Accepted for publication in Journal of Financial Education. I am grateful to participants at the North American Case Research Institute 2002 conference in Banff, Canada, for their helpful comments and for research assistance from Wang Zhiqiang and Xu Zhi in preparing some tables. Please contact me at [email protected] edu. hk should you find any errors in the case. Bank of China Hong Kong’s Initial Public Offering Abstract China’s entry into WTO has set a deadline on opening its financial services sector to foreign competition.
Privatization is one strategy to help modernize the sector. The first bank in line for privatization is the Hong Kong commercial banking subsidiary of Bank of China (BOC), Bank of China Hong Kong (BOCHK), a subsidiary recently formed from the merged Hong Kong interests of BOC. Foreign investment and commercial bankers are meeting in January 2002 with BOC and BOCHK to negotiate the initial public offering (IPO) of BOCHK. But as the negotiations to IPO commence, a scandal erupts that adversely impacts the timing or pricing of the transaction.
Students must decide the timing, number of shares, pricing, place of issue, use of proceeds and strategic investors and negotiate in alliance and competition with others. They analyze financial statements, strategy, industry position and equity valuation in the context of an international banking IPO. Introduction It was January 2002. Top management of the Bank of China (BOC) was keen to proceed with the initial public offering (IPO) of shares of its newly reorganized subsidiary, Bank of China Hong Kong (BOCHK).
BOC invited several foreign bankers to Beijing to discuss confidentially the IPO. These bankers included senior management from the equity underwriting departments of two investment banks Wall Street Associates and EuroUniversal Group and Asia Pacific executive committee members of two global financial groups, BankAssurance NV and FinServe Limited. The bankers would form and propose, either individually or jointly, various strategies for underwriting and strategic partnering on the IPO.
It was up to BOC and BOCHK to assess the proposals and determine a plan for approaching the equity markets. As the rumor mill was operating with its usual efficiency, by the time the five teams of visiting bankers had spent one night in the Peking Hotel, they all knew what each other was doing in town. Bankers being bankers, they discussed the transaction and potential for mutual cooperation and competition among themselves. BOC and the Chinese Banking
BOCHK was a wholly owned subsidiary of BOC, the second largest of the Big Four state wholly-owed commercial banks in China ? in order of size, Industrial & Commercial Bank of China, BOC, China Construction Bank and Agricultural Bank of China. The masthead of BOC’s web-page “About Us” trumpeted “Welcome to The Best Bank in China. ” It was a boast that rang true ? at least among the Big Four. More than any other sector of the Chinese economy, banking in the late 1990s and early 2000s was burdened with the failures of China’s old planned economy.
Under that system, banks had been effectively treasuries, providing funds for capital expansion as designated by the plan. If capital expansions were profitable, loans were repaid. If not, loans remained on the books for many years before they were finally written off. Because profitability was not often the main criterion for selecting planned projects, unprofitable projects were frequent. Although the reforms of the Chinese economy from state-planned to market-driven started in 1978, it was not until the 1990s that the reforms fundamentally addressed banking.
Three particularly important aspects of this delay were (1) there was no effective bankruptcy legislation until 1991; (2) policy lending was not formally separated from commercial lending until 1994 and (3) not until 1998 did the Peoples Bank of China (China’s central bank and commercial bank regulator) direct commercial banks to base lending on borrower credit-worthiness (See Exhibit 1). By then, however, the Big Four were all technically insolvent. Recognizing the problem, in 1999 the Ministry of Finance set up four Asset Management Corporations (AMCs), one for each of the Big Four, to purchase non-performing assets .
Each AMC used mixtures of AMC bonds and cash to buy assets from its parent bank. AMCs either auctioned off the assets or (more frequently) entered into debt for equity swaps. By the end of 2000, some RMB 1. 49 trillion (US$180 billion) of non-performing assets had been purchased. But even after nominally implementing commercial lending practices and setting up of the AMCs, many branches of the Big Four continued to lend for political reasons. Within this dismal industry, BOC shone relatively brightly.
For example, its asset management company, China Orient Asset Management accounted for a disproportionately low RMB 226 billion (US$32 billion) of total non-performing assets purchased from the Big Four by the end of 2000. The predecessor of BOC was founded to serve as a modern bank for the Ministry of Revenue of the Qing Dynasty in 1904. The bank’s name was changed to “The Great Qing Bank” in the final years of the Chinese Empire and within a year of the 1911 Nationalist Revolution that overthrew the Qing, the new nationalist government issued the bank a charter, giving it the name “Bank of China.
