University of Amsterdam, Amsterdam Business School Master in International Finance
The Impact of private equity Funds on Performances of Small and
Medium-Sized Enterprises —An Empirical Analysis based on the national
equities exchange and quotations of China
Supervisor: Prof. Jens Martin Student: Panrui Zhou 11813598
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Abstract
In this thesis, the impact of private equity (PE) funds in small and medium-sized enterprises (SMEs) listed on the national equities exchange and quotations (NEEQ) in China is investigated. First, this paper introduces the background and significance of SMEs financing through PE funds, followed by the literature review of previous studies conducted by many scholars on different aspects of SMEs financing through PE, which are of great importance for the references for this paper.
Following a detailed theoretical framework, the qualitative and quantitative analysis of the impacts of PE on SMEs is conducted. From a qualitative perspective, this paper points out the main benefits that SMEs could benefit when supported by PE. From a quantitative perspective, two multivariate linear regression models are built to explore the impact of PE on the enterprise value and operating performance respectively. Through this research, performance and enterprise value of small and medium enterprises backed by PE funds are becoming better and higher respectively.
Based on the research result, relevant suggestions are put forward from three different perspectives: government function supervision, PE investment company and SMEs, which could steadily improve the positive impact of PE funds and effectively promote the operational performance of PE backed enterprises.
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Table of Contents
1. INTRODUCTION ... 4
2. LITERATURE REVIEW... 6
3. THE CURRENT SITUATION AND PROBLEMS OF PE FINANCING OF SMES ... 9
4. THEORETICAL ANALYSIS OF THE IMPACT OF PE FUNDS ON CORPORATE PERFORMANCE ... 15
5. DATA AND METHODOLOGY ... 21
6. CONCLUSION AND SUGGESTIONS ... 31
LIMITATION ... 37
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1. Introduction
In the rapid development of China's socialist market economy, the number of SMEs accounts for more than 99% of the total number of enterprises. In 2017, SMEs contributed more than 60% to China's GDP. Meanwhile, it provides more than 80% of employment opportunities and generates more than 50% of the total tax revenue in China (National Bureau of Statistics of China, 2018). This shows that SMEs play an essential role in the development of China's market economy, especially in solving employment problems, contributing to national taxation and optimising industrial structure.
However, compared to the large state-owned enterprises, SMEs are at an inferior position due to the limitation of the current economic and financial structure in China. One the one hand, the current financing system of commercial banks is still hard for SMEs to reach. At present, the main financing method for SMEs in China is based on commercial bank loans. Enterprises need to undergo strict review, and the amount of money a bank can lend is quite limited. The limitations of bank loans are listed as follows: First, the standards of bank loans are strict, the loan procedures are complicated, and the loan circle is relatively long. All issues above are difficult to be solved timely and effectively. Secondly, interest and principal need to be paid on time, which would increase the cost of debt. Thirdly, bank loans only provide financial support to enterprises, rather than advanced management experience and skilled talent. Therefore, the loan is only regarded as a large amount of corporate loans. Although enterprises obtain bank loans in time, it is still difficult to completely solve the practical problem of funds shortage. On the other hand, the requirements for equity financing of the main board, Chi Next and SME board are too stringent, resulting in the inability to continue further development due to the lack of financial support. On the other hand, China's SMEs have only developed for more than 30 years since the reform and opening up. It means that a good corporate governance
5 model has not yet been formed, which has dramatically restricted the subsequent development of enterprises.
The NEEQ was established in 2006. As of the end of 2017, a total of 11,630 companies were listed on the NEEQ. Most of the companies listed on the NEEQ have completed the reforms of shareholding system with the support of PE investment institutions. The existence of the NEEQ makes the financing of SMEs no longer limited to bank loans and government subsidies. As a result of institutional protection of NEEQ, more equity investment funds have taken the initiative to invest. At the same time, the establishment of the stock transfer system has become a new exit for PE funds. Therefore, listed companies have become another hot spot for PE funds.
In summary, SMEs contribute a lot to the development of national economy, but the problem of financing difficulties is urgently needed to be solved by the current government and regulatory authorities. We must keep up with the pace of developed countries, establish and improve China's multi-level capital market, and solve the financing problem by encouraging SMEs to corporate with equity financing. Besides, the listing of the NEEQ could avoid the problems brought by bond financing. This paper conducts the qualitative and quantitative analysis to investigate the impacts of PE on SMEs listed on NEEQ, based on the operating conditions and related financial data. The analysis puts forward relevant opinions on promoting the development of SMEs and PE in China from various aspects and offers suggestions for promoting the healthy development of SMEs in China and solving their financing problems.
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2. Literature Review
2.1 Relevant research conducted by western scholars
PE first appeared in the United States, since then PE has been developed for more than 60 years. Venture capital was created in the US, one of the objectives of which is to design a private organization to solve the financing problems of SMEs. At the same time, it is hoped that this private sector can provide long-term capital and management services. From this we can see that the emergence of PE can be seen as dedicated to provide services for SMEs. Regarding SMEs' private equity financing, overseas developed countries are not only mature in practice but also quite sophisticated in the literature research. The literature research on private equity financing of small and medium-sized enterprises by western scholars is as follows:
2.1.1 Impacts of PE funds on the business performance of invested enterprises
Most studies by western scholars have confirmed the positive relationship between the private equity funds and the performance of the invested companies. Megginson (1991), based on the data of listed companies in the main board of the United States from June 1986 to December 1990, found that after the initial public offering, the performance of PE-backed firms is better than that of PE-free companies. The performance is better in terms of profit quality indicators and performance growth indicators. Fenn, G. W., Liang, N. and Prowse, S. (1997) recognised the importance of PE funds as the financing channels of small and medium-sized private enterprises and further analysed the motivations and approaches for the growth of PE funds. Lerner and Gompers (1997) analysed the enterprise value of companies with and without PE background after listing. The results show that companies with PE backgrounds will give more rewards to shareholders than those without PE background within five years after listing. This indicated that PE financing adopted by enterprises to a certain extent is conducive to enhance
7 the enterprise value. By studying the post-listing performance of 136 companies with venture capital participation and 136 venture-free investments in the North American securities market, Jain and Kini (1995) found that venture capital-backed firms performed significantly better after listing than those without venture capital investments. It is mainly because that venture capital can improve the company's operation and management, which in turn can improve the company's operating performance.
