Investment banking: Foreign firms make their moves in China

After years of speculation, disappointment and frustration, foreign investment banks are finally in a position to make decisive moves in their onshore China businesses.

On Christmas Eve, 2018, UBS completed a transaction to lift its stake in UBS Securities from 24.99% to 51%, becoming the first foreign bank to gain majority control of a securities joint venture in China. 

(HSBC Qianhai Securities, which is up and running near Shenzhen, is seen as a special case, having been granted its licence under the Closer Economic Partnership Arrangement rules governing free trade between China and Hong Kong, where HSBC is largely funded. Bank of East Asia’s partnership, East Asia Qianhai Securities, falls under the same rules.)

Also in December, Citi told its own partner in China, Orient Securities, that it intended to sell all of its shareholding in their joint venture, Citi Orient Securities. It will instead seek a new partner for a majority-owned securities JV.

Others are working their way through the regulatory process. Nomura and JPMorgan applied for approval for new ventures within days of UBS doing so in May 2018; JPMorgan had already exited a previous joint venture in expectation of the change of regulation. Morgan Stanley and Credit Suisse are on the way to gaining majority control of their ventures.

Goldman Sachs, like UBS, was allowed to build something distinctive and experimental ahead of the formal JV rules being announced in 2007. It now faces the most complicated bureaucratic task of any of the banks in getting to a simple majority-owned JV structure and may yet wait until it can own all of it before proceeding.

Meanwhile some new entrants who never previously had JVs, such as Macquarie, are rumoured to be trying to set up their own ventures.

HSBC and CLSA/Citic Securities aside – UBS is the one that has stolen a march. UBS was always distinct in its China investment, holding a stake in a domestic securities firm rather than a formal joint venture like those that followed, and its attainment of a majority position follows 14 years of history. 

UBS’s circumstances were unique from the outset. In 2005, a municipally owned securities firm called Beijing Securities ran into trouble. The mayor opted against the usual way of dealing with problematic state-owned enterprises, namely injecting capital to bail them out. Instead he decided to try something different – identify an international investment banking firm to be part of a restructure, giving the foreigner a minority position but management control.

The theory was that the foreign house, seeking a long-term commitment to the market, would bring with it international best practice on things like risk management, which had clearly been lacking before.

UBS originally came in alongside the State Development Investment Corporation of China (SDIC) and Jianyin, a China Construction Bank spin-off subsequently folded into what became the national sovereign wealth fund. With them was a state-owned group called Cofco and the original municipal holding vehicle, making five backers. At the time, the foreign ownership limit for single foreign shareholders was 20%, with IFC then coming in to hold a further 4.99% on UBS’s behalf.

In practice, UBS was allowed to forge its own path, with the other partners being primarily focused on the financials rather than the management, and in time the venture was renamed UBS Securities. In 2015, UBS was permitted to go up to 24.99% ownership, and then Shanghai started a free trade zone within which foreigners could go to 49%.

UBS began discussions with its partners about whether or not any of them wanted to sell and, while in the process of discussion, things changed again: on April 28, 2018, it was announced that foreigners could go to a majority holding, 51%, nationally.

With its discussions already so advanced with its partners, UBS was immediately ready to submit under the new rules and did so just days later, on May 2, closely followed by Nomura and JPMorgan, both of which will be building new ventures from scratch (in JPMorgan’s case having abandoned its previous venture).

Approval from the China Securities Regulatory Commission (CSRC) came in November. Since December 24, UBS is officially the majority shareholder. In the meantime, other partners have come and gone, and the others today are Beijing Guoxiang Property Management with 33%, Guangdong Provincial Communication Group with 14.01% and China Guodian Capital Holdings with 1.99%.

On the face of it, the increased shareholding makes little practical difference; UBS Securities can do the same things now it could before. But there is more to it than that.

“Our enhanced shareholding means more economic interest,” explains Eugene Qian, president of UBS Securities. “Every dollar we put in, we used to get back only 25%. Now we get 51%.”

Beyond the economics, stepping up leads to a greater alignment between the venture and UBS more broadly. It also looks good.

“It was a long-term strategic objective to move to majority ownership,” says Axel Weber, chairman of the board of UBS. “The outside signal of that, and the recognition of our history, and being the first bank to be granted that status, is important.”

