Barbarians at the gate, a phrase made famous in financial terms by Bryan Burrough and John Helyar’s account of the 1988 RJR Nabisco takeover, has a striking resonance in today’s capital market in China.
RJR Nabisco, a food and tobacco-oriented firm most noted for Oreo cookies, was the target of a particularly heated US$25 billion acquisition by Kohlberg Kravis Roberts (KKR), a private equity firm. The leveraged buyout – a takeover made mainly with debt with the company’s future cash flow for collateral – was the most famous of its kind, and was financed mostly by the issuance of high-yield junk bonds by KKR to attract investors.
Chinese regulators and analysts see in this a forerunner of the heated battles over corporate control in China’s capital market. Over the past 18 months, several Chinese insurance companies have become the most aggressive investors in China’s listed companies. But to their critics, their dubious sources of funding and the stock manipulations make them the “barbarians” threatening a stable market and the entrepreneurship most needed for China’s future growth. Traditionally, insurance companies have always been expected to be stabilizing forces offsetting fickle retail investors. That leaves regulators facing the challenge of balancing containing risk while at the same time respecting market forces.
According to a Haitong Securities report by Xun Yugen and Zheng Yuliang in early December, insurance companies held about 6.7 percent of tradable shares on China’s stock market by the end of June 2016. Statistics from the China Insurance Regulatory Commission (CIRC) showed that insurance companies invested 14 percent of their funding in buying shares and funds for the first 11 months of 2016. Neither figure was particularly high, the Haitong survey argued. The former was dwarfed by the total holdings of either retail investors or corporate holders, while the corresponding figure for the latter in US insurance companies was about 30 percent. Insurance companies were actively encouraged by regulators to buy more shares after June 2016 to offset the mess of China’s stock market crash.
In a press conference in March 2016, Xiang Junbo, chairman of the CIRC, said that insurance companies represent 70 percent of institutional investors and make 75 percent of transactions on overseas stock markets. As insurance firms invest for long-term returns, they facilitate the steady development of stock markets. Therefore, he believed, “The more big buy-in deals [by regulatory standards, defined as exceeding 5 percent of stakes of a listed company] insurance companies make, the happier chairman Liu Shiyu [of the China Securities Regulatory Commission] would be.” Under China’s rules, any deal involving buying more than 5 percent of the stakes of a listed company has to be registered with the CIRC, disclosed publicly and held for more than half a year.
It turned out, however, that Liu was not as happy as Xiang imagined. After staying silent for some time, in his speech at a meeting of Asset Management Association of China on December 3, he suddenly warned asset management institutions “not to use ill-gotten money for leveraged buyouts, nor to behave like strangers-turned barbarians at the gate, ending up becoming bandits preying on the industries [they have invested in].” In striking language, he accused firms that behaved this way of “being degraded and morally bankrupt, both in humane terms and professional ones” and said such actions were “anything but financial innovation.” He labeled offenders as “gremlins” or “vermin.”
Liu’s sharp remarks shocked the market and were widely interpreted as targeting insurance companies, already known for their aggressive tactics even as relatively small market players. Listed companies already targeted by insurance giants echoed Liu’s statements. The same day, Dong Mingzhu, chairperson of Gree, a leading home appliance maker based in Zhuhai, Guangdong Province, noted at a forum in Beijing that she hoped “[the flow of] capital won’t end up damaging the made-in-China [initiative].” Just a few days earlier, the Shenzhen Stock Exchange asked Gree to explain why its share price had soared by 27 percent, and why the turnover rate of stock had reached 32 percent within ten days. Gree discovered that Shenzhen-based Qianhai Life Insurance had made itself Gree’s third largest shareholder during that period. As Qianhai’s holding remained below five percent, its bold investment was free from regulatory requirements of registration.
There are two main reasons why insurance companies’ big investment in publicly-held Chinese companies has not been as welcome as once imagined. The first is the risky source of the funds used by insurance companies to buy the shares. As in the leveraged buy-out boom in the US in the 1980s, thanks to complicated financing structures, insurance companies made far more use of someone else’s money than their own capital. A big source of their borrowing are the numerous holders of a product called “universal life insurance policy.” It works as both a life insurance and asset management tool – but the latter is not a part of the insurance contract. Insurance clients can change the mix of the two accounts at any time. Insurance companies provide a high minimum interest rate on the investment account to attract clients, making it a wealth management product similar to that offered by banks.
With a lack of other investment opportunities for ordinary people in China, especially following the stock market crash, such wealth management products – often of dubious integrity – have boomed. That gives insurance firms access to a massive source of potential capital. Due to the high cost of the funding, Ren Zeping, chief economist with Founder Securities in Beijing, described the universal life insurance as an “alternative junk bond” in a July 2016 report. And unlike permanent effective universal life insurance in the US, this contract in China remains valid for less than five years, or even one to two years in some cases. The CIRC warned in a statement after the March 2016 press conference that investors could go bust if insurance companies use the money to buy long-term assets or if policy holders rush to cancel their contracts in the case of a bearish stock market.