There are also researchers who have an uncertain or opposing view of the study. Rosa and Walter (2003) took the Australian listed company as the research object, studied the impact of PE on listed companies but did not found that PE helps to improve the business performance.
2.1.2 Impacts of PE funds on the corporate governance of invested enterprises
Wright (2009) believes that PE helps to improve the cash flow, bring new incentive mechanism, improve the original governance structure, enhance the vitality of enterprises, and improve the original principal-agent problem. Ultimately, it will boost the company's performance. Wright also focused on the role of private equity funds in monitoring and improving the governance of target companies. Scholes and Wright (2009) proposed that private equity funds promote the development of enterprises through strategic investment. Private equity funds have more extensive resources and stronger resource integration ability than enterprises.
2.1.3 The exit of PE funds
Armin Schwienbacher (2008) analysed the exit strategy of PE funds. He believes that whether for the investor or the company, the benefits of IPO are higher than other exit methods. Through several case studies, Andreas Bascha and Uwe Walz (2001) pointed out
8 that PE investors and invested companies usually choose different exit methods to maximise their interests.
2.2 Relevant research conducted by domestic scholars
Compared to the PE industry in developed markets, PE in China is relatively immature, and has changed greatly every year thus the authenticity of the data is difficult to estimate.
2.2.1 Impacts of PE funds on the business performance of invested enterprise
Many scholars in China have different views on whether private equity firms play a positive role in the performance of the invested enterprises, but most of them have found that private equity funds can improve the performance of enterprises.
By analysing the financial data of 153 companies listed in the second board from 2007 to 2009, Yuanyuan Liu, Zhuo Huang and Xiaofeng He (2011) concluded that PE funds could improve the overall operational performance of enterprises. Qun Xiang (2010) had a similar conclusion. By studying 233 companies listed on the SME board, he found that PE funds significantly improved the operational performance of SMEs by diversifying the financing methods and funding structure. Xiaorong Xue and Zhen Li (2012) pointed out that applying the power of PE enables companies to solve the financing problems encountered in the business process more efficiently. Based on Tobin's Q value, Bin Zhang, Juping Lan (2013) and Jing Zhu (2011) highlighted the positive impact of PE on the enterprise value of the SMEs. However, Shanshan Liang and Qisen Jiao (2014) considered that when SMEs they also run the risk of loss of their management rights when financing through PE.
9 Bing Liu and Manhong Zhang (2005) through a questionnaire survey of private equity
investment enterprises in key cities in China, found that the more private equity investment shares, the lower the operating performance of enterprises.
2.2.2 Impacts of PE funds on the corporate governance of invested enterprises
Jiujin Li, Shengfu Wang and Yuqing Ye (2015) pointed out that there are still three main problems in the governance of SMEs in China: unreasonable ownership structure, imperfect incentive mechanism and imperfect decision-making mechanism. Xiang Ding (2009) stated that PE makes profit by investing in target company’s equity at a lower price and selling at a higher price. This is an invisible incentive mechanism, so PE is bound to help optimize the corporate governance structure, provide resources for enterprises, and promote rapid growth of enterprises.
2.2.3 The exit of PE funds
Yingchao Ju (2007) pointed out that compared to IPO, the cost of merger and acquisition(M&A) is lower in term with her analysis on exit mechanism of PE institutions, while Hongwei Zhu and Wenyan Yao (2014) thought PE institutions are more inclined to IPO than other exit methods based upon their analysis of PE investment projects from 2003 to 2012.
3. The current situation and problems of PE financing of SMEs
3.1 PE in China
3.1.1 The definition of PE in China
The European PE and Venture Capital Association (EVCA, 2006) defines PE investment as a professional equity investment that invests in early (seed and start-ups) and extended periods
10 of enterprises. In China, PE investment is defined in both broad and narrow sense (Takeshi Jingu, 2012). Broadly speaking, PE investment means raising funds through non-public forms and conducting various types of equity investments in companies. This type of equity investment covers all stages of an enterprise before the initial public offering, i.e., seed, initial, development, expansion, maturity and Pre-IPO, and PE after listing. The narrowly defined PE investment mainly refers to the PE investment portion of a mature company with a particular scale that generates stable cash flow, such as PE investment portion of venture capital in the later period. The PE in this paper mainly imply the PE in a broad sense, which includes venture capital.
Compared to other financial investment instruments such as stocks and bonds, PE investment is featured by non-public capital raising, long investment term, high potential risk and return, irregular investment form and active intervention in the management of invested enterprises.
3.1.2 The exit of PE in China
With the development of multi-level capital market system in China, the main board, SME board, second board, NEEQ and so on are gradually improved, and become the channel for many private equity funds to exit.
IPO is considered the most popular exit channel for private equity funds because of the high returns, reputation and social image. However, with a large number of companies listed in the NEEQ in recent years, the NEEQ has become the most convenient channel for SMEs to carry out equity financing and equity transfer. Prior to 2014, the exits through the NEEQ was extremely rare. After the expansion in 2014 and the formal implementation of the market making transfer method, the NEEQ was gradually sought after by investment institutions.
11 In particular, in the past two years, the number of the NEEQ listings and the volume of transactions have increased by leaps and bounds.
M&A is also considered to be one of the important exit methods. The advantage of M&A is that it is not limited by the conditions of IPO, it has the characteristics of low complexity and less time consuming, and it can apply flexible and diverse methods at the same time. M&A is suitable for enterprises whose performance is gradually rising, but still cannot meet the listing conditions or do not want to go through a long waiting period.
Other exit channels are also concerned by all parties, for example, backdoor listing is considered as an alternative IPO exit, equity transfer can achieve a rapid exit, and repurchase is a more stable way of exit. Liquidation is the last thing investors might want.
3.2 The definition of SMEs in China
SME normally is defined based its company size and its number of employees. But the definition of an SME in China is much more complex and different. The classification depends on the industry category in terms of the number of employees, sales, and assets (SME promotion law of China, 2003).
