Valuation Insights - Greater China Edition, May 2017

Valuation Insights is a quarterly e-newsletter that provides you with the latest news from Duff & Phelps and the trends and changes in valuation and accounting that could affect your business transactions in Asia.

In this edition, our top stories cover Hong Kong's SFC issuing guidance on corporate transactions and the use of valuations, the Financial Accounting Standards Board issuing an Accounting Standards Update, robust fair value measurement, the International Valuation Standards Council releasing the 2017 edition of its International Valuation Standards, and a recent Duff & Phelps study about fairness opinions.

We will also look at various important updates, including fintech in China; European market updates; and our Global Regulatory Outlook 2017. 

This Issue's Articles:

Top Stories:

• Hong Kong's SFC Issues Guidance on Corporate Transactions and the Use of Valuations
• New FASB Accounting Standards Update Revises the Definition of a "Business"
• Valuing Fund Interests of Increasing Concern?
• IVSC Releases 2017 Edition of its International Valuation Standards
• New Study by Duff & Phelps Puts Fairness Opinions in New Light

Updates and Market Trends:

• Fintech in China: Biggest in the World, Getting Even Bigger
• European Market Updates: Growth in the Shadow of Brexit
• Chinese State Council Releases New Guidelines on Strategic Emerging Industries
• PBoC Releases New Circular Concerning Cross-Border Financing Issues
• New Restrictions Set on China Outbound Investments

Latest Duff & Phelps Report and Articles:

• Professor Damodaran Recorded Forum Presentation
• Global Regulatory Outlook 2017
• Transaction Trail 2016 Annual Study: Latest Southeast Asia M&A Trends
• Embracing the Change: A Concise Report on India's Most Valuable Celebrity Brands

Top Stories

Hong Kong's SFC Issues Guidance on Corporate Transactions and the Use of Valuations
The Securities and Futures Commission ("SFC") of Hong Kong, having become increasingly concerned with some listed companies pricing acquisitions at unreasonably high levels or selling assets at an undervalue that harm shareholders' interests, on May 15, 2017, issued a guidance note on directors' duties, a circular to financial advisers regarding valuations in corporate transactions together with a statement on the liability of valuers for disclosure of false or misleading information.

The guidance note sets out the SFC's expectations on the due diligence that directors should take regarding corporate transactions.

The circular reminds financial advisers of their obligations under the Corporate Finance Adviser Code.

The statement (liability statement) warns valuers of their potential liability for valuation reports and related information in the disclosure documents published by listed companies. Valuers are expected to exercise the degree of skill and care ordinarily exercised by reasonably competent members of the profession. They may face both civil and criminal liability if the valuation report contained any materially false or misleading information.

"We expect to be drawn into a greater role than hitherto in assisting company directors in reaching reasonableness conclusions," said Patrick Wu, Duff & Phelps Valuation Advisory Services Leader for Greater China. "Our robust internal peer review system should enable our reports to withstand any heightened external scrutiny."

Read more on the SFC website

New FASB Accounting Standards Update Revises the Definition of a "Business"
In January this year, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2017-01, clarifying the definition of a business and introducing a framework for determining when a set of assets and activities constitutes a business.

The definition of a business influences how an entity treats acquisitions and disposals of an asset (or group of assets), and how it accounts for goodwill and consolidation.

"Stakeholders expressed concerns that the definition of a business is applied too broadly and that many transactions recorded as business acquisitions are, in fact, more akin to asset acquisitions," FASB Chairman Russell G. Golden explained in a press release. "The new standard addresses this by clarifying the definition of a business while reducing the cost and complexity of analyzing these transactions."

The new ASU prescribes an initial screen that specifies when substantially all the fair value of the gross assets acquired (or disposed of) is concentrated in a single identifiable asset (or a group of similar identifiable assets), the asset(s) does (do) not constitute a business, removing the need for further assessment.

As per the new ASU, to qualify as a business, an acquisition must include an input and a substantive process that altogether significantly contribute to the ability to create outputs. The ASU provides a framework to evaluate when an input and a substantive process are present. To still qualify as a business without outputs present, an organized workforce must be present.

Finally, the new guidance narrows the definition of the term "outputs" to be consistent with how it is described in Topic 606, Revenue from Contracts with Customers.

"The update will result in less assets and activities meeting the definition of a business, increasing the number of asset acquisitions accounted for," predicts Ricky Lee, Duff & Phelps Managing Director in Hong Kong. "This will have repercussions in many areas of accounting – among them acquisitions, goodwill impairment and consolidation."

Simon Tsang, Duff & Phelps Managing Director in Shanghai, believes the ASU's impact will affect a wide range of interests. "Most affected by the new ASU will be businesses concerned with real estate, pharma, and oil & gas," he explains.

