SPRINGER BRIEFS IN BUSINESS Jiazhuo G. Wang Juan Yang Who Gets Funds from China’s Capital Market? A Micro View of China’s Economy via Case Studies on Listed Chinese SMEs SpringerBriefs in Business For furthervolumes: http://www.springer.com/series/8860 Jiazhuo G. Wang Juan Yang • Who Gets Funds from China’s Capital Market? A Micro View of China’s Economy via Case Studies on Listed Chinese SMEs 123 Jiazhuo G.Wang Juan Yang School ofBusiness HSBCBusiness School College ofStaten Island Peking University CityUniversity ofNew York Shenzhen,Guangdong New York, NY People’s Republic ofChina USA ISSN 2191-5482 ISSN 2191-5490 (electronic) ISBN 978-3-642-44912-3 ISBN 978-3-642-44913-0 (eBook) DOI 10.1007/978-3-642-44913-0 SpringerHeidelbergNewYorkDordrechtLondon LibraryofCongressControlNumber:2013957358 (cid:2)TheAuthor(s)2013 Thisworkissubjecttocopyright.AllrightsarereservedbythePublisher,whetherthewholeorpartof the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation,broadcasting,reproductiononmicrofilmsorinanyotherphysicalway,andtransmissionor informationstorageandretrieval,electronicadaptation,computersoftware,orbysimilarordissimilar methodology now known or hereafter developed. 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While the advice and information in this book are believed to be true and accurate at the date of publication,neithertheauthorsnortheeditorsnorthepublishercanacceptanylegalresponsibilityfor anyerrorsoromissionsthatmaybemade.Thepublishermakesnowarranty,expressorimplied,with respecttothematerialcontainedherein. Printedonacid-freepaper SpringerispartofSpringerScience+BusinessMedia(www.springer.com) Preface Why China? About 20 years ago, when China’s Shanghai Stock Exchange and Shenzhen Stock Exchange were re-opened and newly established in 1990, this would have been the typical question that foreign investors would ask had they been suggested to take a look at these just-born capital markets. Even about 14 years later, when the Shenzhen Stock Exchange introduced its small and mediumenterprisesboard(SMEBoard)inMayof2004,manycontinuedtoholda skepticalviewoftheChinesecapitalmarkets,believingittostillbeinitsinfancy. It was true that, if those skeptics were right, then indeed, why China? From a foreign investor’s perspective, China’s stock market was still way too ‘‘green’’ in many aspects, especially compared with its counterparts in New York, London, Frankfort, Tokyo, Singapore, or even Hong Kong which, after its time under the British Commonwealth in twentieth century, was returned to China’s jurisdiction in 1997. Among the many shortcomings of China’s growing capital market, incomplete and insufficient regulations, ineffective law enforcement, unreliable accounting information and disclosure, and unsustainable business models that were unable to generate sustainable future cash flows deterred the interests of the potential investors from China’s capital market. Even to this day, the improvement of law enforcement and the quality of financial information and disclosure may still appear as an ever-present issue. However, significant progress has undoubtedly been observed on the regulation side, and in the innovation of business models in China in the past two decades. In particular, these business models, developed by companies across all kinds of industries,havefundamentallychangedthe waythatpeopleusedtothink,look at and evaluate Chinese companies. Thereareanumberofpossiblereasonsforwhythesenewbusinessmodelshave begun to be developed in the past few decades. Cometothefirstisthemoststraightforwardone,whichisthevolatileeconomic climate of the last decade and the increased competition in the market place that haveinevitablyencouragedinnovation-drivencompanies.Nottoolongago,asthe ‘‘workshop of the world,’’ China was feeding the whole world with almost everythingpeopleneedintheirdailylife.Thiswasmadepossiblebythesupportof China’sabundantlabor forces releasedcontinuously fromChina’srural areasand the no-one-can-beat-it prices on the global market. Taking advantage of its entry into WTO and the overwhelming demand from the world (especially those from v vi Preface themajordevelopedmarkets),Chinawasabletoreclaimaperiodofthe‘‘shortage era,’’whendemandwasnotanissueandproducingwhatevertheworldneededat the most competitive pricing was the only game to be played. In those good old days, any business model other than ‘‘lowest possible pricing’’ seemed obsolete. But every party has its end, and it is true for both China and the world. The highlyleveragedconsumptionmodelthathadhelpedcreatethelongestexpansion period in the USA history since World War II eventually triggered a worldwide financialcrisisandthedeepestrecession since theGreatDepressionofthe1920s. Meanwhile, China’s export-investment oriented, low-cost labor driven growth modelalsoseemed tocomeascloseasitpossiblycouldtoanend.Whenthefirst