” Far more so than other Chinese banks in the early years of the twentieth century, BOC followed western banking precepts. Following the founding of the People’s Republic of China in 1949, BOC assumed its role as the foreign exchange bank of the new regime. Whereas the other three of the Big Four were absorbed into the People’s Bank of China, China’s central bank, in the 1960s, only to be spun off again as separate banks in the 1980s, BOC continuously existed as a separate business entity.
From 1949 to 1976, the Chinese Communist Party completed the revolution, socialized agriculture and industry, embraced and then rejected the alliance with the Soviet Union, and underwent the tumult of the Cultural Revolution. But while China was closed to the western world, BOC remained open, maintaining branches in the financial capitals of the world and keeping its management conversant with global financial developments. With a major presence in the Hong Kong Special Administrative Region, it possessed a substantial non-renminbi (RMB) denominated retail and commercial banking portfolio that was profitable.
The debt of BOC had been scrutinized for many years prior to 2002 by the major rating agencies: Moody’s Investor Service, Standard and Poor and Fitch IBCA. The ratings Moody’s and S&P applied to the senior unsecured debt of both BOC and BOCHK were Baa1 and BBB+ respectively. The ratings agencies were unanimous in considering BOC to be a weak bank on a stand-alone basis. Considering the unknown quality and amount of non-performing loans, no credit rating agency would have awarded BOC investment grade status were it a bank whose liabilities were not implicitly guaranteed by a creditworthy party. But, as Fitch expressed it, “…
due to the domestic and international importance of BOC to the PRC, it is inconceivable that the government would allow it to fail. ” In short, the ratings agencies and international bond investors considered BOC to be largely Chinese sovereign risk. BOC had assets of RMB 3. 36 trillion (US$405 billion), ranking it among the top 50 banks in the world. Although BOC’s Hong Kong operations accounted for about one quarter of those total assets, they had produced in recent years about 60 percent of BOC’s profit. Thus the IPO under consideration would spin off the most attractive assets of China’s most attractive large bank.
Bank of China (Hong Kong) Limited In January 2002, BOCHK was three months old. It had been founded on October 1, 2001 by merging the Hong Kong branches of BOC with eleven Sister Banks. Following the merger, nine of the eleven sister banks ceased to exist while Nanyang Commercial Bank Limited and Chiyu Banking Corporation Limited continued their existence as subsidiaries of BOCHK. BOC Credit Card (International) Ltd, a former subsidiary of BOC also became a subsidiary of the new BOCHK. Headquartered in the most striking building on the Hong Kong skyline ?
a building designed by the Chinese-American Architect, I. M. Pei (see Exhibit 2) ? BOCHK was one of the dominant banks of Hong Kong. With assets of Hong Kong dollars HK$766 billion (US$ 98 billion), customer deposits of HK$606 billion (US$78 billion) and net loans of HK$308 billion (US$39 billion), BOCHK’s share of the Hong Kong market was second only to the Hong Kong and Shanghai Banking Corporation, a subsidiary of HSBC plc. BOCHK, together with Standard Chartered Bank and the Hong Kong and Shanghai Banking Corporation were the three issuers of banknotes in Hong Kong.
And BOCHK’s Chairman served on a rotating basis as the Chairman of the Hong Kong Association of Banks. Accounts for BOCHK for fiscal year end December 31, 2001 are found in Exhibit 3. The relationship between BOCHK and BOC had but a short history, yet most analysts considered that it would follow the tradition of the former branches of BOC in Hong Kong and the sisters. A majority of directors and senior management of BOCHK would continue to be BOC (i. e. , Beijing) appointees, but the vast majority of staff and a part of the senior management would continue to be local Hong Kong bankers.
Moreover, operations and strategy BOCHK would continue to be largely independent of the parent, BOC. Although it had been a special administrative region of the People’s Republic of China since 1997, Hong Kong in 2002 functioned as a modern city-state under its own legal and regulatory system firmly founded in western commercial practice. BOCHK, like other banks doing business in Hong Kong, was regulated by the Hong Kong Monetary Authority (HKMA), a government body concerned with preserving the safety and soundness of the banking system, the integrity of the payments system and the value of the Hong Kong dollar.
