Cash me if you can
Khor Un Hun
Companies sitting on too much cash may not be a good thing. That is because it opens the possibility for controlling shareholders to find uses for the money other than the straightforward solution of returning it to equity investors.
Two examples, China Mobile and the China Resources Group, could perhaps be used to illustrate this potential risk.
China Mobile announced on August 12 that it would invest 4.6 billion yuan (HK$5.6 billion) for a 92 per cent stake in China Mobile Finance (CMF), with its ultimate controlling shareholder, China Mobile Communications Corporation (CMCC), taking the remaining 8 per cent for 400 million yuan. CMF was set up to help China Mobile strengthen its treasury operations.
Even though this was a connected transaction, because of the huge size of China Mobile, the transaction was below the relevant thresholds and not subject to prior independent shareholder approval.
Nevertheless, it is difficult to see what value CMF brings to China Mobile, which has been managing its own funds for many years.
In another case, on December 22, the independent shareholders of China Resources Enterprise (CRE) approved - by a very narrow 50.8 per cent - the participation of the company in a scheme by China Resources Group to share surplus cash among its group listed companies.
China Resources Co (CRC) owns 100 per cent of China Resources Holdings (CRH).
CRH, in turn, holds majority stakes in various group companies listed in Hong Kong: 65.4 per cent in China Resources Land, 51.4 per cent in CRE, 64.2 per cent in China Resources Power, 73.3 per cent in China Resources Cement, 68 per cent in China Resources Gas and 60.6 per cent in China Resources Micro. Under the scheme, listed group companies could make unsecured loans to one another, to be guaranteed by CRC and CRH, for up to six months at rates approximating those commanded by CRC or CRH in the banking markets.
That means borrowers could enjoy lower rates and lenders could earn higher returns on their surplus cash. The aggregate maximum amount the listed group companies could lend would increase from HK$10.2 billion this year to HK$12.7 billion in 2013, and CRE's exposure would increase from HK$6 billion to HK$7.2 billion over the same period.
The group said that CRE, being in the fast-moving consumer goods sector, generated a lot of cash, which could be used to finance the capital-intensive operations of other listed group companies.
CRE shareholders were sceptical of the scheme.
First, the numbers involved are huge and CRE would be the largest lender among the group.
Shareholders invested in CRE because of its consumer business, not lending business, which is not its core competence.
Monies not needed for its core businesses should therefore be returned to shareholders.
Although CRE would benefit from higher interest income, shareholders could enjoy higher returns by investing in a wider range of investments tailored to their individual risk profiles if the excess cash were returned to them.
But shareholder distributions are not efficient to the group, as CRH will receive only 51.4 per cent of any distribution. That is compared with getting 100 per cent of CRE's excess cash via a loan.
While loans extended by CRE would be guaranteed by CRC or CRH, their ability to honour the guarantees may be affected if any listed group company defaults.
There could also be doubts as to how vigorously CRE would enforce the guarantees against its parent companies. Moreover, enforcement may be difficult since most of the group's assets are on the mainland.
While CRE is said to have full discretion over any lending decision, there would be nagging suspicions whether advice from above could be ignored.
The group also wanted listed group companies to place deposits with Zhuhai City Commercial Bank, which is 75.3 per cent owned by CRC.
This does not require prior independent shareholder approval, as the maximum deposit each listed group company is allowed to place with the bank is set below the relevant thresholds.
Even then, the numbers are large. The total maximum deposits that all listed group companies could deposit with the bank was 4.2 billion yuan, of which CRE accounted for 2.6 billion yuan.
They represent more than 40 per cent of the bank's existing deposits, which would significantly enhance its profitability to the benefit of its shareholders.
One would, however, question the rationale for, and wisdom of, placing cash deposits with a bank with a small capital base.
As of December 31, 2009, the bank's shareholder equity was about 1.38 billion yuan.
If the bank runs into problems, listed group companies will be treated like any other depositor.
This means that placing cash with, or lending to, Zhuhai City Commercial Bank is less favourable than making a loan under the lending scheme. That is because the lending scheme is guaranteed by CRC or CRH.
In addition, if the bank, subject to mainland banking regulations, on the back of these deposits extends loans to other group companies, it will further increase any exposure that listed group companies may have under the lending scheme.
If minority investors believe companies are not using surplus cash for the full benefit of all shareholders, there is typically little they can do to stop the process.
However, investors will always have the ultimate vote of no confidence at their disposal: they can sell the shares.
Khor Un Hun is a former investment banker with extensive experience in advising on mergers and acquisitions and fund-raising in Asia