Read the full ASU, with examples for various industries

Valuing Fund Interests of Increasing Concern?
For Chris Franzek and David Larsen, Duff & Phelps managing directors based in the New York and San Francisco offices respectively, robust fair value measurement remains an enduring topic of interest, despite no major revisions in five years to the accounting rules that define fair value.

In a new editorial published in Pensions & Investments, Franzek and Larsen note the following developments:

Limited partners demand greater accountability from general partners or lead investors, as far as fair value reporting is concerned. The use of fair value as the only objective measure to compare dissimilar investments allows LPs to make better-informed decisions around performance and asset allocation.

With more tools available to allow LPs to evaluate their portfolio performance, LPs now feel more motivated to reach out to GPs whenever a fund's net asset value or fair value underperforms. If GPs are found to lack robust valuation processes, or otherwise fail to prove their ability to create value in their investments, they may find less future allocations coming their way.

"Fair value is an important piece of the analysis that is an input to the capital allocation decision," writes Franzek and Larsen. "Gone are the days when a GP got meaningful credit for increases in value because the market went up."

Regulators' influence on fair value determination will continue. The regulatory regime will continue to place high importance on fair value, as evidenced by developments in the EU and Brazil. In the U.S., the SEC and European regulators have penalized funds for poor valuation practices.

By 2018, the American Institute of Certified Public Accountants will release a new guide for the valuation of private equity investments. CPAs will benefit from the guide's examples, and audit firms are predicted to implement the guide on a global basis.

The valuation profession will also undergo a form of self-regulation, through the implementation in the U.S. of the Certified in Entity and Intangibles Valuations ("CEIV") designation for fully-certified valuation professionals.

"Once the CEIV certification rolls out, auditors will place more credibility in valuations performed by a CEIV-holding professionals," explains Patrick Wu, Duff & Phelps Valuation Advisory Services Leader for Greater China. "In time, only CEIV-compliant professionals will be perceived to have sufficient competence and confidence in performing fair value measurements."

Read the full article in Pensions & Investments

IVSC Releases 2017 Edition of its International Valuation Standards
The International Valuation Standards Council ("IVSC") has released the 2017 edition of its International Valuation Standards ("IVS 2017").

The new edition allows greater harmonisation for valuation practice on a global scale. Valuation professionals may use IVS 2017 as a key guiding text to reinforce consistency, transparency and confidence in valuations.

IVS 2017 is composed of a Framework, five General Standards, and six Asset Standards:

• General Standards: Requirements for the conduct of valuation assignments performed under IVS, including establishing the terms of a valuation engagement, bases of value, valuation approaches and methods, and reporting;
• Asset Standards: Requirements related to specific types of assets, including background information on the characteristics of each asset type that influence value, and additional asset-specific requirements regarding common valuation approaches and methods. Guidance is available for intangibles, real property, personal property, and financial instruments, as well as for business and business interests.

"IVS 2017 represents the latest in IVSC’s continuing commitment to developing high-quality valuation standards," noted Sir David Tweedie, Chairman of IVSC. "The valuation of assets, both tangible and intangible, plays an essential role in financial and real estate markets – and therefore the global economy."

"IVS 2017 will be instrumental in improving valuation practice and will bring greater efficiency to capital markets."

The IVSC has announced that IVS 2017 adoption will become effective by July 1, 2017. Early adoption is encouraged.

The IVSC is an independent, not-for-profit organization whose objective is to build public trust in valuation by producing valuation standards and securing their adoption and implementation globally.

Read more on the IVS 2017

New Study by Duff & Phelps Puts Fairness Opinions in New Light
Most fairness opinions use a robust set of methodologies to produce a useful range of valuations, according to Duff & Phelps' recent study on the subject. This conclusion addresses periodic criticisms that fairness opinions generally provide little utility for boards analyzing potential transactions as they produce valuation ranges too wide to provide meaningful information.

In an effort to assess the validity of these criticisms and determine the overall usefulness of fairness opinions, Duff & Phelps conducted a thorough analysis of more than 3,000 fairness opinions during the ten-year period ending in 2016.

The study found that in the vast majority of cases, fairness opinions offered valuation indications falling within 15 percentage points on either side of a midpoint: a range sufficiently narrow to justify its use as a valuable tool in evaluating purchase offers.

That average range narrows even further as the deal size grows larger. For deals carrying a value of $10 billion or more, DCF analyses produced average price ranges between 78 percent and 106 percent of the offer price.

"The analysis proves that fairness opinion advisors use robust, sophisticated methods to reach those valuations," reports Varun Gupta, Duff & Phelps Managing Director and leader of the firm's operations in Southeast Asia and Japan. "We can only conclude that, broadly speaking, fairness opinions represent a reliable way for corporate boards and executives to evaluate purchase offers."

