Last week, a South China Morning Post article caught the attention of an informal seminar I hold every Sunday evening at my home, mostly for current and former Peking University students and a few outsiders. The article discussed several Chinese companies that are trying to shore up their stock prices by ensuring employees against losses if they buy stock in the company. It reads:
At least 18 mainland-listed companies mobilised employees to buy their shares, and said any losses incurred will be covered by the chairman of the respective companies on condition that the purchased shares are held for at least 12 months.
Companies including Shenzhen Fenda Technology and Hunan Kaimeite Gases cited the need to stabilise the stock market amid “irrational” declines in share prices as reasons for soliciting the support of employees, according to company filings.
In recent times the securities regulator has introduced measures to bolster confidence in the stock market against a continued slide in share prices. The Shanghai Composite Index is down 4.5 per cent from this year’s high in April amid government-led deleveraging in the financial sector.
The article goes on to suggest that investors greeted this offer with mixed responses.
Guangdong Anjubao Digital Technology jumped by the 10 per cent daily limit for three consecutive days after the maker of surveillance camera equipment called on its staff to buy its stock. But oil exploration services provider GI Technologies, which made a similar offer to its employees, dropped 6 per cent during the same period. So far this year, Anjubao is down 25 per cent and GI Technologies has tumbled 19 per cent.
The 18 companies, which are mostly smaller firms trading on the Shenzhen stock exchange, are a bit pricier than their peers. They are valued at an average of 45 times estimated earnings for the year, according to data compiled by Great Wisdom. That compares with the multiple of 40 times for the board hosting small and medium-sized enterprises on the Shenzhen bourse. The SME index tracking the bourse’s 861 smaller companies has fallen 5.1 per cent this year.
EMPLOYEE STOCK PROGRAMS
During our seminar, we discussed what informational content, if any, these programs might provide about financial markets in China.
The devil is in the details, of course, but assuming that these programs can be put into place efficiently, for employees such programs are the equivalent of receiving a free put option for every share they purchase, with the option struck at the price at which they purchased the shares. Share prices for small companies on the Shenzhen Stock Exchange are likely to be very volatile, so these are valuable options. This is a very good deal for employees who decide to buy shares.
We came to several initial conclusions about how these employee stock programs work and about what kind of information we might be able to extract from the ways in which they evolve.
- Because employees receive for free a valuable put option with every share they purchase, except under two conditions, employees should buy as many shares under this program as they can, even if they are generally pessimistic about the prospects for share prices. The first of the two conditions has to do with the return on alternative investments, which mainly means the interest rate on bank deposits. If the bank deposit rate is high enough and the expected volatility in share prices is low enough (I am assuming the dividend rate is zero), the value of the put option employees receive might not be enough to compensate for the foregone interest. This is unlikely to be the case, however, because the deposit rate in most banks is currently about 1.5 percent and Chinese equity markets, especially share prices for small companies on the Shenzhen Stock Exchange, are very volatile.
- The second of the two conditions has to do with the credibility of the put option. There cannot be substantial risk that the writer of the put option will be unable to pay should share prices decline. Of course, the only time the writer of the put might be unable to pay is in the case of a sharp decline in share prices and if most of his attachable wealth consists of shares in the company, so that there is a chance that the option expires worthless if share prices fall to close to zero, when employees are most urgently in need of the guarantee.
- Depending on how well employees understand the offer, how much extra liquidity they have, and whether or not they are comfortable with the idea of buying shares, employees should aggressively take advantage of the offer made by their employers to invest substantially in shares. If they do not, it may suggest that for whatever reason they don’t trust the ability of the chairman or the company to honor the promise.
- According to the South China Morning Post article, it is the chairman who is providing the guarantee. There is a difference between a program in which the chairman personally covers the losses and one in which the company covers the losses. If it is the latter, existing shareholders automatically would take the other side of the offer, making this a very bad deal for existing shareholders not covered by the program.
- In either case, for every share owned outside the program, either the existing shareholders or the chairman must give away, for free, a put option whose nominal amount is equal to the number of shares covered by the program divided by the number of shares not covered by the program. If half the shares of the company are owned by employees and covered by the offer, for example, for every share not covered by the program, the outside investor or the chairman would have to give a put option on one share. If employees own one fifth of the shares under the program, for every four shares not owned by employees the chairman or the outside investors must write a put option on one share, and so on.
- The net impact on share prices can be complex. If the company pays for the program, existing shareholders should immediately sell their shares until prices have dropped by enough to compensate them for the value of the implicit put option they are giving up, but the more prices drop, the greater the value of the put they are giving up. The more shares they sell in the aggregate, the greater the number of puts they must give away.
- If the chairman pays for the program at no cost to the company, there is no reason for existing shareholders to sell shares initially, as they do not pay directly for the value of the put option. They may bear a cost nonetheless to the extent that the program undermines the chairman’s ownership role.
