Management Buy-out (MBO) practices are not an appropriate method at this time for domestic enterprises to re-arrange their ownership structures, given the country's immature economic environment.

MBO refers to the acquisition of all or part of the equity capital of a company by its directors and senior executives, usually with the assistance of a financial institution.

By trying to combine ownership with management, the MBO scheme aims to solve the problem of inefficient corporate agencies incurred from separate ownership and management teams.

Since the early 1980s, the MBO has been a common financial arrangement in Western economies. Transferring corporate equities to the managers, it acts as a direct incentive for management and reduces agency costs.

Based on those merits, the MBO has been introduced into domestic markets, as have many other Western financial practices. It has become a widely used financial tool in restructuring domestic enterprises since last year. This year, it has become even more popular.

Dozens of domestic firms have recently completed MBO restructuring. Non-listed firms that have conducted MBO restructuring far outnumber listed ones. And a number of firms are expected to experiment with the MBO system.

Facing such a trend, cooler heads must prevail. Past experiences show that many financial innovations - although effective in advanced Western economies - may go awry in China, which is only at the initial stage of establishing a market-driven economy.

Analysis shows that the difference lies in different economic environments. There are many preconditions for the smooth implementation of MBOs.

The ownership arrangements with the targetted enterprises must be clearly drawn. Social credit levels should be high; the economic environment must guarantee that contracts be effectively fulfiled. There should also be the existence of a full-fledged human resources market and a high-level and strict financial market, where an effective pricing mechanism is in place. Moreover, a functioning regulation system must exist.

MBOs cannot be effectively carried out if any of these prerequisites is not met.

Not all of these conditions are present in China at the moment.

Seen from the perspective of targetted companies, 84 per cent of the eventual ownership of domestic listed companies belongs to the State, which means that in practice, ownership is often entangled with other interests.

Given the unclear ownership of the equities of listed companies, it is hard to decide who will be responsible for assets of the targetted companies and how to fix prices during the process of restructuring the assets.

Besides, the senior executives of those companies are appointed by the government. There also is a lack of a mature high-calibre executives market.

Under these conditions, it is possible that the management of targetted companies, which are directly appointed by higher administrative departments, may not be truly responsible for the assets evaluations of their companies. Managers might even take advantage of inside information to seize corporate assets.

For example, they may conspire to conduct correlative transactions or underquote State assets to eat away at the public's fortunes. They may also tailor financial accounts to control the prices of the targetted companies for their own benefit.

Under such circumstances, if we rush to push through MBOs, a large quantity of State assets may be set at risk.

That partially explains why many people have been eager to introduce such practices.

Although the State Asset Supervision and Administration Committee has been established, the problem of pricing targetted companies remains. It is still possible that some managers and government officials could collude to acquire State assets.

From the perspective of resource allocation, the government holds most of the resources in listed companies and commercial banks. With most of the resources in the hands of administrators, the sale and purchase of companies could not be conducted in a competition-based market environment, which makes it impossible to come up with rational market prices for the companies on sale.

Transactions thus run the risk of being mired in under-the-counter or government-controlled deals, which may not only lead to the loss of State assets, but could also put a premium on power-for-money deals.

Seen from the perspective of systematic arrangement, domestic laws and regulations governing MBOs are either absent or do not function well. This leaves too much room for dealers to manoeuvre for their own ends and may cause possible legal risks.

The financing of managers, for example, is the most important part in the process of MBOs. But there have been no legal documents governing in what way management can pool the necessary capital for purchasing a company. This not only makes it difficult for management to finance such moves, but means many of the existing financing methods in place are illegal.

This, in turn, may even spur management to adopt illegal methods while conducting MBOs.

To regulate MBOs, the relevant laws and regulations must first be established.

What is significant is not whether MBOs can or cannot be carried out in China, but whether a comprehensive legal framework is in place.

Only when such a framework is established can the MBO become a part of the market and grow on the right track.

And only in that way can the MBOs be effective to improve the efficiency of corporate management.

The author is a researcher with the Institute of Finance and Trade Economics under the Chinese Academy of Social Sciences.

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