Read the summary of the study

Updates and Market Trends

Fintech in China: Biggest in the World, Getting Even Bigger
A fintech boom has taken China by storm. In 2015, online financial technology services managed funds amounting to US$1.8 trillion. China stands out as the world's largest fintech market - "leading the world when it comes to total users and market size," as a 2016 McKinsey report noted.

Why has China beat the rest of the world in fintech? Several converging factors can be considered, but timing plays a huge role in their runaway success. Chinese enterprises stepped in where conventional banks and lending agencies would or could not, reaching the world's largest internet-connected userbase (amounting to over 700 million users) who needed online financial services denied to them by China's old-fashioned state-owned banks.

Chinese borrowers leapfrogged the West's avid use of credit and debit cards, proceeding from cash directly to digital payments via smartphone. Early adoption via smartphone has also allowed non-financial companies to seize the high ground in fintech early on, specifically the three biggest Chinese Internet giants – Baidu, Alibaba and Tencent – who got their start offering internet search, e-commerce and internet messaging, respectively.

Today, these three companies have leveraged their core competencies to dominate the fintech space.

Other fintech startups have followed in their wake. A current tally of 27 fintech "unicorns" (startup companies valued at over US$1 billion) all over the world counts eight Chinese companies among them, with a combined valuation of US$96.4 billion.

The top four in the list are all based in China: Ant Financial (worth US$60 billion), Lufax (US$18.5 billion), JD Finance (US$7 billion), and Qufenqi (US$5.9 billion). All told, these companies have made great strides providing the following services:

Payments Services
China's internet giants helped create – then took advantage of – a massive e-commerce ecosystem, leveraging the data and user base collected in their core businesses into one of the largest online payments markets in the world. Mobile payments in 2016 tripled from its previous year's value to 38 trillion yuan, or over US$5.5 trillion – a figure fifty times higher than the American market.

Online Lending
China's state-owned banks used to overlook small borrowers, forcing users to resort to extortionate gray-market lenders like pawnshops and loan sharks. This has set up a massive opportunity for online lenders, who can step in to cover a US$3.5 trillion "financing gap" faced by small businesses.

In 2015, registered peer-to-peer lenders in China originated over US$60 billion consumer and over 40 billion business loans. This space is owned by Lufax, China’s biggest peer-to-peer lending platform, currently valued at US$18.5 billion.

Wealth Management
A decade ago, China's young white-collar workers could either invest their money in low-interest bank accounts, or in the high-risk stock market. Fintech companies provided another solution. One example is Alibaba's Yu'e Bao which, launched as an opportunity for Alibaba users to earn interest on the funds in their ecommerce accounts, sold out within three days of its launch in 2014.

Users were attracted by rates over three percentage points higher than banks, with minimal risk. Within 18 months of its debut, Yu'e Bao had 600 billion yuan of assets under management. Tencent launched its wealth management platform Licaitong in the same year, and had about 100 billion yuan of assets within a year of launch.

Chinese regulators have so far proven lenient: recent guidelines provided by the China Banking Regulatory Commission ("CBRC") look to ease restrictions hampering commercial banks’ entry into the fintech space. New rules governing the Chinese money market are seen to be "moving in the right direction", but not yet completely in alignment with international best practice.

There's no question that fintech in China enjoys government support. No less than Premier Li Keqiang confirmed this at a recent visit to a Shenzhen fintech launch when he said, "The government won’t leave you in the cold. A warm spring will be created for the new private banks."

European Market Update: Growth in the Shadow of Brexit
The issue of Brexit aside, Europe is set for healthy growth ahead – maintaining its position as a choice destination for investment by Chinese firms.

According to MOFCOM, over 2,000 Chinese firms currently have offices in the EU, employing over 47,000 people and worth a cumulative investment of US$ 40 billion from 2010 to 2014 – increasing fivefold over that time span.

This growth is largely due to encouragement by the Chinese government, including initiatives like the creation of the China Investment Corporation sovereign fund and bodies like the China Eximbank, China Development Bank (CDB), and the Asian Infrastructure Investment Bank.

Chinese outbound M&A takes advantage of the EU's trade-oriented mindset, and the latter's realization that China represents a significant and growing market for European companies. A certain degree of protectionism in the EU encourages Chinese companies to invest by other avenues aside from stake acquisition, such as through strategic alliances and joint ventures.

Critical Chinese investments in Europe include the acquisition of Swiss agrochemical firm Syngenta by ChemChina for US$43 billion; a majority share in German industrial robot maker Kuka by the Midea Group; and financing of the UK Hinkley Point nuclear plant by Chinese state-owned nuclear company China General Nuclear Power Group.

Despite the shadow of Brexit, Chinese investment in the UK has grown by 203.7% since 2010 – with a predilection for investment in the UK real estate market.

