Apollo Investment Management 
Angel of mercy, or falling angel? Strange happenings at Quality HealthCare

The high-flying Quality HealthCare Asia announced recently that it will set up ehealthcareasia.com. As shareholders we were delighted by this news. True, there is plenty of competition - in my first twenty-four hours in Hong Kong last week I met no less than five old friends and acquaintances immersed in five different web startups of a healthcare flavour, and there are US sites and startups with enormous financial backing. Within Hong Kong, QHA's large network of medical, dental, and physiotherapy practices, and its tie-up with Hong Kong Baptist University in Chinese medicine, gives it a useful head start for content, and it may be able to build a regional franchise with Chinese language content, sections on Chinese and alternative medicine, and information of local relevance, such as on tropical diseases and local epidemics. It shouldn't cost very much, and there is scope for huge windfall gain if one can cobble this together quickly and float it while Internet fever lasts.

We were even more delighted when I visited the company on 1 December and was told that this was a logical extension of the internal intranet development which the company needed to do anyway, for administrative purposes - patient records, staff education, and presumably information on drugs etc.

We were less amused to hear later of a press release* which had been issued that morning, proposing that, "subject to independent shareholder approval, ehealthcareasia Limited would be granting a company beneficially owned by [QHA's executive chairman] Mr O'Connor a right to acquire up to 20% shares in the internet subsidiary. A proportion of these shares will be used to attract key personnel to ehealthcareasia.com..."

When I raised this issue with the company, I received an extremely aggressive response by telephone from the chairman, accusing me of appalling misrepresentation and deliberate mischief-making for referring to the first sentence without the second, so there you have the two together. Mr O'Connor does not deny that he will keep some of the shares, but told me that he will be lucky if he ends up with 2-3%.

My point, however, is that it best serves the minority shareholders if the interests of key executives - particularly executives as pivotal as Mr O'Connor - are as closely as possible aligned with those of the minorities. Jack Welch has absolutely refused to contemplate tying executive compensation to the performance of individual units within General Electric. The Financial Times of 4th December commented that "allowing top executives to benefit from the results of a particular unit or fund could put their interests at odds with shareholders. Graef Crystal, an executive compensation expert in Santa Rosa, California, said: 'It's like a chef who somehow manages to get the finest morsels of tenderloin on his plate and the gristle on someone else's.'"

Mr O'Connor claims that this is appropriate because (1) he "brought ehealthcareasia to the group", (2) stock exchange limits on option issuance prevent him from being adequately incentivised. Let's take those arguments in turn.

Any chief executive or board of directors who is not by now considering the impact of the Internet on their business, the threats and the opportunities it presents, must surely be extremely remiss. No great originality of insight was required here. ehealthcareasia has not yet started up, and Mr O'Connor is paid by Quality HealthCare for a full time job there. (For the record, we'd like to thank Mr O'Connor for the great job he's done for shareholders to date. We implore him not to lose that focus now.)

As for incentives, by 31 December 1998 he had been granted 10.75m options at an average exercise price of HK$0.4832. At 30 November prices, the difference between market and exercise price was worth US$3.7m, not bad for two years work, on top of a salary which appears up to Hong Kong standards. (We don't know whether more options have been granted in 1999.) His family trust Montel owned 58.58m shares, worth US$24m, as well as 50% of Cherish which owned another 196.81m ord shares and 31.37m warrants - so Mr O'Connor's stake at end-November was worth US$68m. He considers this irrelevant, on the grounds that he paid for the shares. We paid for ours too. If I were in your shoes, Mr O'Connor, I'd still think it worth coming to work in the morning.

Mr O'Connor assures me that at least one investor has thanked him gushingly while wishing him even greater corporate largesse. The Atlantic and Pacific oceans both contain deep rifts, with some American investors condoning greater incentives and tolerating conflicts of interest which would be unacceptable in other jurisdictions, so it is fortunate that we shall have the opportunity to vote. Meanwhile the Hang Seng Index has risen 7% since the end of November, but Quality HealthCare has fallen 8%, which strongly suggests that some shareholders have been voting with their feet.

I am told that the independent directors were happy with the announcement made, although they will be advised by the Independent Financial Adviser (yet to be named) before making a formal recommendation to minority shareholders on how to vote. Now, the usual problem with independent directors in Hong Kong is that they are appointed and removed by the controlling shareholders, and are therefore independent only in name, but in this case they include Ronald Carstairs, Managing Director of Dah Sing Financial Holdings, and Moses Cheng, Chairman of the Hong Kong Institute of Directors and described in the annual report as "an advocate of good corporate governance in public companies" - so I'm somewhat surprised at their acquiescence to date. Let's have a public debate, for there is a precedent at stake here.

