Go into a casino and you have only yourself to blame if you leave with empty pockets. It’s much the same if you’re an equity investor in Asia, the U.S., or Europe.

But that simple risk/reward equation goes haywire when you put your money into a subsidiary owned by some of the best-known companies in Hong Kong. Invest in these family- held conglomerates and you have to kick yourself twice. The first for what you lost, knowingly. The second, for what the owners did with your money — but didn’t bother to divulge.

Indeed, corporate stewards can treat minority shareholders worse than punters at a casino without fear or sanction. While most of these practices go unnoticed by investors, they are not completely hidden from view. In-depth research of public documents shows how the flow of money and questionable dealings keep Hong Kong from attaining top marks for corporate governance in Asia. Recent research from the Chinese University of Hong Kong’s (CUHK) Department of Finance, for example, shines a harsh light on the activities of $487 million-in-revenues Wheelock, the parent of Wharf Holdings. The public documents of another well-known Hong Kong company, New World Development, make for equally interesting reading.

Both of these Hong Kong conglomerates primarily make their money in real estate. Wheelock built and operates major projects for Hong Kong’s Mass Transit Railway. New World constructs high-rise residential developments. But research conducted by CUHK’s Department of Finance and CFO Asiashows that managers at both companies often make their riskiest investments through their publicly listed, associated companies — not through their family-owned, parent companies. In essence, they appear to treat minority shareholders as second-class citizens, using them as buffers against loss stemming from risky investments.

Companies associated with Wheelock, for example, engaged in intercompany lending at little or no interest, siphoning cash that might have been used for more rational growth strategies. In the case of $3.1 billion-in-revenues New World, there appears to be a big difference between the investments made by the owner’s privately held vehicle and the risky and disastrous investments made by subsidiary New World Infrastructure.

Management at Wheelock rejects the findings of the CUHK report, calling them flatly wrong. While the figures are correct, notes Kevin Hui, group chief accountant at Wheelock, the conclusions drawn from them are misleading. He argues that all associates of Wheelock have an equal stake in the joint venture projects for which the loans were made, and therefore stand to reap equal reward for their share of risk in the ventures. (Henry KS Cheng, CEO at New World Development, and Fergus Chow, CFO of New World Infrastructure, declined to be interviewed for this story.)

Just Send Money

Despite these protestations, public records show that shareholders of the two companies have suffered mightily on their investments over the past four years. Wheelock’s share price has fallen to HK$6 (US$0.77) from HK$23 in 1997. In the same period, the price of New World shares dropped like a rock, down to HK$6.3 from a high of HK$68 in 1997.

Admittedly, all real estate companies in Hong Kong have been hit hard in the past five years. But few have fared as poorly as Wheelock and New World Development. For example, the stock price of Sun Hung Kai Properties, the real estate arm of the Hong Kong conglomerate Sun Hung Kai, has lost about 50 percent of its value in five years. By comparison, an investor who put HK$100,000 into New World Development in 1997 would be holding HK$9,265 today.

To be sure, owners of the associated companies lose on their investments as well. But the ownership structures of their companies shield them from downside risk and allow maximum return if the stock price rises. Indeed, if the share price of an associated company looks as if it’s rebounding, the owners will often offer a buyback at a discount to asset value.

Wheelock has done this repeatedly. The company is owned by Hong Kong tycoon Peter Woo and his family. Woo owns 61 percent of Wheelock, which in turn owns 100 percent of Wheelock Properties and 48 percent of Wharf Holdings, both major Hong Kong real estate developers. Beneath these two powerful companies are many smaller ones, with many subsidiary suppliers, servicers and builders. Three of these, New Asia, Realty Development, and Harbour Centre, are at the lower end of Wheelock’s control chain. But transactions over the past three years suggest that these companies, plus Wharf, take a larger proportionate share of risk in major real estate projects than the parent company. Basically, says CUHK Professor Larry Lang, “they’re used as automated teller machines to provide cash for the company’s larger projects.”

The projects in question: three developments in and around Hong Kong. The ownership of each project is divided equally among Wheelock and its associates. For instance, a project begun in 1997 called MTRC Kowloon Station Package Two is being jointly developed by Wheelock plus Wharf, Harbour Centre, New Asia, and Realty Development, each of which has a 20 percent stake in the investment.