Chinese State Council Releases New Guidelines on Strategic Emerging Industries
China's State Council unveiled guidelines on China’s strategic emerging industries last December, to be implemented as part of its 13th Five-Year Plan period.

Five new pillar industries will be given particular attention: information technology, bio-industry, green and low-carbon industry, high-end manufacturing, and digital and creative industry. The output from these industries is expected to reach up to 10 trillion yuan (about 1.44 trillion U.S. dollars), accounting for 15 percent of GDP by 2020.

As per the Guidelines, several objectives will be set for implementation during the 13th Five-year Plan period. The objectives include innovation in the bio-industry, growth in new-energy vehicles, economies of agglomeration to be promoted across all five industries, and attraction of foreign capital to support them.

With cross-industry convergence implemented on a broader scale, the Guidelines forecast that the industries will be responsible for the creation of over 1 million jobs each year.

"The Guidelines set high expectations for stakeholders in strategic emerging industries," explains Kevin Leung, Duff & Phelps Managing Director in Beijing. "Robust growth is projected in the IT industry, new energy industries, and digital and creative industries. Policy support from the Chinese government will prove invaluable in helping achieve these objectives."

Read the press release

PBoC Releases New Circular Concerning Cross-Border Financing Issues
A new circular issued by China's national bank loosens cross-border financing restrictions for banks and businesses, giving Chinese enterprises a bit more freedom to procure financing from beyond its borders.

On January 11, 2017, the People’s Bank of China ("PBoC") issued its Circular on Issues concerning the Overall Macro-prudential Management System for Cross-border Financing ("Circular 2017").

The Circular doubles the upper limit for financing from abroad, to two times an enterprise's net assets. Foreign-invested enterprises have one year to choose whether to use the old “borrowing gap” rule for cross-border financing, or a new model under Circular 2017.

Affected enterprises include businesses and financial institutions incorporated within China's territory, including the branches of foreign banks in China. Government financing vehicles and real estate enterprises are not included in the Circular's coverage.

"We don't expect an effect immediately, given the one-year grace period provided to enterprises in China," says Duff & Phelps Managing Director Joe Zhou in Hong Kong. "But from a valuation point of view, we predict that Circular 2017 will prove beneficial to Chinese enterprises and financial institutions in the medium term." 

New Restrictions Set on China Outbound Investments
A sharp drop in the value of RMB against the US dollar in 2016 and increased M&A activities by Chinese enterprises have pushed the Chinese Government into implementing new measures to tighten outbound transaction approval.

The Government is reported to be implementing stricter oversight on six different types of outbound investments: extra-large outbound investments; ODI by limited partnership; minority investments in listed companies; "small parent, big subsidiary"; privatisation; and high risk/low return transactions.

The measures, endorsed by officials from the People’s Bank of China ("PBOC"), the State Administration of Foreign Exchange ("SAFE"), the National Development and Reform Commission ("NDRC") and the Ministry of Commerce ("MOFCOM") cover sectors like real estate, hotels and hospitality, cinemas, and entertainment.

Banks are subject to tighter rules as well: overseas transfers of US$5m or more under any capital account item must be reported to Beijing SAFE. Rules for cross-border RMB lending by Chinese companies have also been modified by the PBOC, requiring pre-registration with SAFE and applied to both foreign currency and RMB lending.

The restrictions are rumored to stay in place until September 2017.

"For companies concerned with outbound fund transfers, the situation is more difficult than ever," comments Patrick Wu, Duff & Phelps Valuation Advisory Services Leader in Greater China. "We would suggest that Chinese buyers consider alternative plans, such as using offshore funding to avoid fund flow from China to overseas, subject to the buyer’s overseas financing ability."

Read a full analysis

Latest Duff & Phelps Reports and Articles

• Professor Damodaran Recorded Forum Presentation
  On January 18, 2017, Duff & Phelps hosted a Valuation Forum at Trident Bandra-Kurla Complex, Mumbai with over 200 attendees. NYU Stern School of Business Professor Aswath Damodaran was the esteemed guest speaker.
• Global Regulatory Outlook 2017
  The Duff & Phelps fifth annual Global Regulatory Outlook (GRO) report aims to assist the global financial services industry with navigating the key regulatory and financial services developments in 2017.
• Transaction Trail 2016 Annual Study – Latest Southeast Asia M&A Trends
  In December, Duff & Phelps released the Transaction Trail report for 2016. Now in its sixth year, the report covers 2016's salient developments in M&A, private equity/venture capital investments and initial public offerings in Singapore, Malaysia and Indonesia.
• Embracing the Change: A Concise Report on India’s Most Valuable Celebrity Brands
  The second edition of our annual study of celebrity brand values in India was released in November 2016. The report, “Embracing the Change: A concise report on India’s most valuable celebrity brands" ranks the top 15 celebrities in India based purely on their earnings potential from brand endorsements.