waveoftheeconomictsunamifloodedin,unsurprisingly,itwasthecompaniesthat had survived for solong on the thread oftiny price margins and a ‘‘make aquick buck’’ philosophy that were the first to get blown aside. At the same time, the companies that were built up on stronger values and unique business models unambiguously stood their ground. Only these companies, those with long-term visions, a focus on long-run brand buildup and strategic business model develop- mentbecamethecompaniesthateventuallypickedthecherryonthetopofthetree. Thesecondandpotentiallymorepressingreasonforbusinessmodelinnovation may have stemmed from Chinese companies need to get financing, which, intrinsically,requiresmoredepthofdiscussion.Asmanymayknow,financingfor smallandmediumsizedenterprises(SME)isalwaysachallengingissue,notonly in China, but also globally. The difficulties in getting financing for SMEs may result from a number of SMEs’ inherent characteristics, and also of the risks inheritedbyfinancingsmallerbusinesses.Justtonameafew,thesecharacteristics and risks may include: (a) Asymmetric information. The outsiders of a company always know less than the insiders about what actually goes on at a firm. It is not only true for publicly traded large corporations, but also, and especially for SMEs. Either duetocostconsiderationsorprotectionconcerns,SMEstypicallydiscloseless informationtothegeneralpublicthantheirlargercorporatecounterparts.Asa result, SMEs are typically perceived as enterprises with much higher degrees of uncertainty and risk. (b) Non-standardized financial information. In addition to less information released to the general public, the financial information possessed by the SMEs is also less likely to be standardized in a format that is in compliance with the generally accepted accounting principles. Due to limited resources, SMEs usually cannot afford to hire financial professionals to prepare their financialdocuments,orcontractpublicaccountingfirmstoaudittheirfinancial statements. As a consequence, even when SMEs consent to providing their documents, not much of the information can be actually used by financial institutions when they make financing decisions toward SMEs. (c) Lack of adequate collateral for bank loans. Because these firms are small, the amount of assets that they can use as collateral for bank loans are typically less.WhencomparedagainstthefinancingvaluesthatmostSMEsrequestand Preface vii need, the collateral they possessed are usually not adequate to meet the requirements of banks. (d) Insufficiency of credit records. Commercial banks typically need to use the credit history of their borrowers as an important reference when making financing decisions. However, many SMEs usually don’t have any history of borrowing money from banks due to the difficulties in securing bank loans as described above. As a consequence, they are usually rejected for bank loans duetothelackofcredithistory.Clearly,thiscreatesaviciouscycle.IfaSME doesn’thaveadequatecredithistory,itwon’tbeabletogetcredit;ifitcannot getcredit,itisalmostcyclicallybannedfromeverbeingabletoobtainaloan. (e) Management flexibility in changing a firm’s risk. The classical agency prob- lem normally occurs in large corporations due to the separation of ownership andmanagement.Smallbusinessesusuallycanavoidthisproblembecausethe owner and manager are typically the same person. However, retaining the functionality of ownership and management in one person may increase theflexibility,inbothapositiveandanegativesense,ofthefirm’soperations. Ontheonehand,smallbusinessescanchangethedirectionoftheirbusinesses or the composition of the firm’s assets more easily and rapidly in response to thechangesintechnologyorbusinessconditions.Atthesame time,however, this flexibility may also increase the uncertainty about the future operations and development of the firm, hence, increasing the firm’s risk. (f) Lackofeconomyofscaleasadisincentive forfinancialinstitutions.Fromthe perspective of the commercial banks, no matter the size of the firm that requests the loans, the bank must input the same amount of effort and procedure to clear that firm for lending; that is, the same application reviews, credit assessment, comprehensive analysis, on-site investigation, and final release offunds, all of which are heavy uses of time and resources. Given the relatively smaller size of loans to SMEs comparing with ones to larger cor- porations,itisdifficultforthecommercialbankstoachievethesameeconomy of scale when lending to SMEs. Needless to say, commercial banks, on the whole, prefer larger corporations. For SMEs, this financing issue is even more severe in China as its economy is stillinatransitionfromacentrallyplannedregimetoacompletelymarket-oriented one.SoinadditiontotheissuesthataresharedincommonwithSMEsindeveloped countries,SMEsinChinafacetheadditionalburdenofevenmorelimitednumbers