PE Valuations and Arbitrage in China

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BY QUINN CAMPBELL

The Center for China & Globalization believes China will be the world’s largest source of foreign direct investment by the end of this decade. According to the think tank’s 2015 report on Chinese enterprise globalization, China’s annual direct investments overseas will reach $367.3 billion by 2022, surpassing the United States around the year 2020. Premier Li Keqiang added fuel to fire in November 2015 by stating that China is likely to invest more than $1 trillion overseas over the next five years.

Given the unprecedented growth in China’s outbound direct investment over the last few years, Li’s claims are not hard to believe. According to data from the Ministry of Commerce, Chinese outbound investment grew by more than 16% in the first 10 months of 2015. At this pace, total outbound investment for 2015 will be approximately $115 billion. Assuming a constant growth rate of 16% over the next five years, China’s total outbound investment from 2016 to 2021 will be about $917 billion — well within reach of Li’s $1 trillion claim. Using a constant growth rate is also very conservative.

There are a number of forces driving China’s investment growth, but I want to focus on one area in particular: outbound mergers and acquisitions by China-listed companies. While almost non-existent currently, this area is expected to pick up in the next three to five years for two reasons: the China Securities Regulatory Commission recently announced plans to ease the approval process for Chinese-listed firms to acquire foreign assets, and there are persistently high price-to-earnings valuations on China’s stock markets that have created an arbitrage opportunity for publicly-traded Chinese companies.

The CSRC is the main regulator of the securities industry, and is essentially China’s equivalent of the U.S. Securities Exchange Commission. All potential mergers and acquisitions deals that involve a Chinese-listed firm must be approved by the regulator, which has been a sticking point for potential outbound investment deals. The goal of the proposed changes is to make the acquisitions by Chinese-listed companies easier and faster. The proposed changes will open China’s doors just wide enough to introduce a large and attractive pool of potential Chinese buyers for foreign firms. Therefore, we can expect Chinese outbound mergers and acquisitions to further increase in the short-term.

When these Chinese-listed firms finally purchase foreign companies, they are going to find a pleasant arbitrage opportunity due to different price-to-earnings valuations. The price-to-earnings ratio is the most widely used measure to determine a public company’s value. It shows how much money investors are willing pay for a claim to $1 (or 1 RMB) of the firm’s earnings. In a free-market scenario, price-to-earnings ratios should be the same everywhere, even across borders. However, tight capital controls in China lead to persistently high price-to-earnings valuations on the Chinese stock markets. For example, let’s say there are two identical companies, one listed in New York and one listed in China. If the company in New York is worth $1 million, then the company listed in China would be worth $1.1 million.

Therefore, if the two companies merged and traded as one company in China, the combined firm would have a value greater than the sum of the values of the two individual firms. This is arbitrage. Although this is an oversimplified example, in principle it describes the real comparative price-to-earnings ratio scenario that currently exists. Once Chinese stock market regulators make it possible for firms to participate in outbound mergers and acquisitions, they will go crazy buying up foreign firms to take advantage of this arbitrage.