China: A controversial ESOP

Hillhouse Capital’s battle with Hopu Investment for a 15% stake in Gree Electric Appliances in 2019 was notable for its size, status, and background politics.

At RMB41.6 billion ($6.4 billion), the deal was huge by Chinese standards, and it involved a state-owned company that dominated the local air conditioner market. Moreover, suggestions were rife that the asset only became available because Mingzhu Dong (pictured), chairman of Gree Electric, had fallen out with Gree Group.

The associated employee stock ownership plan (ESOP) that would give Gree Electric’s staff up to 4% of the business received little attention. When details of who would receive these shares and how much they would pay for them emerged on June 20, nearly 20 months after Hillhouse’s triumph, the company’s stock dropped 5%. It fell another 2.5% the following day, reaching a 12-month low of RMB49.80.

“Investors are generally favorable towards ESOPs, but the Gree situation is controversial because of the pricing and the distribution ratio,” says one China private equity investor who has experience launching ESOP schemes for portfolio companies.

Employees were entitled to buy shares for RMB27.68 apiece, less than half the price immediately before the Hillhouse investment was announced. While the ESOP complies with A-share market regulations in that the entry point is not below the company’s net asset value (NAV), experts describe it as unconventional.

“Compliance with regulations and market response are two different things. When formulating an ESOP, it is standard practice to refer to a company’s peer group or benchmark against other companies. If there is a big difference, it may cause strong market reaction,” says Simon Cheng, an accounting advisory services partner with PwC in Hong Kong.

Xiaomi, which also generates most of its revenue from consumer electronics, might be considered one of Gree Electric’s peers. The Hong Kong-listed company launched a pre-IPO ESOP and a post-IPO share option scheme. Pricing for the latter is based on the public market fair value. Hong Kong regulations stipulate that ESOPs cannot be priced below this level.

Personal windfalls

The distribution of Gree Electric’s ESOP is controversial because it is heavily weighted in favor of Dong, who can apply for 27% of the shares allotted under the scheme. At present, she is one of the company’s 10 largest shareholders with a 0.74% stake.

Moreover, questions have been asked about Dong’s relationship with Hillhouse. The private equity firm’s consortium invested in Gree Electric through Zhuhai Mingjun. Gezhen Investment, an entity majority-owned by Dong, invested RMB2.4 billion for a 6.3% interest in Zhuhai Mingjun. Gezhen also holds 41% of Zhuhai Yuxiu, the management entity for Zhuhai Mingjun. Another entity, known as Jinghai, which is described as often acting in concert with Dong, has an 8.2% stake in Gree Electric.

It is not unusual for private equity firms to seek an alignment of interests with management or key executives of a target company. At the same time, it might be argued that by taking an interest in Gree Electric’s largest shareholder, Dong has consolidated her power within the company.

"When the actual controller of the company becomes the major beneficiary of ESOP, there might be concerns about this individual’s motivations and whether it is just an action to gain more control over the company," says Shiduo Xu, a Beijing-based partner at law firm Zhong Lun.

In the first phase of the ESOP, about 108 million shares are sold to 12,000 employees, accounting for about 1.8% of Gree Electric. Dong is entitled to subscribe to 30 million shares for RMB830 million, which means she could lock in an immediate paper gain of more than RMB800 million.

Employees are barred from cashing out immediately. The ESOP mandates a potentially extraordinary long holding period – rights can only be exercised on retirement.

While the lock-up period runs for the standard two years, shares allotted under the scheme are managed in a centralized manner, with a management committee acting on behalf of employees. If an individual sells any shares before retirement, or pledges them in return for cash payouts, the committee can recover the corresponding shares.

Although the arrangement appears to bind ESOP participants to Gree Electric for as long as they work for the company – thereby solidifying the align of interests – Dong is a risk factor. Aged 66, she might be nearer than most to exercising that sale right.

Gree Electric states that the ESOP is structured to ensure the sustainable development of the company. “This ESOP not only creates benefits for employees, but more importantly, it hopes to motivate employees to grow together with the company, instead of just pursuing short-term benefits. Gree is not a capital-operated enterprise,” the company said in a written response.

Not everyone appreciates this approach. “In my opinion, this is a relatively special clause, because if you can only exercise your right after retirement, the incentive effect for employees will be very weak. It means that the time limit has been extended a lot. A 30-year-old employee has to wait 30 years to cash out,” says Zhong Lun’s Xu.

ESOP qualification is another area of debate. According to PwC’s Cheng, ESOP allocations can be based on performance or length of service, depending on industry or peer group practice. Gree Electric’s method has been criticized. It requires a 10% improvement in net profit in 2021 and a 20% improvement in 2022 from 2020 levels. Annual cash dividends will not be less than RMB2 per share or the total cash dividend shall not fall below 50% of net profit.

The major criticism is that 2020 was not a normal year. Gree Electric’s net profit came to RMB22.2 billion, down 10.2% year-on-year due to COVID-19. To trigger the ESOP in 2022, the company must generate at least RMB26.6 billion; in 2018, net profit was RMB26.2 billion. Gree Electric’s public defense is that it will maintain stable growth and unrealistic performance targets are meaningless.

Corporate backpedaling

However, there have been some adjustments in the wake of the ESOP announcement. The company has launched a share buyback program, spending RMB6 billion in February and the same amount in May for an aggregate 3.48% stake. A third round, estimated at RMB7.5-15 billion is underway.

Gree Electric originally planned to distribute these shares to employees, but it changed tack seven days after details of the ESOP emerged, declaring that the second round shares would be repurchased “for cancellation to reduce registered capital.” By this point, shares acquired in the February round had already been used to support the first phase of the ESOP. The company says it has no specific plans regarding the timing of phase two of the scheme.

Hillhouse, meanwhile, has stayed silent. The private equity firm didn’t respond to a request for comment from AVCJ. Neither has it sought to intervene at Gree Electric at board level.

Lei Zhang, founding partner of Hillhouse, has said on numerous occasions that he "will respect entrepreneurship and insist that entrepreneurs sit in the 'C' position" at companies. At the Global Mulan Forum in April, Dong observed that Hillhouse having no board representation doesn’t equate to no communication. “Mutual understanding is an invisible force,” she said.

Although they acknowledge that mutual understanding is a desirable situation, experts suggest that private equity investors include protective clauses in their agreements.

”For example, an ESOP affects the rights of all investors, so a private equity investor can demand the right to review and approve it,” says Cheng of PwC. “Other important issues on which investors may want to exert influence as major M&A events, the establishment of joint ventures, the purchase and sale of major assets, amendments to a company's articles of association, and dividend distribution decisions.”

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• Topics
• Greater China
• PIPEs
• Regulation
• Consumer
• China
• Hillhouse Capital Management