of financial institutions that can legally provide funding to them, which in turn exacerbates the imbalance between demand and supply in the loanable funds marketinChina.Formanyyearssinceitsinception,thefinancialindustryinChina has been so highly regulated that only large, state-owned commercial banks were allowed to be major fund suppliers. Private funds were typically not permitted to directly enter the market. From an economic perspective, under this regime, providing their already limited funds to larger, state-owned (nonfinancial) corporations was clearly a better choice for the large, state-owned commercial banks,consideringalltherisksandpossiblereturns.Asaconsequence,manyillegal viii Preface ‘‘shadow loans’’ with annualized interest rates as high as up to 50 % emerged in someofthemoredevelopedareasinChinaintherecentyears,1inanattempttofill the gap in funding supply. And it’s no surprise that these ‘‘illegal’’ financing activitiesgeneratedtremendousrisksandhadthepotentialtotriggerfinancialcrises invarious forms. Considering this background, the development of Chinese public equity mar- ketsinthepastfewdecades(asbenchmarkedbytheopeningoftheShanghaiand Shenzhen Stock Exchanges) did in fact provide an important new funding source forSMEsinChina.Thehappynewswasthat,since2004,whentheSMEBoardof ShenzhenStock Exchangeestablished,anincreasing numberofSME stocks have been listed in both the Shenzhen Stock Exchange’s SME Board and that of the SecondBoard(GrowthEnterpriseBoard),whichwasestablishedin2009.ByJune 2013, 701 and 355 SME stocks have been listed in these two boards, growing 88 and 13 times, respectively, compared with the numbers from 2004. The total market value also increased from 41.3 billion RMB to about 4.4 trillion RMB during the same period of time, increasing by about 109 times.2 The hard part was that in order to get funds from equity investors, the SMEs that were looking for equity capital must meet the expectations of the equity investors.Becausetheyaremakingalong-terminvestment,equityinvestorsfocus not only on the historical performance of a firm, they also look at the future cash flows that, together with the inherited risks associated with the companies’ earn- ings, determines the value of the firm; only a sustainable future cash flow would maximize the wealth of equity shareholders. The question, then, was on what parameters should equity investors judge the future cash flows of these SMEs? As the age of low cost and low pricing gives way to a different kind of com- petitive market, generating a sustainable cash flow, on the business side, is now anchored upon well-designed business models and flawless execution. A well- designedbusinessmodelneedstoadequatelyaddressallthestrategicissuesfacing thefirmforitslong-termdevelopment,whichinclude,butarenotlimitedto,which industrythefirmshouldbein?Whatproducts/servicestheyshouldproduce?What kindofrelationshipsdoesthefirmneedtobuildwithitscustomers,suppliers,and venders so as to minimize cost or increase profit? And most importantly, what unique business model does the firm need to create to distinguish itself from its closest competitor(s), and how can they highlight their core competencies? In the post-financial crisis era, a well-designed and well executed business model will become the ace that distinguishes the winners from the losers, not only in the goods/services market but in the financial market as well. In the last 20 years, the question of ‘‘why China’’ has been near completely mutedasChina’scapitalmarketsgraduallyimproveinvalue,andtheopportunities 1 Wall Street Journal: http://online.wsj.com/article/SB100014240529702039143045766269418 13821726.html 2 ShenzhenStockExchange:http://www.szse.cn/main/marketdata/,SohuSecurity:http://stock. sohu.com/20091225/n269197316.shtml Preface ix that Chinese companies can offer have been increasingly revealed on a global scale. During the past 20 years, Chinese capitalmarkets have been re-categorized by many portfolio managers worldwide from a ‘‘transitional investment’’ to a ‘‘permanentallocation.’’Manytop-notchinvestorssuchasWarrenBuffet,George Soros, and Jim Rogers, and many active private equity funds and investment banking houses such as Bain Capital, Blackstone, Goldman Sachs, and Morgan Stanley, have appeared on the list of Chinese equity investors. It is the Chinese companies with solid, unique business models, among other distinguishing char- acteristics, that have been hungrily chased by investors both inside and outside China. Like in the USA, SMEs comprises over 99 % of the total number of Chinese companies.3 The 1,000 or so companies listed in the SME Board and Second Board only represent a very small fraction of the total Chinese companies that need external financing. Without a question, these SMEs that were listed on China’scapitalmarketareamongthemosteliteones.Whoarethese‘‘luckyguys’’ that received funds from China’s competitive capital market, and what did they bringtothetablethatcausedthemtobeChina’sfinancialmarkets’favoredstars? Answers to these questions are certainly among some of the most intriguing and sought out to both Chinese and foreign readerships. The general interest in this issue of China’s SMEs and the capital markets is a resultofthehugerolethatChinaisexpectedtoplayinworldeconomicgrowthin the forthcoming decades. It is also a result of the highly interconnected and interdependent global market that is now an economic reality. Although the Chineseeconomyrevealedsignsforslowdowninthepastquarters,itsroleasone ofthemostpowerfulenginesforworldwideeconomicgrowthinthenextdecades is still indisputable. Even more unavoidable is China’s ever-growing purchasing power that has been accumulating over the past 30 years by an over 9 % average annualgrowthrate,anditsproductionandexportcapacityas‘‘theworkshopofthe world’’. Most importantly, its ambitious urbanization plan from about 50 % as of currenttoabout75%inthenext30years4willalonegenerateanothermarketthe size of the currently existing China market. As one of the major sources fueling China’s enormous growth engine, the Chinese financial markets and their activity—which cover over 99 % of all Chinese companies—is both a critical and extremely fascinating issue for anyone whomaybeinterestedinorimpactedbytheChinesemarketinthecomingyears. In particular, institutional and individual investors both inside and outside China should be finding this topic relevant and intriguing. Financial institutions such as security firms, investment banks, private equity funds, venture capitals, commercial banks, other financial intermediaries, and individual investors 3 Zibin Li, President of Chinese SME Association, Xinhua News Net: http://news.xinhuanet. com/fortune/2010-05 4 WallStreetJournal:http://online.wsj.com/article/SB1000142405297020373530457716665200 2366514.html x Preface includingangelscouldalldowellwithwatchingChina’sfinancialmarketclosely. Given the interconnected nature of the global financial markets and the comple- mentarynatureofdifferentsegments/areas ofthefinancialmarkets, whatkindsof ChineseSMEsthatcaneventuallybelistedandtradedpublicly,whatstorieswere broughtbytheSMEstoconvincethemarket,andwhatkindofreturnsforPre-IPO investors obtained at the exit will be undoubtedly relevant to all these investors, and in turn, will also influence investors’ investment decisions at all stages of the target companies’ financial growth cycle. The Chinese SMEs that are looking for public equity funding should also take interest in this topic. The products, the industries, the business models, and the growthpotentialtheselistedSMEspromisedaresolidindicatorsforwhatinvestors prefer and where they are willing to put their money. Foreign companies, especially foreign SMEs that are looking for external funding from overseas market, are impacted as well. Given the abundant funds available in China’s current market and an increased possibility of an opening of an international board in China to list foreign companies, understanding what kinds of Chinese SMEs are already listed would certainly be instructional for them. Finally, the academia inside and outside China should also take interest, for a number of reasons: (a) China’s sustainable economic growth in the next decades truly depends upon whetherornotChinacansuccessfullytransferitsgrowthmodelfromthepast 30 years to a new one in the next 30 years, that is, transferring from an investmentandexportdrivenwaytoadomesticconsumptiondrivenone,from an environment-damaging, energy-wasting method to an environmentally- friendly and energy-saving one, and, finally, transferring from competing on low labor cost to competing on branding and technology innovation. (b) More and more people realize that technology innovation is not a pure ‘‘technology’’concept,asJosephSchumpeterindicateddecadesago.5Instead, tech innovation is an economic concept that involves in an entire process of research, development, production, marketing, consumption and feedback about an innovation of a product, a service or a business model. As a result, entrepreneurs,insteadofscientistsandengineers,aretheprimary participants of the innovation process. (c) Since over 99 % of Chinese companies are SMEs, active participation of SMEs will undoubtedly determine the success of technology innovation and the transformation of China’s future growth models. (d) Given the economic nature of tech innovation, receiving adequate financing willbeadeterminingfactorofnewinnovationdevelopment,especiallyforthe techinnovationinitiatedbySMEs.Consequently,understandingwhatkindsof SMEs can obtain funds from China’s public equity market and how they got 5 Schumpeter, J., 2006, Capitalism, Socialism and Democracy, New Edition, Routledge, London.