A large portion of the funding for the project, however, did not come from Wheelock, which has the deepest pockets. Instead, the capital came from Wharf and its subsidiary Harbour Centre, as well as from New Asia and its subsidiary Realty Development. These loans totaled $389 million in the fiscal year ending June 1999 and $555 million in the fiscal year ending 2000.

According to Hui, Wheelock’s group chief accountant, the loans were made to the joint ventures themselves, not directly to Wheelock. Hui also states that all companies in the joint venture benefit from the project equally. But the CUHK researchers disagree, arguing that the loans went to Wheelock because it was the majority owner of each of the joint venture projects. They note that: “As disclosed in notes to the accounts … Wheelock was the only net borrower, whereas Wharf, New Asia, Realty Development and Harbour Centre were the net lenders …” Their point? The funding — and the risk — fall on the shoulders of the smaller companies — and all the benefits of the projects accrue to Wheelock.

Nice Rates If You Can Get ‘Em

Granted, intercompany lending is hardly a sin in itself. But the arrangement must be beneficial to both the lender and the borrower. A cardinal rule is that interest rate should not be so low as to impose a harsh opportunity cost on the lender. If the rate is too low, the lender could have done better putting its money elsewhere.

The annual reports of Wheelock’s associates in the joint ventures say that interest for intercompany loans was determined by shareholders of associated companies “with reference to” prevailing market rates. The authors of the CUHK report estimate that interest charged in 1998/99 averaged out at 8.84 percent. This is a reasonable rate, given that the prime rate that year stood at 8.5 percent.

But for the 1999/00 period, the estimated rate, at 2.8 percent, is a lower coupon than the International Monetary Fund would offer to a state-run project in Bangladesh. Notes to the annual report do explain why this figure is so low: About half of the loans were offered without any interest. “It’s obvious,” the CUHK report alleges, “that the interest received by the subsidiaries was generally not justified in terms of the risk to which the lending companies [were] exposed.”

The story doesn’t end there. With the exception of Wharf, the loan amounts seem disproportionately large for the asset sizes and market caps of the companies doing the lending. Loans in 1999 for the MTRC project from Realty Development to the joint ventures, in one example, amounted to 18 percent of Realty’s total assets — and 60 percent of its market cap at year-end. New Asia’s total loans to Wheelock for the projects for the same year amounted to 21 percent of total assets and an astounding 157 percent of the company’s market cap.

There are ample reasons why the parent company would choose these associates at the bottom of the control chain to conduct the lion’s share of its intercompany lending. They have thin trading volume, high levels of liquidity, and significant market discounts in comparison to their competitors, the report notes. The current assets of these three subsidiaries are mainly bank deposits and stock investments. “By maintaining a high level of liquidity,” the report says, “it is easier for the controlling shareholder to extract funds from these subsidiaries.”

In the meantime, the minority shareholders of these companies have been left in the dark. What’s more, these publicly listed companies now have uniformly low trading volume. Monthly turnover in March 1999 of the Harbour Centre was HK$9 million, and Realty Development HK$7.3 million — low activity compared to other companies in their sector.

This minuscule trading volume reflects the greater market discount of these companies in comparison to their peers. New Asia’s market cap at end-1999 was HK$2.7 billion, or 14 percent of its net asset value of HK$19.4 billion. Great Eagle, a comparable Hong Kong property development company, had a market cap of HK$5.5 billion, or 34 percent of its net asset value of HK$9.7 billion, in the same year. “Thin trading volume and significant higher market discount,” write the authors of the CUHK report, “are the implicit and explicit costs embedded in holding these shares.” They continue: “In other words, the market is efficient enough to properly reflect these improper arrangements.”

Investors can only guess at the ultimate rationale for using — as the research alleges — companies at the lower end of the control chain as ATMs at the expense of share price and minority shareholders. One reason suggested in the CUHK report is that by weakening the companies, Wheelock might seek to gain control of these subsidiaries. By increasing its shareholdings gradually, Wheelock could then resell or redevelop the subsidiaries’ assets for their true market value.

In fact, several times in the past two years, rumors floated in the market that Wheelock was going to buy back its subsidiaries. The latest was this summer, when directors of Hong Kong’s Wheelock Corp., the majority owner of Wharf Holdings, flirted with privatizing some of its smaller real estate assets. The rumors flew that Marco Polo and New Asia, two development companies, would be bought by the majority owners, driving the stock price up 7 percent.