The HKMA, in conformity with the Bank for International Settlements (BIS) Basel Committee on Banking Supervision’s Capital Accord required that banks maintain a level of total equity capital to risk assets (the Basel Capital Adequacy Ratio) of not less than eight percent. In addition, the HKMA reserved the right to raise the Basel Capital Adequacy Ratio from eight percent to 12 percent for any given bank, a policy that led most banks to keep their ratios above the 12 percent level as a matter of course. At year-end 2001, BOCHK’s Basel Capital Adequacy Ratio was 14. 5 percent.
Banks in Hong Kong were also required to maintain the Statutory Liquidity Ratio, being the ratio of liquifiable assets to qualifying liabilities of not less than 25 percent. In practice, most banks maintained liquidity above the 25 percent requirement: BOCHK’s Statutory Liquidity Ratio was slightly under 40 percent. The HKMA also maintained internationally accepted guidelines of banking practice with which BOCHK complied. Every year, within three months of fiscal year end, BOCHK, like other HKMA-authorized banks, submitted its audited financial statements to the HKMA.
Accounting and auditing standards in Hong Kong were largely on a par with North America. This made Hong Kong banks ? such as BOCHK ? much more transparent than banks in the rest of China ? including BOC. But the rest of China was due to change. Entering the WTO “Ru Shi” or “Entering the World” was the short form expression in Chinese referring to the accession of China into the World Trade Organization (WTO), that formally occurred on December 11, 2001. For Chinese banks, more than most other enterprises in China, WTO accession was truly an entry into a world from which they had long been sheltered.
The WTO was the international organization that set and policed the global rules of trade. Started in 1947 as the General Agreement on Trades and Tariffs, the WTO spent most of it first half-century promoting freer trade in goods. In a series of “rounds” from 1947 through the 1980s, trade diplomats from around the world pursued the goals of (1) conversion of hidden and complex non-tariff barriers to simple import tariffs and (2) mutual tariff reductions in product-by-product, country-by-country and rule-by-rule multilateral negotiations.
In the 1990s, the WTO expanded its sights to include trade in services, including banking and other financial services. Long considered by many to be an area of national sovereignty too sensitive to allow competition from non-locals, financial services were henceforth to be freely traded by applying three WTO principles: ? Non-discrimination. No member should apply more favorable rules to any one member than to all others. This “most favored nation” principle required that each member receive the same treatment as the most favored nation.
?Transparency. Laws and regulations governing trade in services should be precisely, clearly and promptly published, not subject to bureaucratic discretion. ?National treatment. Members should apply to other members’ companies the same treatment that they applied to their own companies. These three WTO principles, however, represented medium term goals, not extant reality. The WTO accepted that members of trading blocks and bilateral treaties (e. g. , European Union, NAFTA and Mercosur) violated non-discrimination. The WTO
understood that governments the world over liked to help out friends, ethnic groups and/or electorates, thereby clouding transparency. And, as was well known, when countries dealt with sensitive services like banking, “national treatment” often yielded to “national sovereignty. ” WTO addressed these conflicts by requiring member countries to catalogue their existing preferential practices and to commit to liberalize restrictions according to specific schedules. In no case was a member allowed to increase market protection.
When China acceded to the WTO, the 900-page agreement it signed catalogued exceptions to non-discrimination, transparency and national treatment. In banking, restrictions on renminbi lending by non-Chinese banks and restrictions on the clients and geographical markets that non-Chinese banks could serve were explicitly catalogued and scheduled to be phased out by 2006. Only two areas, (1) provision of financial information, data processing and software and (2) financial advisory services were reserved for domestic providers of financial services after 2006.
These exceptions and the schedules for elimination of exceptions are given in Exhibit 4 Banking Terms of Accession of China to the WTO. In short, within two to five years in most financial services markets, China would be open to competition from the best banks in the world. As one of the strategies to meet this challenge, BOC decided to “enter the world” in its own way — by becoming the first large state-owned Chinese bank to tap global equity capital markets through the public listing of its subsidiary, BOCHK. Entering the Market It was widely anticipated that BOCHK would enter the market with a listing on the Stock Exchange of Hong Kong (HKEx).
