HK Stock Privatization Sparks Investment Opportunities

The successful implementation of the privatization of Hong Kong-listed companies hinges on a key factor: the concentration of the company's equity structure. Additionally, the transaction price should be significantly lower than that of comparable companies in the A-share market, to the extent that the controlling shareholders believe the current stock price does not accurately reflect the company's intrinsic value. Such companies typically have a strong internal drive to push forward the privatization process, thus becoming potential high-quality investment targets for privatization.

In recent years, the persistent downturn in the Hong Kong stock market has led more and more Hong Kong-listed companies to opt for privatization. For these companies, the low trading volume of Hong Kong stocks and the stock price that fails to reflect their intrinsic value, along with the constraints on the capital market financing capabilities of the controlling shareholders, mean that the cost of maintaining a listed status may outweigh the benefits of being listed.

Since 2024, 26 Hong Kong-listed companies have announced privatization plans. As of June 13, 2024, eight have been completed, with 18 companies still in the process of privatization. This may provide potential investment opportunities for investors.

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How to Participate in Privatization Investments

The first way to participate in privatization is to predict and lay out in advance companies with privatization potential based on some objective conditions. The advantage of this method is that it allows for full enjoyment of the privatization premium. An excessively high premium can significantly increase the company's financial burden, affecting the benefits of its privatization, while a premium that is too low may cause dissatisfaction among minority shareholders, thereby increasing the risk of opposition to the privatization plan and reducing the likelihood of success. According to a research report by CICC, the average premium for privatization cases in the Hong Kong stock market in 2023 reached 29%. For example, the paper industry giant Vinda International offered a price of HKD 23.5 per share. If investors had already held the stock before the preliminary plan was announced, then the privatization would at least bring a premium of 20%.

The second method is to participate from the secondary market after the privatization is officially announced. Typically, the stock price soars on the day the privatization is announced, and then the stock price usually converges further towards the offer price, but there may still be some investment opportunities. Taking the ongoing Asia Cement (China) as an example, on June 13, the company's stock price was HKD 2.88 per share, and the privatization offer price proposed by the controlling shareholder, Asia Cement Corporation, was HKD 3.22 per share, with a profit space of 11.8%.

Looking at the time limit for privatization, past privatization cases in the Hong Kong stock market show that from the company's announcement of the privatization offer to the final completion of the privatization and delisting, it usually takes 3-6 months. If the privatization of Asia Cement (China) takes 4 months, then buying the company's stock in the secondary market now, the annualized return rate after a successful privatization may exceed 35%.

Risks of Participating in Privatization

However, both of the above investment methods carry certain risks, which stem from the failure of the privatization to pass, potentially leading to a decline in stock prices. Among the 51 companies that announced and completed privatization in 2023, five companies ultimately declared the failure of privatization, and once the privatization fails, it may trigger a decline in stock prices. For example, on October 18, 2023, the resolution of Junzhi Group was not approved by the plan shareholders at the court meeting, and the closing stock price fell by 21.74% on the same day. The stock price of another failed company, Anning Holdings, was even lower than before the announcement of privatization.Private equity transactions in Hong Kong stocks typically employ two methods: tender offers and scheme arrangements. The former refers to the controlling shareholders extending an offer to purchase shares to non-controlling shareholders of a listed company. If the acquisition reaches a certain percentage of shares and meets other conditions, the company can apply for delisting. The latter involves the controlling shareholders requesting the company to propose a scheme arrangement, suggesting the cancellation of all shares held by minority shareholders, and paying a consideration to the minority shareholders in exchange. If the scheme is approved, it becomes binding on all shareholders.

In either case, it is necessary to comply with the regulations of the jurisdiction where the listed company is registered, as well as the requirements of the Hong Kong Stock Exchange's "Takeovers, Mergers and Share Buy-backs Code," including shareholding percentages and other stipulations. For instance, a company registered in Hong Kong that intends to privatize through a voluntary tender offer must meet the local company law requirement that "when the offeror purchases more than 90% of the shares without a conflict of interest, a notice can be issued to fully acquire the minority shareholders' shares." Additionally, it must satisfy the three conditions of the Stock Exchange's voluntary offer: "the number of votes in favor of the resolution is not less than 75% of the shares held by shareholders without a conflict of interest present at the meeting; the number of votes against the resolution does not exceed 10% of all shares without a conflict of interest; and the offeror exercises the right to compulsorily acquire securities."

