HONG KONG  - A green light for Chinese buyers is a red flag for shareholders. The country’s securities regulator just lifted restrictions that restrained unprofitable listed companies from pursuing acquisitions. That might help fragmented industries consolidate, but also invites abuse.

As China’s $14 trillion economic engine decelerates, intense competition keeps eroding profit. Excess investment and local protectionism have saturated sectors like robotics, retail and automotive. A cleanup may already be underway. The number of domestic M&A deals has grown 12% in the first half of 2019, according to consultancy PwC, even as the overall count shrank because of curtailed overseas activity.

There are more than 350 companies trading in Shanghai and Shenzhen that lost money in 2018, according to a Breakingviews analysis. They include state telecoms operator ZTE and plenty of carmakers. These companies held a combined $60 billion of cash and equivalents in the latest quarter. The rule change on Friday by the China Securities Regulatory Commission makes it easier for them to buy rivals, or alternatively to snap up promising start-ups in areas like biotechnology.

This new freedom could enable unwarranted empire building or ill-conceived sprawl. It is all too easy to imagine chief executives in heavy industries with too much capacity chasing targets in faster-growing, unrelated targets, spawning yet more incoherent Chinese conglomerates.

Another big risk is bosses taking advantage of liberalisation to foist companies owned by friends, family or even themselves onto shareholders at inflated prices. In 2018, for example, Fosun Group founder Guo Guangchang sold his personal stake in matchmaking site Baihe Jiayuan back to subsidiary Fosun International for a toppy $600 million. Its stock price has fallen nearly 30% since.

The biggest problem is the financial condition of newly unshackled acquirers. All but two in the group screened by Breakingviews have negative free cash flow. On average, the net debt to equity ratio is 200%. Worse, many of them are backed by local governments that resist any move to reduce headcount or otherwise cut costs. Injecting potentially weak assets into companies unable or unwilling to find efficiencies would destroy value; if the scale of such deals is large, they could drag down benchmark indexes. In this case, it’s more beware the buyer.

CONTEXT NEWS

- The China Securities Regulatory Commission said on Oct. 18 it scrapped the net profitability requirement in merger and acquisition deals involving publicly traded companies. The restriction had made net income a consideration in applications by listed companies seeking to restructure via acquisition, alongside operating income, net assets and outstanding shares.

(Editing by Jeffrey Goldfarb and Katrina Hamlin)

© Reuters News 2019