HKEx was increasingly an international market for Chinese equity. Although its capitalization was less than the combined capitalization of China’s domestic stock markets, the Shanghai Stock Exchange and the Shenzhen Stock Exchanges, HKEx provided clear advantages for a Chinese-based company seeking an international listing. Listing requirements were broadly in line with those of major stock markets of the world and there were no foreign exchange restrictions on the currency of issue: the Hong Kong dollar.
For a Chinese company wishing to raise foreign currency in a market frequented by international institutional investors, HKEx provided a good listing venue. The international financial press speculated that BOCHK might simultaneously issue American Depository Receipts (ADRs) on the New York Stock Exchange. An ADR was a receipt issued to a U. S. investor by a U. S. based bank against shares purchased in a foreign market. ADRs were quoted in U. S. dollars and were traded on U. S. markets like locally issued shares.
The depository bank held the foreign shares in trust for the holders of the ADRs and administered all transfers, exchanges, and distributions of dividends, translating them from the foreign currency to U. S. dollars. ADRs formed a convenient device for investors normally unable to diversify into foreign markets. A Chinese company wishing to tap U. S. markets could have its primary listing on HKEx and sponsor an ADR on the New York Stock Exchange. Attracted by these advantages, mainland China-incorporated companies issued more than 40 percent of their new equity in the 1990s through HKEx “H-Shares”.
The remaining 60 percent of new equity was raised on the Shanghai and the Shenzhen Stock Exchanges through renminbi-denominated A-Shares (for domestic investors) and foreign currency-denominated B-Shares (available to international investors). Notwithstanding its ownership, BOCHK, was a Hong Kong company, not a mainland China company. Hence its proposed IPO was not an H-Share issue, but was loosely called a “Red Chip”, a Hong Kong-based company with mainland ownership. Unlike most Red Chips, however, BOCHK’s main revenue source was its Hong Kong operations and most of its employees were Hong Kong permanent residents.
Regardless of the definition of the proposed IPO, however, BOCHK’s IPO pricing would be compared with H-Share listings on the Hong Kong Exchange. The year 2000 had been a banner year for HKEx for IPOs with over HK$100 billion (US$13 billion) of equity issued by 43 companies. In contrast, the year 2001 was dismal: only 20 companies came to market with IPOs raising a total of HK$ 15. 66 billion (US$2 billion). Exhibit 5 “Large Hong Kong IPOs in 2001” gives a summary of the four largest IPOs in 2001. Three out of four involved dual listings in Hong Kong and New York and three out of four involved mainland companies.
But one issuer dominated: CNOOC. CNOOC was the Chinese offshore oil and natural gas exploration, development and production company with exclusive rights to explore and produce in cooperation with international oil and gas companies. In February 2001 it raised HK$11 billion (US$1. 4 billion), 95 percent of which was in ADRs listed in New York. Originally scheduled to be led by Salomon, Smith Barney in 1999, the deal had been withdrawn by Salomon at the last minute because of volatility in oil prices and poor investor sentiment.
The deal languished for over a year before CNOOC mandated Merrill Lynch, who brought in Credit Suisse First Boston and BOCI (the investment banking subsidiary of BOC) to co-lead the transaction. Prior to its public offer, CNOOC recruited several strategic investors for a collective stake of 9 percent of the post-IPO shareholding: American International Group, Shell Eastern Petroleum, Hong Kong Electric, Hutchison Whampoa and Singapore Government Investment Corp. The IPO, which left the parent holding 70 percent of the shares, was six times oversubscribed and closed on the first day with an 18 percent return on the issue price.
Market pundits were predicting that 2002 would see a turn-around in Hong Kong IPO activity because of supply pressure. Some 75 to 100 new listings were expected to raise about HK$100 billion (US$13 billion) of funds with three quarters of these issuers being China-related. The majority of the IPOs were projected to be small, privately owned Chinese companies listing on the Growth Enterprise Market, a secondary “buyer beware” market, on which new and rapidly expanding companies could raise funds from sophisticated investors with high risk tolerance.