3.3 The NEEQ
3.3.1 The development of the NEEQ
In order to promote public innovation and support the development of SMEs, China has established a stock exchange platform called the NEEQ, drawing lessons from and imitating
12 the NASDAQ. NASDAQ was established in 1971. At that time, the United States was in the period of economic transformation, and a large number of start-up companies in new industries such as electronics and telecommunications emerged. NASDAQ played a very important role in nurturing and supporting the growth of companies in these emerging industries, and in boosting the transformation of the US economy. The success of NASDAQ has given a lot of reference to the development of the NEEQ. The NEEQ provides an alternative way for SME’s financing and the NEEQ changed the previous financing method from bank loans to stock issuing.
In June 2018, the State Council of China announced that foreign investors are allowed to invest in the NEEQ listed companies. Until then, the NEEQ was open only to Chinese market.
3.3.2 The similarity and difference between the NEEQ and the NASDAQ
As the first registration-based system in China, the NEEQ has been compared with the NASDAQ market since its inception. The NEEQ shares two striking similarities with
NASDAQ. First of all, the services objects of both platforms are innovative, entrepreneurial, growth enterprises. In terms of access conditions, the two markets do not set a financial threshold. Innovative technology companies that have flocked to NASDAQ for failing to meet earnings requirements are finally gaining a foothold in China's capital markets.
However, compared to the mature NASDAQ, the NEEQ still has a long way to go. First of all, the liquidity of the NEEQ is seriously inadequate because the entry threshold for investors are too high. And the agreement transfer transaction system are not transparent, which causes the transaction condition to be harsh, at the same time, the market-making system has not effectively enhanced the corresponding stock fluidity. Second, the investor selection is too
13 strict. But NASDAQ, does not set a threshold at all, even if it is now upgraded to the exchange after which its threshold is only similar to the NYSE, is still open to the public.
Nasdaq has gone through three layers in its history: started to operate in 1971, and first stratified in 1975, establishing a listing standard to distinguish it from the OTC market. The second stratification took place in 1982, when NASDAQ picked out some of the best companies and turned their equity deals into market-makers. In 2006, as a result of the proliferation of companies such as Microsoft and Google, the market capitalization of listed companies on NASDAQ increased, gradually surpassing the New York Stock Exchange, thus opening up a third stratification, establishing a global selection market and adopting a system of open bidding trading. But at present the NEEQ only stays in the first stratification stage, but we may foresee in the future it will grow up with a batch of outstanding companies.
3.3.2 The Difference between the NEEQ and other stock exchanges in China
Besides the difference between the NEEQ and the NASDAQ, there are four main difference between the NEEQ and other stock exchanges in China. First, the target audience are different. The "Decision of the State Council on Issues of the National Equity Exchange and Quotations" clarifies that the orientation of the NEEQ is mainly to develop innovative, entrepreneurial, and growing SMEs. Such companies are generally small in scale and have not yet formed a stable profit model. Second, regarding the access conditions, there is no threshold applied on the profitability of the companies applying for listing. As long as the shareholding structure is clear, the business is legal, and the corporate governance is sound, the company which performs the obligation of information disclosure could apply for the guarantee broker to refer it to the stock market. The third difference is investor groups. The investor structure of stock exchanges in China is dominated by small and medium-sized investors, while the NEEQ implements a more
14 stringent investor suitability system. In the future, the development direction will be a market dominated by institutional investors. Last but not the least, the national equity transfer system is a service medium for SMEs and industrial capital, which is mainly for enterprise development, capital investment and exit services, instead of trading purposes.
3.4 Problems in the PE financing of SMEs
PE investments in China has developed rapidly in the last decade by catching up with the international market. However, the limitation of the industry and the lack of external regulatory interference leads multiple struggles to the domestic PE markets in all stages. Most relatively mature PE institutions are still facing the following problems in actual operations:
3.4.1 Limited fundraising capacity
Compared to the overseas capital market, PE fundraising in China is inefficient and small in scale as most domestic large institutional investors invest less in PE funds. The scale cannot be competed with large overseas PE projects such as industrial restructuring and enterprise merger and acquisition. It is difficult to invest when it is difficult to raise capital, therefore PE funds only invest in projects with smaller amount.
According to the US Securities and Exchange Commission's "Quarterly Report of the Private Equity Industry in the Fourth Quarter of 2017", as of the end of 2017, there were 2,997 private equity fund managers in the United States, and the asset management scale was 12.54 trillion US dollars. While in China, as of the end of June 2018, there were 23,903 private equity fund managers, and 73,554 private equity funds, with a management fund of 1.94 trillion US dollars. In other words, the number of private equity funds in China is nearly eight times that in the
15 United States, while the total fund size in the United States is nearly seven times the size in China.
3.4.2 Investment projects are limited
On one hand, it is difficult for small-scaled PE fund to participate in the investment projects with long-term and high risk but high return because of the lack of long-term stable capital. On the other hand, quality projects are attractive to many PE institutions. For innovative high-tech enterprises which are in the early stage, PE institutions, especially financial investors, are often reluctant to invest in them due to the unclear development system of enterprises and insufficient improvement of the financial management system. Thus, PE funds have a rather limited choice of investments.
3.4.3 Non-professional strategic investors
As most domestic PE investment institutions have a low investment quota, their fund management teams are not familiar with the industry of the invested enterprises thus cannot participate in the management of the invested enterprises, letting alone the management to determine the control and transformation of the invested enterprises. Even the management team of industrial investment fund still lacks guidance in financial management and exiting operation and fails to meet the professional standards of overseas private fund institutions.
4. Theoretical analysis of the impact of PE funds on corporate
performance
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4.1.1 Principal-agent Theory
Separation of corporate ownership and operating rights is an essential feature of modern incorporated enterprises. Laffont, Jean-Jacques, Martimort, David (2002) analysed the “Principal-Agent Model” with the separation of the company’s ownership and management rights. The owner of the company can transfer operating rights and retain only the remaining claim. The owner gives the professional manager the right of choice, residual claim, and significant decision-making power so that the professional manager can better manage the enterprise and serve the interests of the shareholders. Based on this authorisation management relationship, the principal-agent relationship emerges.