The company argues that options in the e-subsidiary are normal and necessary to encourage the right people to work there. This might be true in the US (although it is not clear that General Electric is yet suffering as a result of its refusal to adopt such incentives), but it is not necessarily true in Hong Kong, especially when the parent stock is itself a high-flyer, and of a size where the success of the e-commerce venture could be very material. Paying with shares or options may enable a start-up to minimise salary costs, but Quality HealthCare is an established company which already employs hundreds of professionals and can afford to take on a few more. The directors will also have to consider the morale of existing staff, who may be required to sink significant effort into helping the e-commerce team - particularly in this case, where the project is so integrated with the existing business.

Even if one were to accept the case for ehealthcareasia.com stock to be issued to certain specialist staff (which I do not), it is unclear why this should include Mr O'Connor. We are not aware that he has particularly relevant experience in e-business. Arguably his skills in assembling and motivating and managing a team, marketing a concept, raising finance and managing the exit strategy are highly relevant, but then those are precisely the skills for which he is employed and incentivised to run the Quality HealthCare group, and his responsibilities already include the subsidiaries.

If, despite these arguments, one took the view that Mr O'Connor should be included in the elite group to be incentivised, why is it necessary to give away 20% up front, leaving discretion with Mr O'Connor as to how much should be distributed to others? In the main board scheme, for example, the listing rules permit option schemes of up to 10% of the issued shares (but the company does not have to issue these all at once), with any individual employee or director limited to 25% of the scheme (equivalent to 2.5% of the ordinary shares). Surely discretion should remain with the company, and Mr O'Connor's maximum stake be fixed in advance, to avoid any conflict of interest when it comes to recommending the appropriate remuneration package for other employees.

One of QHA's advantages lies in the strong shareholder incentivisation of the doctors and other key staff who have accepted stock for acquisitions. Employee shareholders of Quality HealthCare may be particularly concerned to maintain the alignment of interests with their chairman. While I find it hard to agree with Mr O'Connor that he personally is inadequately incentivised, it is possible that the number of professionals employed and the overall size of the company make this one of the rare cases where the options limitations set by the listing rules are inappropriate. If this is thought to be the case, then shareholders could be asked to approve a scheme whereby all employees with options over QHA shares are given a proportionate stake in ehealthcareasia.com. A simpler scheme, however, would be that salaries if necessary should be supplemented by a bonus applied to the purchase of new QHA shares at market - and this would be a more durable structure, since an ehealthcareasia flotation, if achieved, could well follow the "roman candle" pattern so common in the US (soaring skywards, then plunging to earth), enriching only a single generation of employees rather than laying a base for the future.

Quality HealthCare at present prices can only be treated as a concept stock, with a ten-fold rise in the ordinary shares from their Sept 98 low. I reported to investors in April that the price had risen steeply but appeared justified on a prospective PE of about 16. Now the current year PE is believed to be of the order of 50, and with little evidence on the timing of profits we fall back on market capitalisation as the main valuation tool. At the end of November this was a diluted US$360m. Given the size of the Hong Kong market and privatisation drive, commensurate profits are not inconceivable, but for healthcare companies elsewhere, profitability has been notably elusive. The strong incentivisation of employee shareholders is one of QHA's great advantages. If preserved, this may allow the company to restrain costs while racing for growth and the desired trade sale. Since both this incentivisation, and the effective cost of new acquisitions, depend on the share price, all the more reason for the share price to be nurtured. You've done so well with this company, Mr O'Connor. Don't blow it now. 

Claire Barnes, 11 December 1999

*  I quote above from the press release, but a formal announcement was made to the Stock Exchange. This highlights another issue on which both David Webb and I have commented before: the failure of the Stock Exchange to ensure efficient dissemination of information which should be readily available to investors. QHA publishes press releases on its website; it does not publish its formal announcements, nor apparently make them available to Bloomberg. This puts at a disadvantage both non-residents of Hong Kong, and all those resident investors who cannot afford the time, personnel, or space to clip and file the newspapers on a daily basis. In the Internet age, the Stock Exchange has no excuse for its failure to ensure that "public information" is indeed made public. Moreover, a useful site would draw traffic. If it had any commercial nous, the Exchange could fund the minimal expenditure through advertising, or indeed through its own flotation.

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