That’s more than just a matter of bragging rights. Ventures like UBS Securities have to ask for things from regulators, and will speak more clearly as an instrument of UBS now there is ownership control.

“In issues like QDII [Qualified Domestic Institutional Investor] and QFII [Qualified Foreign Institutional Investor] quota, we can more credibly ask for more quota with the majority ownership structure,” says Weber. “It gives us a stronger negotiating hand being a majority owner.”

Last April’s announcement that foreigners could take majority positions was widely welcomed, but an often-overlooked point is that for it to happen, the local party had to be willing to sell.

“For us it was very easy,” says Qian.

UBS pre-dated the Sino-foreign joint venture rules, which came out in 2007, requiring the partner to be a local securities firm. This was the case when Credit Suisse launched the first such firm with a 33% stake shortly thereafter, partnering with Founder Securities.

“We didn’t have to do that,” says Qian. “We bought into a securities firm rather than having to partner it.

“It’s hard to imagine how you ask a Chinese domestic firm, in their own turf, to give up 51% when many of them have become listed A-share companies. It would be against their shareholder interest. But for us, from day one, the partners, none of which are engaged in financial services, are always passive in their nature, who never intended to run UBS Securities anyway.”

For others, it was not so straightforward. Citi, for example, was in one of the more successful joint ventures, Citi Orient Securities, launched with Orient Securities in Shanghai. Part of the problem for Citi was that the brokerage licence resided within the parent, not the JV, and under rules only one financial entity can ever hold that licence. Citi asked Orient if it was prepared to transfer the licence to the JV and sell a stake to give Citi management control. Not unreasonably, Orient, which is a listed company with its own ambitions, declined.

And so they went their separate ways. 

“On the back of recent regulatory changes, Citi wants to pursue ownership of a domestic JV with a wider scope of business across banking and markets to support our clients in China,” says Citi in a statement. “As a result, Citi and Orient Securities have mutually agreed to end the JV.”

Orient will buy out the stake, which at current market value should cost about $50 million, but since Citi has been accounting for the gain year-by-year, there will be no one-off boost from the sale and the amount is not particularly big.

Instead, Citi is now seeking a partner.

There is a tendency to assume that new partners for Sino-foreign JVs will be sourced from the many entities in China that already hold a brokerage or underwriting licence, ideally both. These are plentiful: the Securities Association of China surveys 131 brokerages. Partnering with one of these means the licences are in place and the venture is ready to go once it is approved.

But Euromoney understands that this will not be the route Citi – and others in a similar situation – will take. The problem with going that way is that there is no clear path to 100% ownership, nor to the foreign partner having complete management control. If you can find a licensed brokerage in China with an established business, would it be willing to surrender not only management but its entire equity ownership within a few years?

Instead, the preference is to look for something greenfield with a clear path to taking 100% ownership when regulation allows.

“I think every bank is looking at this the same way,” says one banker. “Regulators have already given us the roadmap to 100% – with not too long to wait – so why wouldn’t you want 100%? And, therefore, you want a passive easy partner who will let you get there.

“The alternative is if an established partner brings a lot of strategic value,” the banker continues. “That sounds nice, but it’s tough. We, like the other banks, run an integrated business within countries and within regions, and want our onshore China business to be as integrated as possible. For that you need a green-field startup with a passive partner.”

Doing it this way means that the venture, once approved, would need to apply for new licences from scratch. That makes it a very long-term game. Wherever Citi is at in talking to potential partners, it would be a great surprise to see a venture licensed and operational in anything less than 18 months; two years is probably more realistic.

The CSRC has so far licensed only one venture – UBS – since the rule change in April, even though three applications (the others being Nomura and JPMorgan) were lodged in May. It is not in a rush.

When Citi does put its venture together, one would expect it to start out by applying for brokerage and underwriting licences, and then later bolting on others such as those for futures trading and commodities.

Like most banks, Citi hopes to replicate what it can do in Hong Kong or New York onshore in China. In order to do so, it accepted it had to make a backward step, backing out of a minority stake in a reasonably successful partnership and starting afresh.

It is not the first to do so. Morgan Stanley sold its stake in CICC partly because there was no path to control of that business and because it could not start a new venture without exiting the first one.

More recently, JPMorgan ended its association with First Capital Securities in 2016. Chief executive Jamie Dimon said at the time that the bank remained committed to China and would re-enter with the right domestic partner.