PE funds have advantages over individual investors in the process of investing in enterprises. They are reflected in various aspects such as professionalism and, capital advantages. Large-capital holders have greater bargaining advantages towards companies. Besides, equity funds can better deal with the issue of entrustment and agency between investors and invested companies, and PE institutions can formulate a specific system and terms for enterprises and supervise and standardise their business operations. The interests of investors are safeguarded.
4.1.2 Cost-Benefit Theory
The cost-benefit analysis proposed by Euston Quah, E.J Mishan, Euston Quah (2007) pointed out that under the premise of “rational man”, any subject must balance his own cost and benefit level when making any decision and consider whether the matching of costs and benefits is reasonable.
Using the method of cost-benefit analysis, it is also possible to explain the motivation of PE funds to participate in the corporate governance of the subject company. PE funds participate
17 in corporate governance mainly with explicit costs and implicit costs. Explicit cost refers to costs that directly cause resource consumption. Implicit cost mainly refers to opportunity cost. In China, PE funds usually have abundant practical experience in other invested companies, so that they can better participate in business management, reduce conflict between investors and company, and supervise more efficiently, which reduces the corporate governance costs. From the perspective of revenue, the better the company's operation and management, the higher the efficiency, the faster the growth of the company, the higher the company's stock price and, the higher the appreciation of the equity acquired by PE fund investment companies.
4.2 Mechanism analysis of the positive impact of PE investment on the operating performance of SMEs
This paper mainly studies how PE investment affects the business performance of SMEs from the following three aspects, namely, equity structure, valuation adjustment mechanism and reputation enhancement.
4.2.1 PE investment helps to optimise the enterprise equity structure
If a company is backed by PE investment, the investor will interfere with the board of the company to participate in the management of SMEs to form an investment management model. Therefore, when making investment choices, PE institutions often choose SMEs that have fewer board members, which is more conducive to controlling the company. Then, it pays attention to the operation of SMEs and the value of enterprises, mainly playing the role of supervision in enterprises, ensuring that enterprises will not overinvest, so that all financing funds can be effectively applied to the operation and development of enterprises. By improving the equity structure, PE institutions play an essential role in the business decision-making of
18 enterprises, ensures the optimal use of funds, and eventually improves the business performance.
4.2.2 The VAM helps the management to exert their enthusiasm
The “valuation adjustment mechanism” (VAM) is a model which commonly used in the international markets. Nowadays, it is also a new model in the PE investment market. From the perspective of China’s market, PE investment intermediaries use it very frequently (Qiong Fu, 2011). VAM indicates that PE investors and start-up companies cooperate in the form of PE financing. Due to the uncertainty of the future development of the enterprise, both sides agree to the “hypothesis”, if, in a specified period, the direction of the enterprise moves in accordance with the hypothesis, the enterprise will share the benefits according to the agreement; If a deviation occurs, the investors will have the right to take in charge to optimize the business performance. This method is based on conditional and effective evaluation of the enterprise value. Oversea countries started to promote PE 30 years ago; the VAM has also changed a lot since then. Regarding the content, it mainly covers all aspects of the enterprise, including the enterprise’s financial accounting and management. Compared to the VAM used in developed countries, in China the model is simpler and more inflexible: the measurement is solely based on corporate profits. The main influencing factors of VAM include the price and volume of equity trading and the level of corporate profits. If, the enterprise experiences a business failure in an economic downturn the PE investors will take control of the equity of the enterprise. In this case, even if PE institution wins the VAM, there is no real change in the interest due to the drop-in enterprise value in the business failure. Therefore, it is not difficult to see that the VAM in China urgently needs a diversified development.
19 In order to motivate the management of the SMEs, the PE investment institutions in some cases reserve shares for the management to invest, so that the management can also become minority shareholders of the enterprise. It is believed that in this wat, management sense of improving will be stimulated. Regarding the VAM, there is a certain external incentive effect. If an enterprise is under enormous external pressure, in order to cope with the pressure, it will unite as one and strive for the same goal to realize the maximum value of the enterprise. It can be said that the VAM can make the enterprise more cohesive and beneficial to the development of the enterprise.
4.2.3 PE investment can help improve the reputation of SMEs
Pettit, R.R (1972) is the first scholar to propose the market reaction of dividend announcement. According to the signal theory, under the premise of information asymmetry, investors or business partners can judge the enterprise’s development status, development prospect, financial status and integrity status, etc. When a large PE institution invests in an SME, it is giving signals to the upstream and downstream partners that the enterprise is a rather promising investment. Large private-equity firms will never invest in enterprises appearing dishonest behaviour. Otherwise, its reputation will be negatively affected, so this signal also raises the reputation of the enterprise and enables the enterprises to attract more cooperation opportunities, eventually improve the SMEs’ business performance.
4.3 Mechanism analysis of the negative impact of PE investment on SMEs business performance
Everything has its advantages and disadvantages. PE funds have no exceptions. PE fund has been developing for more than 20 years in China. Not all of PE investments successfully promoted the cognitive and healthy development of enterprises and achieved a steady increase
20 of enterprise profits. Meanwhile, a PE fund with a low level of qualification will also hinder the development of enterprises.
4.3.1 PE institutions lack professional management skills
Besides the fund provided, the management experience brought by PE investors is another attractive factor to SMEs. Experienced management enhances internal enterprise development thus fundamentally improve enterprise performance. However, the establishment of a good management team cannot be completed overnight. In some cases, PE investment institutions have not set up their professional management team to invest in the target enterprises. As a result, no value-added services can be expected from the team. The enterprise can only continue its previous development path without improvement by the management team from PE institutions.