The IPO-ing companies were expected to come to market soon after their fiscal year 2001 accounting information were available. In addition, the market expected four large, state-owned companies, including BOCHK to IPO on the main board of HKEx. Each was expected to sell a minority of its equity to the public while retaining majority ownership for the government (see Exhibit 6 “Hong Kong Market Chinese IPOs Predicted to Come to Market in 2002”). Pricing and Use of Proceeds BOCHK planned to approach the market in Hong Kong (and possibly New York through ADRs) to sell US$4 to US$5 billion in shares.
The market would perceive it not only as a large state-owned Chinese corporation but as an international bank with a major Hong Kong presence. In pricing an IPO, the underwriting banks and investment analysts typically compared the IPO with similar companies. Similar companies were determined by similarity of size, structure, performance, strategies and markets in which they operated. Analysts applied price to earnings, market price to book price, price to cash flow etc. ratios to come up with appropriate ranges in the value of the company to be listed.
But for BOCHK, determining which companies were similar and which group of banks constituted a peer group was not an easy task. Exhibit 7 gives summary accounting ratios and other data for several potential candidates for peers of BOCHK while Exhibit 8 gives some stock market related data for the same banks. In January 2002, BOC had yet to formally award the mandate for the IPO of BOCHK to any bank, although it was rumored that two banks, Goldman Sachs and UBS Warburg were the main contenders.
Lead banks in an IPO like the proposed BOCHK transaction typically obtained mandates by detailing their analysis of the valuation of the company to be IPO-ed, outlining an IPO strategy, outlining their superior market knowledge and placing power and quoting an indicative price range. The shares listed in the IPO might be a primary issue (i. e. , an “offer for subscription”) of new shares from the treasury of the company being listed, in which case the funds would flow into the IPO-ed company (in this case, BOCHK).
Alternatively, the shares could be a secondary sale (i. e. , an “offer for sale”) of existing shares from the balance sheet of the parent company, in which case the funds would flow to the pre-IPO owner (in this case, BOC). Or the IPO might involve a combination of primary and secondary shares. The price range was the lead bank’s forecast for a fair share price in the approximately three months that were required to prepare for listing. The quoted price range was not a formal, fixed price underwriting, yet banks were very careful in setting price ranges: being unable to place shares within the range often led to loss of reputation.
From the issuer’s point of view, the narrower the price range, the better. Following the award of the mandate, the lead bank (or banks) would detail the terms of the transaction, the condition, accounts, prospects and strategy of the company to be IPO-ed, the competitive conditions of the industry and the use of the proceeds in a prospectus. The lead bank would exercise due diligence to ensure that the contents of the prospectus was complete, clear and truthful and would work with lawyers and accountants to prepare filings with the exchanges and securities regulators.
In Hong Kong, the formal process of application for hearing by the listing committee of the Hong Kong Exchange took 25 business days. Assuming that conditions for listing were appropriately fulfilled and approval was given, the lead bank then would publish the prospectus, conduct a book-building roadshow among the institutional investors and set the price. About five days would elapse between publishing the prospectus and the price setting date, another two or three before shares would be allotted and a final two or three days before the shares were first traded on the stock exchange.
If an ADR was to be used, additional time before the formal launch would be required ? three months if the ADRs were to be publicly listed securities and a somewhat shorter time if the ADR was a 144a issue. Pitches by Wall Street Associates and EuroUniveral Group Both Wall Street Associates and EuroUniveral Group were keen to win the IPO mandate for the first state-owned bank in China. Their teams in Beijing saw their meetings with BOC as more important than the average deal pitch.
During a pitch, the banker had to, in a formal presentation that usually lasted less than half an hour (followed by a question an answer discussion that could last all day), summarize the transaction and why the transaction proposed was best for the prospective client. Most pitches were unsuccessful. Bankers often lacked the necessary information and time to do an ideal analysis and structure the optimal deal. In such a case, the ability of the presenter to think on his or her feet and the flexibility to meet the prospective clients concerns, were as important as the initial analysis.
Wall Street Associates and EuroUniveral suspected that BOC might have requested them to pitch the deal simply to obtain ideas, or to get ammunition for better discussions with the favored investment bankers — Goldman and UBS. But all banks were well aware of the upset of Salomon on the CNOOC deal and so were keen to make their best efforts to get the mandate. If they pitched well, even if they lost, they would raise their reputations and would be considered favorably for BOC’s future transactions.