One senses that Dimon either knew what was coming in regulation or had great faith that it would happen eventually. JPMorgan was extremely quick off the mark when the rules changed in April, putting in for approval from CSRC within days.

Little is known about JPMorgan’s plans, but they are thought to involve more than one partner, which would cement the US bank’s dominance of the venture. This may prove to be a commonplace approach. It is thought that Macquarie, for example, is putting together a venture in a similar way.

This makes some sense. CSRC put out a consultation suggesting a different set of qualifications for investors according to the stake that they were taking – so a 51% shareholder would have different requirements to a 25% shareholder, which would be different again to a 5% shareholder. While it is understood these rules have never been enacted, it does suggest that having a number of smaller shareholders widens the field of potential partners rather than just looking for one to take 49%.

“There is some benefit in having smaller shareholders,” says one banker, not at JPMorgan. “If the objective is to take them out in a few years and for them to be passive, it is easier to take 5% or 10% each rather than have one person with 49% who, by definition, has to be more involved in your business. I think that could be a common scenario.”

Once approved – it is still with CSRC at the time of writing – it will then start applying for the licences, starting with brokerage and investment banking, to allow JPMorgan to offer a fully functioning investment banking capability (it is not thought to be seeking to do onshore private banking at this stage).

Lacking detail, the market has been looking for clues. The fact that the US bank has just signed a lease with Shanghai Tower, the tallest building in the city and the second-tallest in the world, clearly suggests that is where the venture will be based.

Mark Leung, chief executive of JPMorgan for China, says the move “enables JPMorgan to consolidate all our Shanghai-based employees into one excellent location.”

The lease covers more than 10,000 square metres of the tower, which is room for more people than they have there right now.

The other bank that was extremely quick to get an application in after the rules changed was Nomura. It is also thought this may involve multiple partners, but Nomura is not saying much about it.

“We have applied to set up a securities venture in China,” the bank told Euromoney in a statement. “We are currently discussing the details with the relevant parties.”

Two others appear to have a reasonably clear path to control of their ventures once approval is granted.

Credit Suisse owns 33% of its joint venture with Founder Securities. Like Orient Securities, Founder is listed in China; unlike Orient, it appears to be happy to allow Credit Suisse to take control of the venture. 

In June, it said it would allow a capital raising within which Credit Suisse would participate but Founder would not, with the effect of bringing the Swiss bank to majority control. The parties are just waiting for approval to do so, the application apparently having been made on June 16.

The venture already has its original licence, for primary market underwriting (commonly called the investment banking licence), and subsequently gained one for brokerage; an A-share brokerage business was launched in November 2016. Its asset management joint venture with ICBC is separate.

Then there is Morgan Stanley, which holds 49% of its joint venture with domestic partner Huaxin Securities. In September, it was reported that the joint venture would hold a public auction for 2% of its equity, which Morgan Stanley would subscribe in order to achieve majority control.

Again, this is pending regulatory approval but looks very straightforward. The Huaxin joint venture, one of the more recent JVs following Morgan Stanley’s exit of its investment in CICC, seems to have been set up with the clear understanding that the US bank would one day own and run it. The only delay is likely to come from the fact that Morgan Stanley was thought to be the fifth bank to apply, having lodged with CSRC on September 11.

Some are doing little. Deutsche Bank still has its joint venture with Shanxi Securities, called Zhong De Securities, and does not appear to have applied for a majority stake.

Elsewhere, new names are appearing. In December, Macquarie Group was reported to be in advanced talks to create a new majority-owned securities joint venture, working with two Chinese conglomerates. (Macquarie did once announce a planned JV, with Hengtai Securities in 2008, only to cancel it over concerns about management control.)

And then there is Goldman Sachs. If UBS was a special case, Goldman was arguably more special still. Goldman has always had operational control of its venture and, to a greater degree than any other equivalent, has been able to fold it very closely into the Goldman Sachs whole – its letterheads, carpets and invisible things like HR policies are effectively Goldman. (This is not quite the case with UBS Securities, which has always been a distinct entity.)

“It really is unique,” says one former Goldman employee. “It operates like Goldman, and we wouldn’t even call it a JV internally; it was just our Beijing office. It looked the same, we hired the same people, we were all on the same systems, it’s just that on paper somewhere there were complicated transaction agreements that made it a JV.”