4.3.2 Unhealthy eagerness for quick success and instant benefits
One of the original intentions of the establishment of PE fund is to bring ample returns to the investors, which lead to high pressures to the PE fund managers. As a result, some PE funds will make drastic changes to the companies they invested in order to stand out in performance evaluation among their competitors, such as forcing companies to cut expenses in the short term and squeezing employees to save labour costs. Even some extreme approaches will be implemented, such as replacing current management with a new team with a different strategy and vision, ignoring talent cultivation, disbanding labour unions. Also, such changes will affect the long-term strategy, reducing the research and development funds to focus on technologies that can only be realised in the short term. This eagerness for quick success and instant benefits are harmful to the sustainable development of enterprises. While these practices may boost
21 corporate profits in the short term, in the long run, they lead to a gradual loss of core competitiveness.
4.3.3 Rapid exit leads to the loss of long-term development
China’s PE fund is now in the “golden age”, plenty of PE funds try to seize this opportunity to strengthen themselves in the coming years. In order to be competitive in raising funds, PE institutions have to build their reputation first. Because the reputation mainly comes from successful exit examples of previous investment experience of PE institutions. As a result, PE institutions which have not established a reputation will focus on short-term gains, hoping to avoid risk and get their funds back as soon as possible. PE funds usually bring the invested companies to the capital market by issuing shares in public. After the suspension period, they will quickly sell their shares and use the price difference of the secondary market to obtain high returns. The long-term cultivation of the enterprise will be given up by PE institutions, which will result in the inability to maintaining sustainable development of the enterprise.
After analysing both the positive and negative impacts that PE funds may bring to SMEs.
5. Data and Methodology
5.1 Research ObjectsIn this paper, SMEs listed in NEEQ in 2016 are selected as the research object to analyse the impact of PE on the business performance of SMEs.
The purpose of the NEEQ is to provide services to innovative, creative and growth-oriented SMEs, such as pre-financing actions, valuation service and platforms for corporate
22 presentations, and to play the role of incubators and reservoirs for the Main Board and the Second Board. According to the official NEEQ data, as of the end of 2017, the number of companies listed on NEEQ market reached 11,630, which is 33 times the total number of listed companies in 2013. The total market capitalisation reached four trillion CNY in 2017, which is 89 times the total market value in 2013. The average market value of listed companies has reached 400 million. In the past five years, the NEEQ market in 2016 has experienced the tremendous growth, adding 5,034 listed companies, nearly half of the total at the end of 2017. It can be seen that after the large-scale expansion of the listed companies in NEEQ in 2016, both the number of listings and the amount of financing had achieved a big leap. The table below shows the development of the number of listed companies and the total market value of the NEEQ in 2013-2017:
Table 5.1.1 The Number and Total Market Value of Listed Companies in the NEEQ
Year 2013 2014 2015 2016 2017
Total market value (in billions CNY) 55 459 2458 4056 4941 Number of listed companies 356 1572 5129 10163 11630 Number increase from prior year 156 1216 3557 5034 1467 Source: NEEQ Database
According to the data given by the national small and medium-sized enterprise stock system, the listed companies are classified according to the management type. Among the 11,630 enterprises listed in the NEEQ market as of the end of 2017, the most significant number is manufacturing, information transmission, software and information technology services. The industry is closely followed by leasing and business services. The classification of NEEQ listed companies varies from industry to industry. The specific industry conditions are as follows: Table 5.1.2 The Industry Distribution of the NEEQ of 2016 and 2017
Year 2017 2016
Industry Number of
Companies Percentage
Number of
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Manufacturing 5804 49.91% 5153 50.70%
IT, software and IT services 2284 19.64% 2003 19.71% Leasing and business services 607 5.22% 507 4.99% Wholesale and retail trade 531 4.57% 436 4.29% Scientific research and technical
services 509 4.38% 459 4.52%
Construction industry 379 3.26% 330 3.25% Culture, sports and entertainment 261 2.24% 228 2.24% Agriculture, forestry, animal
husbandry and fishery 223 1.92% 173 1.70% Water, environmental and public
facilities management 198 1.70% 199 1.96% Transportation, warehousing and
postal services 197 1.69% 163 1.60%
Financial industry 144 1.24% 126 1.24%
Electricity, heat, gas and water
production and supply 130 1.12% 101 0.99%
Real estate industry 97 0.83% 67 0.66%
Education 88 0.76% 72 0.71%
Social work 55 0.47% 47 0.46%
Resident services, repairs and other
services 44 0.38% 40 0.39%
Mining industry 42 0.36% 30 0.30%
Accommodation and catering
industry 37 0.32% 29 0.29%
Total 11630 100.00% 10163 100.00%
Source: NEEQ database
Based on the above introduction of the research objects, this paper conducts a quantitative analysis of the PE financing effect on SMEs listed on NEEQ. The main reasons for selecting the NEEQ are as follows: First, it is difficult for unlisted SMEs to obtain relevant financial data. Only through the disclosure of relevant corporate information by listed companies can the financial data needed for research be obtained. Second, the NEEQ has developed at a high speed in the past two years, and the number of enterprises has increased rapidly. Third, the exit
24 channels of PE are generally the choice is to promote the company's listing. Therefore, companies listed in the NEEQ can better demonstrate the effectiveness of the impact of PE financing on SMEs.
5.2 Data Selection and Collection
This paper selects the companies listed on the NEEQ in 2016 as the research object, because in 2016, the number of enterprises listed in the NEEQ has soared, and the number of newly listed enterprises had reached 5,034, far exceeding the increase in 2015 and 2017. The listed companies are divided into two categories: with PE background and without PE background by the Zero2IPO Research Center, one of the top 10 shareholders of listed companies and one of the authoritative research institutions in China's PE investment field. Excluding the enterprises with incomplete data, this paper selected 1786 companies, including 1,100 companies with PE background, accounting for 62% of the total sample, and the remaining 38% were enterprises without PE background. The 2017 year-end financial data of these companies are collected to evaluate the performance and enterprise value. The data used in this article is from Wind Information.
5.3 Variables Selection
5.3.1 Dependent variables
Business performance: There are many reference indicators for measuring the company's
business performance. The research on the business performance of this paper is mainly measured by using the delta return on equity (ROE). ROE = profit after tax/owner's equity. ROE reflects the level of income per equity, thus indicates the company's operating performance. Delta ROE is the difference between ROE in 2017 and 2016, which reflects the growth of enterprises. The higher the indicator, the faster the company's operating performance
25 grows, and vice versa, the slower the company's operating performance. Therefore, this paper selects Delta ROE as an indicator to measure the growth of business performance of the company.