But suddenly, the company announced that there would be no deal. The retreat was telling. Perhaps New Asia’s long-suffering shareholders saw a glimmering of hope of recouping some of their investment. Newspaper reports suggested that Wheelock had lowballed the buyback and that the rise in share price made the minority shareholders defiant enough to hold out. Apparently, Wheelock simply backed off.

New World Order

One reason that Hong Kong companies can engage in such dubious intercompany lending is that disclosure rules in Hong Kong make it difficult for investors to receive information on corporate maneuvers in time to take action. “The system is designed to make it difficult for minority shareholders to be aware of, much less respond to, actions that they might want to fight,” says David Webb, an independent shareholder activist and founder of Webb-site.com. Under Hong Kong rules, shares are not held under investors’ names, but through their brokers under the name of HKSCC Nominees, the local clearing company. That means that shareholders do not automatically receive annual reports and proxy statements, and cannot vote at shareholder meetings.

The system almost invites companies to treat minority shareholders cavalierly. Therefore, investors must have taken the following statement by New World Development on September 18 with a dish of salt: “The Company noted the recent decreases in the price of the shares of the Company,” the announcement on the Hong Kong Stock Exchange Web site read, “and wishes to state that the Company is not aware of any reasons for such decreases.”

This comment was issued midway through one of the sloppiest sagas of corporate disclosure in Hong Kong’s recent history. A confusing series of developments before June 30 earnings were officially released sent New World’s share price into a tailspin. In a rare move, Goldman Sachs and Morgan Stanley both released statements complaining of management’s lack of reliable information (analysts from either bank would not comment on the company). Earnings turned out to be far worse than expected, due largely to lower than expected investments in China made by New World Infrastructure, a subsidiary. Salomon Smith Barney analyst Rachel Tong noted that New World’s earnings came in 37 percent below her estimates. Gearing for New World was 47 percent for the fiscal year ended in June 2001, down only 1 percent from the previous year. Analysts expected New World to be able to retire some of its debt and lower its gearing via asset sales. But the asset sales proved not to be enough to do more than maintain a shaky financial position.

“In New World Infrastructure,” says Bill Mok, analyst for ING-Barings in Hong Kong, “the gearing is over 50 percent. The highest priority is to reduce the debt, but we didn’t see it in the latest [earnings] report.” Mok also says it’s essential that New World Infrastructure not borrow any more, and refinance some syndicated loans.

Nothing like this financial turmoil is in evidence, though, when it comes to the Cheng family’s investments through Chow Tai Fook, a wholly owned family company which owns 37.5 percent of New World Development. Last December, Hong Kong real estate developers Joseph and Thomas Lau bought a 450,000 square foot commercial building in Causeway Bay from Sogo department store for $272 million. The Cheng’s Chow Tai Fook purchased a 50 percent equity stake in the building at a price slightly higher than $226 million. Cheng Yu-tung, chairman of New World Development and the most powerful Cheng family member, announced that the Sogo building would generate a rental yield of about 9 to 10 percent per year.

Why wasn’t this sound investment made through New World Development? At the time, Cheng explained that it was because Chow Tai Fook had about $800 million in cash on hand, whereas New World was dogged by mounting debts. “Does that imply that Cheng adopts a conservative and sensible investment strategy with his own pocket but is less careful in using shareholders’ money?” asks CUHK’s Larry Lang.

Chow Tai Fook certainly reaps the benefits of New World’s transactions. Shortly before New World’s earnings flap this September, the company told J.P. Morgan analyst Raymon Ngai that payouts to Chow Tai Fook resulting from the sale of its Regent Hotel property in Kowloon would be about half that anticipated. New World sold the Regent to the InterContinental Hotel chain for $348 million last May.

As part of the deal, New World had to buy out Chow Tai Fook’s 27 percent interest in the hotel. As previously announced, that stake was estimated at $80 million. In August, when the extent of New World’s troubles began to leak into the market, the worth of that stake was revised down to $40 million. The lower sum will allow New World to shore up its fiscal year 2002 earnings. But it begs the question: Why was New World paying an inflated price to begin with?

The company declined to comment, and analyst Raymond Ngai declined to comment on New World.

Tom Leander is the deputy editor of CFO Asia, based in Hong Kong. The CUHK report cited in this article was written by Professor Lang’s graduate students Aaron Leung, Samuel Poon, and Richard Yeung.

For more articles on finance and technology in Asia, see www.cfoasia.com.

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