The cost of all that, however, was a convoluted structure. Goldman owns 33% of Goldman Sachs Gao Hua Securities in Beijing, with the remainder owned by Beijing Gao Hua Securities, which is controlled by former Goldman rainmaker Fang Fenglei, now very much his own man and a powerful investor and banker on the mainland.

Goldman Sachs Gao Hua only has the investment banking licence; others, including securities trading and private wealth management, are held within Beijing Gao Hua Securities. Although Goldman has always controlled the whole thing operationally, legally, it owns no part of Beijing Gao Hua Securities.

When the new rules were announced, two questions arose in the market.

The first was how difficult Fang would be about selling and what price he would extract for doing so. (Goldman insiders still recall what a tough negotiator their partner turned out to be when they exited their joint venture with Kotak Mahindra in India.)

The second was the licence issue. Since one cannot generally transfer licences from one vehicle to another, how would the licences from Fang’s company end up in the Goldman company?

In practice, Euromoney understands, the first of those has not been an issue. The price, plan and structure are all agreed, and Fang is ready to move on to other things (rumoured to be a retail brokerage that would compete head-on with the likes of CICC).

“The interests are aligned,” says someone close to the matter. “The marriage has served its purpose and both sides want to do different things.”

The bigger issue is that Goldman does not see clarity on exactly how to make progress with the regulator and is inclined to wait until there is a clear path to outright control.

In theory, 100% ownership of these ventures should be permitted within three years of the original announcement, so by April 2021. But the environment – from macro-level concerns like the trade war with the US to more specific worries about frequent changes among CSRC executives – does not allow anyone to be absolutely certain about what will happen and when.

All Goldman is losing in not moving to 51% is the equity participation. Since it has management control already and as much integration with the international business as is permitted, there is not much to be gained in taking a bureaucratically complex interim step if it might be able to go the whole way in one go later.

After all, the process will not be straightforward. If it took regulators the best part of two years to approve HSBC’s green-field JV, how long will it take to decide whether Goldman can move the licensed businesses from Beijing Gao Hua into the joint venture structure and then take a majority stake in that, or whether they will have to seek new licences afresh?

Still, there is nothing to suggest that this is any more than a matter of paperwork and patience, but Goldman should expect to have to employ plenty of both.

Other banks are also looking ahead to the potential for full ownership.

UBS does not intend to automatically push for 100% in two years when it seems it would be permitted to do so.

“For us, it’s a question strategically: do we want to buy out everyone else?” says Qian. “Maybe there are arguments that we don’t need to. The Beijing municipal government is likely to be a long-term partner. We want a much bigger share of a much bigger pie and we don’t necessarily need 100% of this platform.”

Weber agrees.

“We have no plans to push out our partners. Having our partners is useful,” he says. “We are talking about major municipalities, and having partners like these helps with business. It’s good to be in a joint venture with them.”

So, UBS is unlikely to pursue 100% ownership when it becomes possible?

“Whilst we are interested in increasing our stake beyond 51%, we would have to look at the rationale of being wholly owned with no partner,” says Weber. “But given some of the business we do, it does make sense to have partners.”

What could happen – and this is potentially true of many ventures – is that by injecting more capital in order to grow, partners get diluted anyway.

“Building the business onshore will require investment,” says Weber. “If you need to invest in the business, that’s where public partners might be more reluctant to move ahead in sync with you. That might lead naturally to larger UBS ownership.”

For UBS the aim from here is to try to make China look as much like the bank does in the rest of the world: fully capable in investment banking, private banking and asset management. In private banking, in particular, it is aiming higher.

“We want to build the leading high-end, ultra-high net-worth, high net-worth and family office platform in China, because we are number one elsewhere globally and in Asia,” says Qian. “We want to do it onshore in China.”

As usual, UBS will seek synergies between its three businesses – private banking clients who are entrepreneurs and need capital raising services, for example.

However, it will not automatically go head to head with local competitors in the capital markets.

“At UBS, cross-border is the sweet spot,” Qian says. “And we still focus on wholesale institutional. We do not intend to go too mass affluent to have hundreds of retail outlets as our Chinese friends do, offering retail services.

“For certain businesses, which we can’t play to our strength, we prefer to sit on the sidelines.”