Enterprise value: The Tobin’s Q ratio is used to evaluate whether a firm is fairly valued.
Tobin’s Q ratio = Total market value / Replacement value of total asset. Since the company's replacement cost is relatively difficult to obtain, this paper replaces it with the book value of the total assets. According to the current situation of the existence of tradable shares and non-tradable shares in listed companies in China, a flexible approach is adopted when calculating Tobin’s Q ratio: Tobin's Q ratio = (tradable shares * share price + non-tradable shares or restricted shares * net assets per share + book value of liabilities) / total assets.
In this paper, the above data is calculated using the 2017 year-end data, in which the stock price is the average stock price at the end of December 2017.
5.3.2 Independent variables
PE background: 0-1 variable, if the company has PE background as of the end of 2016, PE=1, otherwise PE=0.
5.3.3 Control variables
Company size: Using the logarithm of total assets, the impact on the company's business
26
Leverage ratio: This indicator tells the status of the company's financial leverage and reflects
changes in the company's financial status that will affect the company's value and business performance.
Holding ratio: This ratio is the holding ratio of the biggest shareholder, which indicates the
concentration of equity.
Industry: To investigate the potential differences due to industry, three representative
industries: manufacturing and others, financial industry and IT are aggregated as dummy variables.
2016 year end-data are used for above variables.
5.4 Regression Model
This paper explores the relationship between PE and PE-backed SMEs’ business performance and company value. Statistical multiple linear regression analysis is conducted based on the following model:
(1) Delta ROEi = 1 + 1PEi + 2Sizei + 3Leveragei + 4Holding Ratioi + 5Manufacturing and Othersi +6Financial Industryi +7IT+ ε
Hypothesis 1: There is a positive correlation between delta ROE and PE, 5>0, PE helps to improve the operational performance of the company.
(2) Tobin’s Qi = 2 + 8PEi + 9Sizei + 10Leveragei + 11Holding Ratioi + 12Manufacturing and Othersi +13Financial Industryi +14IT+ ε
(3) Hypothesis 2: There is a positive correlation between Tobin’s Q and PE, 1>0, PE helps to increase enterprise value.
27 5.5 Descriptive statistical analysis
In order to visually reflect the data characteristics, the following statistical analysis is performed on the relevant data, as shown in the following table：
Table 5.5.1 The Descriptive Statistics of Key Indicators of Sample Companies
This table shows the descriptive statistics of the five key indicators of 1787 sample companies. PE is a dummy variable, if the sample company has PE background, PE=1, otherwise PE=0. Tobin’s Q equals the market value of an enterprise divided by the total asset. Delta ROE, ROE and Leverage ratio are shown in percentage. Size is the company size, the logarithm of total asset (in million CNY)
Indicator Average Standard Deviation Maximum Minimum Median
PE 0.59 0.49 1.00 0.00 1 Tobin's Q 2.47 3.34 53.89 -0.63 1.57 Delta ROE -0.61 24.75 273.20 -89.98 -1.76 ROE 11.44 17.58 84.88 -48.99 11.79 Leverage 39.04 19.35 93.98 0.57 38.65 Size 4.76 1.10 10.40 0.78 4.77
Source: NEEQ database
It can be seen from the above table that the average return on net assets of enterprises in the NEEQ is 11.44. The potential for the development of enterprises in the future is relatively enormous. The mean value of the explanatory variable Tobin's Q, which is used to reflect the company's value, is 2.47. In general, if the value of Tobin's Q is greater than 1, it means that the value created by the enterprise is higher than the capital cost invested by the enterprise, so it can be seen that the companies studied in this paper create greater value for society. In the following sections, this paper will perform multiple linear regression on 1786 companies to reflect on how PE affects company performance and corporate value. If we look at the
28 descriptive statistics of the sample with or without PE background separately in the below tables:
Table 5.5.2 The Descriptive Statistics of Key Indicators of PE-backed Companies
This table shows the descriptive statistics of the five key indicators of 1045 sample companies with PE background. Tobin’s Q equals the market value of an enterprise divided by the total asset. Delta ROE, ROE and Leverage ratio are shown in percentage. Size is the company size, the logarithm of total asset (in million CNY)
Indicator Average Standard Deviation Maximum Minimum Median
Tobin's Q 2.56 3.39 49.19 -0.45 1.69
Delta ROE 1.42 27.03 273.20 -77.80 -1.52
ROE 14.62 15.76 84.88 -28.78 13.10
Leverage 38.29 18.45 88.52 0.57 38.02
Size 4.94 1.08 10.40 1.45 4.92
Source: NEEQ database
Table 5.5.3 The Descriptive Statistics of Key Indicators of PE-free Companies
This table shows the descriptive statistics of the five key indicators of 741 sample companies without PE background. Tobin’s Q equals the market value of an enterprise divided by the total asset. Delta ROE, ROE and Leverage ratio are shown in percentage. Size is the company size, the logarithm of total asset (in million CNY). T-tests were conducted to investigate whether indicators in this table are significantly different from table 5.5.2. *, **, and *** indicate significance at 10%, 5% and 1%, respectively.
Indicator Average Standard Deviation Maximum Minimum Median
Tobin's Q 2.34 3.28 53.89 -0.63 2.11
Delta ROE*** -3.47 20.80 147.45 -89.98 -2.08
ROE*** 6.95 19.00 48.36 -48.99 9.45
Leverage 40.10 20.52 93.98 0.79 40.33
Size 4.50 1.07 8.11 0.78 4.53
29 Several t-tests were conducted to investigate whether the indicators of the two groups are significantly different from each other and I found that at a significant level of 0.05, compared to the ROE and Delta ROE of PE-free enterprises, those of PE-backed firms are significantly higher while Tobin’s Q, leverage ratio and company size are not. In European market, PE-backed firms have higher leverage ratio (Achleitner, Braun, Engel, Figge & Tappeiner, 2010), the insignificant difference between the leverage ratio of two groups could be the result of deleveraging encouraged by Chinese government.