This expensive, short-term source of capital has been growing fast. the capital in the investment accounts operated by insurance companies soared by 98 percent in 2015, compared with just 28 percent in 2014, and stayed at 65 percent for the first 11 months of 2016, according to CIRC data. This rapid increase far outpaced the growth of conventional insurance premiums in 2015 and 2016. Funding in investment accounts has become a much larger source of revenue than conventional insurance premiums for those insurance companies that have made the most high-profile deals on the stock market over the last two years. It has been used as the ammunition for their assaults on listed companies. By the end of the third quarter of 2016, Qianhai’s universal life insurance funds had already become the first and second largest shareholders of CSG Holdings, a Shenzhen-based glass maker, according to the quarterly report of CSG.
Another reason for the distrust of insurance firms is the battles and disturbances that have been triggered by the raids of insurance companies against listed companies. Managements of the targeted companies have fiercely resisted the arguably hostile takeover attempts of insurance companies. For example, Wang Shi, chairman of Vanke, a Shenzhen-based real estate giant, openly criticized Baoneng Group, a conglomerate that bought massive amounts of Vanke stock through subsidiaries including Qianhai in 2015, as not creditworthy given Baoneng’s record of risky investment ventures. He later made it clear that a private enterprise was not welcome to become the largest shareholder of Vanke. In June 2016, Baoneng proposed a shareholders’ meeting to dismiss Vanke’s board.
At the end of November 2016, eight senior management members, including co-founder and chairman Zeng Nan, declared they would leave CSG. In their open letter to shareholders and corporate staff, they noted that they respected market forces, but had no desire to “dance in chains.”
Just before the end of September 2016, Grande Life bought 4.95 percent of a hydropower company, becoming the largest shareholder while evading the five percent limit. The flood of capital sharply boosted the company’s share prices. However, Grande then swiftly sold out all its holdings a month later, and the company’s share prices nosedived.
Public opinion was very much divided in Wang Shi’s case. His supporters criticized “capricious capital attacking outstanding entrepreneurs,” while others called for respect for the normal market behavior of capital. Both frowned on Wang’s discriminatory remarks about private enterprises.
Listed companies won more sympathy in the last few months of 2016 when some leading manufacturing entrepreneurs felt threatened, and the maneuvering of insurance capital roiled the stock market, as in the case of the hydropower company. Manufacturing entrepreneurs like Gree’s Dong Mingzhu and CSG’s Zeng Nan are increasingly regarded as the real icons of China’s economic might, while the unhealthily rapid growth of the financial sector and the increasing use of leverage by financial players has left many observers wary.
Insurance regulators also tightened scrutiny of the universal life insurance business after March, and have stepped up their efforts recently. They have imposed stricter standards on this business and checked nine insurers heavily reliant on these funds. Right after Grande cashed in after dumping all its shares of the hydropower company, CIRC asked Grande to “conduct deep self-reflection over the negative impact of its speculative behavior” on the stock market. In early December, Grande was prohibited from buying new shares on the stock market. At the same time, Qianhai was banned from selling new universal life insurance contracts. Several other insurers were warned by regulators. On January 24, 2017, the CIRC declared a package of specified rules on insurance companies’ investment on the stock market. For example, ex ante approval is needed for an investment that make the insurer the holding party of a listed company.
Analysts believe that the recent crackdown actions and warnings of both insurance and securities regulators indicate the boom in universal life insurance is over.
But arguments saying that sometimes stock market barbarians are necessary have also become more common. As Professor Wu Xiaoqiu at Renmin University of China told NewsChina, aggressive investors provide external competition pressure which is a part of the pricing mechanism of the stock market. They also show that the target company’s shareholding and governance structure needs to be improved, he noted.
In her speech on November 26, Wu Xiaoling, chairperson and dean of the Tsinghua University PBC School of Finance, stressed that regulators should stay neutral in hostile takeovers and avoid passing moral judgment. Wu argues that it’s more important for regulators to focus on improving the transparency of market players and coordinating between different regulatory organizations. She believes court cases are the better way to achieve all the necessary balances including between improving corporate efficiency through hostile takeover and the stability of corporate governance, between the interests of shareholders and the company as a whole, and between protecting management and preventing them from acting in their own interests. Regulations alone, she argues, can hardly cover the range of possibilities.
Whether regulators stand aside or step in, the power of stock market barbarians in China won’t fade away overnight. In a new and highly volatile financial environment, sketchy financial moves are always going to occur. But perhaps the arrival of the barbarians also signifies the start of a new era.
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