- However, shares are more valuable to employees than to existing shareholders, so that once share prices rise by some reasonable amount, share prices are then overvalued relative to their value to existing shareholders not covered by the program, in which case unless they currently believe the company to be significantly undervalued, they should sell.
- Employees, on the other hand, should buy as many shares as they can, although if the company pays for the program the more shares they buy in the aggregate, the less valuable the put option they own. In that case, once all the shares are in the hands of the employees and covered by the program, the put option becomes worthless because the employees are both fully long and fully short the put option.
- If the company pays for the program, the price of shares should immediately decline and there should eventually be a complete transfer of ownership from existing shareholders who are not covered by the program to employees whose purchases are covered by the program. Note, however, that as employees own more and more of the company, their incentive to buy declines even as the selling incentive for existing shareholders not covered by the program rises. This can only push down share prices.
- If the chairman pays for the program, however, the price of shares should immediately rise if the chairman’s commitment is credible, which mainly means if he is extremely wealthy and owns assets that are separate from the company.
- In some cases, according to the article, share prices have fallen after the announcement, and in other cases they have risen. This may tell us something about the structure of these deals. In the former case, falling share prices suggest that it is the company that must pay for the program, perhaps directly as part of the announcement, or indirectly because the company is largely owned by the chairman and the rights of minority investors have not been protected.
- The program is clearly a bad deal for existing investors if the company pays for the program, and it is a bad deal for the chairman if he personally pays for the program. Why then would the chairman make such an offer? One very likely explanation is that the chairman owns a lot of shares in the company but is exposed in such a way that if stock prices fall substantially, he loses his shares anyway. In that case, there is no additional cost to him for the guarantee.
- The most likely form that such a position would take is that the chairman has borrowed heavily and has used the shares as collateral. In that case, if he can deliver the shares to the lender when prices have fallen, and retain no other contractual obligation (either because it is a non-recourse loan, or because he has no other attachable wealth), he has in effect a put option from the lender that substantially matches the put option he has transferred to employees who buy shares under the program.
This last point is the most interesting one. Basically, when someone borrows money against which he has pledged certain assets as collateral, assuming no further recourse, if the value of the collateral assets declines to some point, he will be forced to deliver the assets to the lender.
In that case, he can ignore the cost to the existing shareholders of a program in which employees who buy shares are guaranteed against price declines. In the case that the share price increases sustainably, he gets the full benefit. If the share price decreases, he absorbs none of the cost or a very small share of the cost. The bank that made the loan to him must in the end absorb the cost of the program because the value of its collateral will collapse just at the time it seizes the collateral.
If the bank has further recourse to the wealth of the chairman, he is in a very risky position. It is hard to imagine in that case that the chairman would rationally guarantee his employees against losses.
This is because, depending on how many shares employees buy, this can be a highly self-reinforcing process on the way down. If share prices begin to fall after the announcement, unless a major player intervenes it is very likely to continue falling and even to spiral into collapse. It is worth noting that the South China Morning Post article goes on to say:
While some investors argue the stock purchases help to boost share prices, others question the purpose of the scheme. Of the 18 companies, at least four have their shares pledged as collateral for financing and two have plans to sell new shares. In both cases, stabilising share prices are important to their stock pledges and fund-raising plans.
We shouldn’t read too much about the overall economy into these transactions, but the fact that so many small companies on the Shenzhen exchange are implementing these employee stock guarantee programs confirms what I have been hearing anecdotally for several years: owners of businesses are heavily leveraged and in some cases desperately need to shore up the prices of shares or other collateral behind their borrowings. This is an extremely risky way of boosting share prices, and this road is only likely to be taken in cases of extreme urgency.
The structure of these employee stock guarantee programs also suggests that the banks that have lent money against shares pledged as collateral are likely to take much larger losses than they expect. In cases in which they need to seize collateral, it is likely to be worth a lot less than they originally expected because the guarantee against losses may cause share prices to gap down.
- Employees should be eager to participate in these programs. If they do not participate aggressively, there must be a reason, one of which could be that they do not invest much credibility in the chairman’s ability to fulfill his obligation.
- If share prices rise after the announcement of the program, it suggests that employees believe that the chairman’s promise to make good on losses is credible and that the losses will be borne by the chairman and not the company.
- If share prices decline after the announcement of the program, it suggests that investors believe that the chairman will pass the cost of the program directly or indirectly onto the company.
- If share prices decline after the announcement of the program, unless a large and credible player intervenes, prices could quickly spiral downward.
- Companies that announce such programs are likely to be controlled by highly indebted managers who have borrowed heavily against their ownership of shares.
- This would be a terrible deal for the chairman if he has substantial wealth outside of the company that is attachable by his creditors, so the chances are that either he has no other wealth or that it is somehow protected.
- Banks that have lent to the chairman and other managers may have far greater risk of loss than they think if the company is directly or indirectly liable for covering the put option offered to employees.
Reproduced with permission from Michael Pettis’s Blog