By comparing the ROE of these companies, we found that PE-backed companies have significantly improved their performance. The maximum and minimum ROE of enterprises supported by PE are 84.88% and -28.78%, respectively, while the ROE of enterprises supported by PE is 48.36% and -48.99 %. From these data, it can be seen that the performance capability of SMEs has been positively impacted by the support of private equity investment. It can be said that private equity funds have a defined role in increasing the ROE of enterprises.
If we look at Tobin’s Q ratio, leverage ratio and company size, it is also not difficult to find that PE-backed companies present better statistical data.
5.6 Regression analysis
The following article introduces the regression analysis based on 1786 companies listed in the NEEQ, of which 1045 companies with PE backgrounds, to present the impact of PE financing on business performance and enterprise value.
Table 5.6.1 Regression Outcome
30
Delta ROEi = 1 + 1PEi + 2Sizei + 3Leveragei + 4Holding Ratioi + 5Manufacturing and Othersi
+6Financial Industryi +7ITi+ εi
Tobin’s Qi = 2 + 8PEi + 9Sizei + 10Leveragei + 11Holding Ratioi + 12Manufacturing and Othersi
+13Financial Industryi +14ITi+ εi
PE, Manufacturing and Others, Financial Industry and IT are dummy variables. If sample company has PE background, PE=1, otherwise PE=0. Same as for each industry variable, it takes the value 1 if a firm is in that industry. Below the coefficient, the t-statistics can be seen in the brackets. This table also reports the F-statistic and P-value of the two models. *, **, and *** indicate significance at 10%, 5% and 1%, respectively.
Dependent Variable: Delta ROE Dependent Variable: Tobin's Q Variable Coefficient Coefficient
PE 7.4466*** (6.2332) 0.2174 (1.3156) Leverage Ratio 0.2549*** (8.3011) -0.0208*** (-4.7446) Company Size -5.3078*** (-9.1999) -0.1501* (-1.8816) Holding Ratio -0.0317 (-0.9379) -0.0023 (-0.4845) Manufacturing and Others 2.2439
(0.2094) -1.2696 (-0.8569) Financial Industry 9.4804 (0.6520) -1.1810 (-0.5873) IT 3.1806 (0.2951) -0.9773 (-0.6556) Sample Amount 1786 1786 R2 0.0715 0.0266 F-statistic 19.5480*** 6.9387*** Prob(F-statistic) 0.0000 0.0000
Source: Wind database
Table 5.6.2 Correlation matrix of variables
This table illustrates the correlation of each two variables. PE, Manufacturing and Others, Financial Industry and IT are dummy variables. If sample company has PE background, PE=1, otherwise PE=0. Same as for each industry variable, it takes the value 1 if a firm is in that industry.
PE Tobin's Q Delta ROE Leverage Ratio Company Size Holding Ratio IT Manufacturing and Others Financial Industry
31 PE 1 Tobin's Q 0.0327 1 Delta ROE 0.0974 0.0670 1 Leverage -0.0462 -0.1472 0.1133 1 Size 0.1955 -0.0876 -0.1446 0.3088 1 Holding -0.1609 -0.0301 0.0043 0.1356 -0.1086 1 IT 0.0698 0.0792 0.0382 -0.2427 -0.2542 -0.0765 1 Manufacturing and Others -0.0706 -0.0799 -0.0368 0.2375 0.2363 0.0807 -0.9810 1 Financial Industry -0.0100 -0.0055 -0.0053 0.0109 0.1012 -0.0596 -0.0288 -0.1148 1
From the table 5.6.1 we can easily see that both pass the F-tests, which means the two regression models are statistically significant and provide a better fit than an intercept-only model. PE background has a significant positive impact on company’s business performance, company with PE background has a higher ROE increase in 2017 of 7.45%. However, Tobin’s Q, in another words, the enterprise value, is not significantly influenced by PE background. Leverage ratio shows different relationships with Delta ROE and Tobin’s Q, the coefficient is 0.25 and -0.02 respectively, which means for every 1% increase in leverage ratio, delta ROE would raise 0.25% but Tobin’s Q would decrease 0.02%. In terms of company size, delta ROE and Tobin’s Q are both negatively correlated to this variable, while the correlation between Tobin’s Q is less significant. On both dependent variables, holding ratio and industry variables do not have a significant impact, which means the equity concentration and industry of the company, in this case, are not related to the business performance and enterprise value.
6. Conclusion and Suggestions
6.1 Conclusion32 This paper analysed the impacts of PE funds on the business performance and enterprise value of SMEs from both qualitative and quantitative perspectives.
Following the qualitative analyses, the positive impacts of PE funds on SMEs, such as the ability to boost the listing of SMEs, improve the company's governance level, improve the company's equity structure and to provide high value-added services are pointed out based on two core theories- Principle-agent theory and Cost-benefit theory. However, PE financing can also bring negative impacts on SMEs, such as leading to undervalued enterprise value. There is also a risk that companies involved in VAM with PE institutions losing control of management if the company could not meet certain conditions. In conclusion, although backed by PE could bring SMEs a series of benefits, enterprises must always be highly vigilant and take relevant measures to evade certain risks.
From the empirical analysis of the impact of PE funds on business performance and enterprise value of SMEs by using the relevant data of SMEs listed on NEEQ in 2016 by several linear regressions, this paper quantifies the financing effect of PE on the selected sample. The study concluded that the PE funds are conducive to improving the business performance and the enterprise value, but the impact on business performance is more significant than on the enterprise value. The main factor might lead to the insignificance of the impact on Tobin’s Q value is that the NEEQ currently is illiquid and the stock market in China is inefficient, which could not reflect the real market value of the enterprises. Moreover, the degree of leverage ratio and company size should be controlled within a reasonable range according to the actual situation of the enterprise, in order to continuously improve the business performance and enterprise value.