These conditions form the threshold for a successful privatization and also increase the risk of failure. Taking Asia Cement (China) as an example, its stock price inexplicably surged by more than 50% in the two trading days before the privatization announcement. The privatization price proposed by the controlling shareholder of HKD 3.22 was not only not a premium over the closing price before the suspension but was also a discount of about 3%, which may lead to opposition from many minority shareholders. If investors bought at a price below HKD 2 before the privatization announcement, there is still a certain margin of safety, and even if the privatization fails, the possibility of investor losses is not significant. However, if investors bought in the secondary market after the privatization announcement, even with the aforementioned profit space of 11.8%, the failure of privatization could lead to a loss of principal.

How to Screen for Privatization Targets

Whether to obtain sufficient support from minority shareholders is key to the success of privatization and also the most potential obstacle. The measure to guard against risks is to fully assess the controlling shareholders' motives for privatization, price, and difficulty.

When selecting a target company for privatization, a key factor is the concentration of the company's shareholding structure. A highly concentrated shareholding structure, such as a controlling shareholder holding more than 60% or even a higher percentage of shares, has a significant advantage for the implementation of privatization. This structure not only reduces the overall cost of the privatization process but also, due to the controlling shareholder's significant influence in decision-making, it significantly increases the probability of the privatization proposal being approved at the shareholders' meeting. This provides a solid foundation for the smooth progress of the privatization transaction.

Of course, the ideal target company for privatization should have a significant price gap compared to comparable companies in the A-share market, with key valuation indicators such as price-to-earnings (P/E) ratio and price-to-book (P/B) ratio significantly lower than the industry average, so that the controlling shareholders believe that the current stock price does not truly reflect the company's intrinsic value. Such companies usually have a strong internal motivation to promote the privatization process and thus become potential high-quality investment targets for privatization. To ensure the smooth progress of the privatization process, the controlling shareholders must also have strong financial strength and resource integration capabilities, which means that a high debt ratio may be an obstacle to the privatization process. In addition, in many cases, the holding company has multiple listed platforms, which means that the undervalued Hong Kong-listed platform may no longer have significant strategic significance.

A category of enterprises deserves special attention, which are the subsidiaries of central enterprises listed in Hong Kong. Market value management may become a catalyst for the privatization of subsidiaries of central enterprises listed in Hong Kong. In 2024, the State-owned Assets Supervision and Administration Commission (SASAC) pointed out the need to fully implement the market value management assessment of listed companies, to quantify the evaluation of the market performance of central enterprise-controlled listed companies, and to guide enterprises to pay more attention to intrinsic value and market performance.

There are more than 100 central enterprise groups and subsidiaries listed in Hong Kong, and central enterprise market value management will bring many opportunities for valuation restructuring and privatization investments. With the evolution of assessment indicators and strategic directions of central enterprises and state-owned enterprises, the major shareholders, parent companies, or management of central enterprises and state-owned enterprises have begun to pay more attention to key financial indicators such as stock price, shareholder returns, and net profit attributable to the parent company. This shift has stimulated qualified central enterprises to adopt strategies such as privatization and delisting to optimize shareholder value and improve enterprise efficiency, and a wave of central enterprise privatization and delisting in the Hong Kong stock market may arise. For some central enterprises listed in Hong Kong with low valuation and inactive transactions, after privatization, central enterprises may raise funds through other means or markets to obtain funds at a more reasonable valuation, which is conducive to enterprise development and market value management.

If investors choose to lay out in advance for companies with privatization potential, they need to fully consider the possibility of the company having a privatization plan. In this case, it is best to choose a value-based investment strategy, which requires the listed company to have a stable fundamentals and undervalued prices, so that investors can hold them long-term with peace of mind even without privatization. Under this approach, subsidiaries of central enterprises with good performance and low valuation may be a suitable investment target. Taking China Traditional Chinese Medicine (CTM) as an example, in February 2024, the first major shareholder of CTM, which announced privatization, is the central enterprise China National Pharmaceutical Group (Sinopharm). Sinopharm acquired at a premium of 34% per share, with a total acquisition amount of more than HKD 15 billion. According to the mid-2023 report, CTM achieved a revenue of RMB 9.303 billion, a year-on-year increase of 57%; and a net profit of RMB 579 million, a year-on-year increase of 40%. However, if investors wish to buy in the secondary market, they should participate cautiously, paying more attention to fundamentals and seeking a higher margin of safety. After all, if the privatization fails, the potential decline in stock price may exceed the current potential price difference gains of 7.48% in the secondary market.