Strategic Partnerships: BankAssurance and FinServe. Both BankAssurance and FinServe were global financial service firms with over $600 billion in assets and $400 billion under management vying to become financial supermarkets, catering to retail and wholesale customers the world over. FinServe was a US-based commercial banking, investment banking, insurance and fund management group. With over a century of international banking experience, FinServe had a large branching presence in various countries in the Americas, Europe and Asia.
As a foreign bank with one of the largest branching presences in Hong Kong, FinServe was a competitor of BOCHK. But being a competitor had not stopped FinServe from owning stakes of one to five percent in more than a dozen of the largest financial conglomerates worldwide. As the owner of a major investment bank, FinServe was also capable of underwriting BOCHK issue. Although FinServe had been invited to Beijing to talk about strategic partnerships, not leading the IPO, its team included a member of the investment bank, prepared to commit on underwriting, should the opportunity arise.
BankAssurance had grown from its base in northern Europe into banking, insurance and fund management company serving over 50 million clients in 65 countries with a staff of over 100,000, and with over 70 percent of its shareholders from countries outside its home. Its internet financial services had been profitably rolled out in several countries. It was particularly keen to enter markets through strategic alliances and its joint ventures ranged from a 50 percent stake in a postal savings bank in Europe and a 49 percent share in a Mexican insurance company down to stakes of less than 5 percent.
Asia’s contribution to BankAssurance’s worldwide income had grown to seven percent in recent years, but most of the growth was from life insurance acquisitions. In China, BankAssurance had branches in Beijing, Shanghai and Shenzhen that had been pursuing corporate foreign currency lending opportunities and trade finance opportunities. Although its underwriting capabilities were not sufficiently strong to be the sole lead in a transaction such as BOCHK IPO, it was perfectly capable of teaming up with another, similar sized bank to structure the transaction.
Both BankAssurance and FinServe viewed a strategic alliance with BOC, cemented by an equity stake in BOCHK as a win-win proposal. BOCHK could benefit from gaining first class financial service professionals on its board and entering its management. The foreign banks could ease their entry into the post-WTO China market. Yet neither BankAssurance nor FinServe felt that the opportunity was so tempting that it justified paying a premium over a fair price for a stake in the newly IPO-ed BOCHK.
Timing, Homework and Housecleaning Ideally an IPO occurred in a market that was buoyant, when optimism reined in the geographic and industrial sector of the issuer and when good news on the issuer’s condition outweighed bad news. But ideal conditions seldom occurred. In less than ideal conditions, BOC wished to get the best price for its ownership dilution while furthering the strategic goals of BOCHK. Like the invitee foreign banks, both BOC and BOCHK had to analyze the strategy, use of funds, timing and pricing of the IPO.
They had to decide what, if any, preparatory work had to be done to alter the shape of the bank before the issue. Was the equity capital of BOCHK sufficient given its strategies? Should the shares sold be in a primary issue of new treasury shares giving BOCHK cash and an increase in equity or should they be a secondary sale, giving the cash to BOC? Or should a combination be used? Should BOCHK take on strategic investors in the IPO? And if so, at what price and under what conditions? Should one lead bank be used? Should the mandate go to the bank with the highest indicative price range?
Or should the competitors be encouraged to team up to reduce the probability that deal would be withdrawn at the last moment due to adverse market conditions? Although the foreign bankers would propose the plans, the hosts had to be well prepared to engage their guests in meaningful negotiations. Moreover the interests of BOC and BOCHK did not fully coincide. Exhibit 9 illustrates the market performance of the Hong Kong stock market from January 2001 to January 2002. With corporate governance increasingly coming under the microscope, no market forecasters were predicting the return of the bull market.
Should the issue be delayed? On one hand delay was undesirable: BOC management had identified 2002 as the year to IPO and the WTO clock was ticking for domestic financial service deregulation. But the President of BOC, Liu Mingkang, in an interview with Euromoney in December 2000 had emphasized that BOC could successfully go public only after it had “done its homework” in order to earn public confidence that the bank truly had good corporate governance and was following international practice. The extent of the required housecleaning became clear in early January 2002.
The Chinese National Audit Office announced that it had uncovered 22 serious cases of fraud involving RMB 2. 7 billion (US$325 million), that had occurred at BOC during the stewardship of Mr. Liu’s predecessor, Wang Xuebing from 1993 to 2000. Foll