33 6.2 Suggestions
6.2.1 Suggestions for the government
The government plays a vital role in the process of PE financing for SMEs in China, which provides not only a policy environment for SMEs but also a relevant legal guarantee for PE institutions. To ensure that both PE institutions and SMEs use the social resources at a optimal level, the following suggestions are provided to the Chinese government:
First, the government should strive to build a multi-level capital market and broaden the exit channels for PE funds as a perfect and mature capital market is a premise of a smooth exit of the PE fund. As is known to all, the multi-level capital market in the United States is well-developed, which not only meet the different financing needs of enterprises but also create favourable conditions for the exit of PE funds and promote the sustainable development of PE funds. The development of the multi-level capital market in China is still at an early stage. The capital market structure in China is mainly composed of main board and the second board, NEEQ, regional equity trading market and counter market. In 2011, the number of companies listed in China on those market is in the form of inverted pyramids, while the number of US companies listed on the trading floor is in the form of a positive pyramid. The latter form is more conducive to enterprise financing. In addition, the conditions of the OTC market are relatively low compared to SME board and the second board, which makes OTC market a useful supplement to the exchange market. In conclusion, the government should put more effort to accelerate the development of OTC market such as NEEQ. If the government could continuously develop and improve the multi-level capital markets, especially the OTC market, the exit channel of PE funds will be broadened, and the financing difficulty will be solved to a certain degree.
34 Second, the government should improve laws and regulations. Although China has promulgated “The Law of Securities Investment Fund” to define and regulate the PE funds, the relevant legal system of PE is not perfect. In 2011, the National Development and Reform Commission issued “The Notice on Promoting the Standard Development of Equity Investment Enterprises”. However, as far as the current situation is concerned, the implementation of the notice is not optimistic with a limited constraint capacity. Therefore, relevant institutions should strengthen the construction of the relevant legal system and incorporate the relevant rules of PE financing into the legal norms, so that both SMEs and PE institutions can be protected when they seek for corporation.
Third, the government should provide a stable and optimistic macro environment. PE financing of SMEs is inseparable from the macro policies of the government authorities. For example, in the United States and other western countries, the government has created a relative free and favourable macro environment for SMEs. In addition, pension funds, insurance companies and Banks are able to invest in PE fund and they play an essential role in the development of PE. But in China, PE funds are mainly raised by financial institutions and private capital, while the participation of social security funds and pension funds is relatively low. Although the social insurance fund was allowed into the PE investment field in 2008, it was stipulated that its investment proportion should not be higher than 10% of the total assets of the national social insurance fund. Therefore, China should learn from the experience of the United States and European countries, to gradually loosen the restrictions of social insurance fund and pension fund on the PE investment market. In this way, the financing channels of PE fund will also be expanded.
35
6.2.2 Suggestions for PE Institutions
First of all, broadening the sources of funds is crucial. From the existing PE investment business in China, we can see that it mainly relies on the government for financial support, and the private capital in the society is not mainly flowing into PE fund industry. So, there is still a huge space to expand the current funding channels for PE institutions. The suggestions for PE institutions are as follows：
(1) Strengthen the collection of pension funds and make full use of public funds. As far as the pension funds in China are concerned, the amount is relatively large, but the utilisation rate is low. After the adjustment of the national interest rate, the pension funds in China has been depreciating, resulting in severe losses.
(2) Moreover, the pension funds are not able to enter the capital market freely, resulting in the lower utilisation rate of China's pension funds. However, regarding the amount, if more than 20% of pension fund can be used as private capital, it will play a significant role in alleviating the financial pressure of the government.
(3) Accelerate the promotion of the PE institutions themselves, expand the scope of investment, attract capital inflows, and eventually improve the financing capacity. However, when we see the decisive advantages, we cannot ignore the existing risks. In China, there is a lot of money laundering through PE investments, which seriously disturbs the market rules.
(4) Encourage oversea capital to invest in PE in China. For now, the financial market in China has a large capacity, and many foreign investors are also very interested in the Chinese market. These investors can significantly enrich China's private equity investment market, improve the ability of China's financial investment market, and achieve scale development.
36 Meanwhile, advanced corporate management skills and corporate governance skills from large international institution investors could also benefit the both PE institutions and invested SMEs in China. In this way, the financial investment market in China could gradually move toward internationalisation.
The second suggestion would be that standardise the operating model of PE. From the negative impact that PE funds may bring to SMEs, we know that PE institutions in China still need to learn from the experience of mature oversea PE investment institutions and improve the professional capacity of PE fund managers. This kind of professional ability is not only reflected in the project investment choice but also reflected in the professional management after the project investment. Currently, many PE institutions in China are eager for quick success and profitability while management skills are ignored, leading to an unsustainable development of both the PE institutions and invested SMEs. We could conclude that private equity investment institutions must first have rich management experience, and secondly, have the skills to screen high-quality projects, to ensure that the performance boosting role of private equity investment can be better played.
6.2.3 Suggestions for SMEs
First, standardise the financial system. SMEs pay less attention on building an effective financial system, such as the financial budget system, the commercial inventory system and the internal audit system, while a structured financial system is crucial to SMEs. Therefore, an enterprise must standardise its financial system to ensure the authenticity, effectiveness and accuracy of financial information.
37 Second, reasonably expand the scale of the company. SMEs should continuously standardise the operation of enterprises, explore the innovation of enterprises, continuously improve the profitability and operational capabilities of enterprises, and eventually expand the scale of enterprises. It is necessary control the leverage ratio and company size in a reasonable range. Development of an enterprise is not all about pursuing an increase in the number of enterprise scale but also emphasize on improving the quality and quantity of the overall development of the enterprise in the same direction, to benefit the long-term development of the enterprise.
Third, attention should be paid to specific risks when introducing PE funds. SMEs must first define the goal of which they want to achieve together with the PE institutions. For example, whether to solve the financing problems of enterprises, to introduce strategic investors of enterprises or to seek to go public. When the goals of enterprises are clear, the enterprises will not be in a passive position. To avoid such risks, enterprises can consult with intermediaries and make decisions after a comprehensive evaluation.
Limitation
As the history PE funds and the NEEQ in China is relative short, only one year post listing business performance and enterprise value of SMEs are evaluated. Although the result indicates that PE funds has positive impacts on SMEs, it could be that PE institutions only seek for short term profits. A long-term analysis is needed as to strengthen the conclusion of this paper.
38
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