence the cross-shareholding. Both companies are listed on the Stock Exchange of Hong Kong. The Keswick family, which has been running the group since 1874, is estimated to have a stake of less than 10 per cent stake in Jardine Matheson and a negligible equity interest in Jardine Strategic.

The cross-shareholdings are circular. Let's start off with Jardine Matheson, with its control of Jardine Strategic. It happens that Jardine Strategic is also the majority shareholder of Jardine Matheson. But because Jardine Strategic is a subsidiary of Jardine Matheson, Jardine Matheson is effectively controlling itself through Jardine Strategic.

At the centre of this circle are the boards that run both companies. Most of the directors of one company are also directors of the other, and the Keswick family are heavily represented on both boards.

Therefore, by having a strong influence on both boards, the Keswick family effectively control both Jardine Matheson and Jardine Strategic, and their less than 10 per cent equity interest in Jardine Matheson may not even be relevant or necessary in the grand scheme of things.

The Jardine Group put this cross-shareholding structure in place to thwart hostile takeovers after the group lost Wharf (Holdings) and incurred heavy debts when defending a key unit, Hongkong Land, from hostile takeovers in the 1980s.

An institutional investor tabled a proposal in 2001 for Jardine Matheson to unwind the cross-shareholdings by making Jardine Strategic a wholly owned subsidiary. If this proposal was implemented, the Keswick family would be left with a larger minority stake in Jardine Matheson and be exposed to hostile takeovers, which could be why it was not approved by shareholders.

The Jardine Group's cross-holding structure is watertight. As Jardine Matheson and Jardine Strategic are subsidiaries of each other, there is absolutely no risk of either company being taken over to destroy this delicate equilibrium.

Investors usually do not like cross-shareholdings.

The Jardine Group's structure is relatively neat and simple. Most cross-holding structures are a tangled web, confounding understanding by outsiders. This could create conflicts of interest and result in numerous connected transactions.

The valuation of companies with cross-shareholdings is not straightforward. Say we have two companies, A and B, each with HK$1 million in cash and a 50 per cent shareholding in each other. If the two companies are valued separately without their cross-holdings, their aggregate value would be HK$2 million.

With the circular cross-holding, the value of A becomes higher when its 50 per cent shareholding in B is included. But this increases the value of B as it owns 50 per cent of A, which leads to a higher value of A and in turn B, and this continues until an equilibrium is reached. As a result, the value of each company will increase to HK$2 million each or HK$4 million in total, creating value out of thin air.

A huge mismatch between ownership and control also creates issues.

First, while it is legal, it is not equitable that some shareholders are more equal than others.

The arrangement allows controlling shareholders and management to become entrenched in the company. If a company underperforms, it is very difficult for shareholders to dislodge them.

Underperforming listed companies often become takeover targets. The arrangement creates a natural mechanism for taking out management if the company does underperform. Cross-shareholdings mute that effect.

Then there is the usual problem of a misalignment of control and ownership. A manager who owns 100 per cent of a company will be more cautious with travel expenses than one with, say, a 10 per cent shareholding, as the latter enjoys all the benefits but foots only 10 per cent of the bill.

Controlling shareholders/management may also decline attractive acquisitions as it might require them to raise more equity, which would undermine their carefully constructed cross-holding control structures.

Khor Un Hun is a former investment banker with extensive experience in advising on mergers and acquisitions and fund-raising in Asia