Bulletins

M&A and Partnering – December 21, 2010

China's Inbound M&A

China’s domestic and in-bound merger and acquisition (M&A) activity reached peak levels before the financial crisis, but has recovered strongly in 2010. While there are enormous opportunities emerging for international and domestic investors, what are the key lessons for foreign access to China M&A? What are the proven strategies and solutions for ensuring deal success?

How was M&A performance by foreign firms in 2010?

In 2010, Chinese companies’ acquisitions overseas dominated the headlines. Be they successful bids like Geely’s purchase of Volvo or Sichuan Tengzhong’s failed attempt to acquire General Motor’s Hummer brand back in February, there have been signs of a gradual reversal of flow of M&A activity in China.

Despite this growing trend, Chinese buyers – often run by the Communist Party or sponsored by state-run banks – have still only accounted for a tenth of cross-border deals by value this year. Foreign investment continues to flow into the country at double the rate of outbound investment, with foreign direct investment into China likely to pass $100 billion this year for the first time.

China’s domestic and in-bound merger and acquisition peaks have rebounded strongly in 2010, reaching peak levels before the financial crisis. While the number of announced inbound M&A deals decreased by roughly 12 percent from last year (largely the result of tightened credit to foreign buyers beginning last year), the average deal size has increased over the same period. In the first quarter of 2010 a total of 8 deals, out of 18 inbound M&A deals announced in Q1 2010, disclosed their M&A value, which amounted to USD 4.5 billion, or a 50 percent increase from Q1 2009.

Given these figures, it is apparent that international and regional companies are eyeing China’s continuing modernization and growing population of consumers – many of whom are part of China’s growing middle class. According to Shen Danyand, a spokesman for the commerce ministry, “Foreign investors are upbeat about China's economic outlook and Beijing's efforts to improve the investment environment have boosted their confidence.” However, despite painting a positive picture for foreign investors, Beijing hopes to avoid an overreliance on the export economy model by increasing domestic consumption and growing Chinese businesses from within thereby making the path for international investors increasingly challenging.

What problems do foreign investors face when entering the Chinese market?

The Chinese government regards foreign investment as a means to attain foreign know-how rather than just jobs and capital. Subsequently, the Chinese government tends to push foreign firms into joint ventures over outright acquisitions of Chinese firms. In some sectors, joint ventures cannot be avoided because of government limits on foreign ownership. This tends to be the case for most financial services such as life insurance, fund management, securities, and banking, where foreigners cannot hold a majority stake. Even in sectors where foreign firms are given greater latitude, joint ventures are commonly created to capture market share, rapid access to distribution or to ensure government support. The Chinese government’s regulation of these cross-border dealings is nothing new, but has been magnified amidst global economic concerns and their own aspirations for continued economic growth.

A recent U.S.-China Business Council (USCBC) study echoed these policy-related concerns among leading American companies. In its November 17 “2010 Member Priorities Survey Results”, the USCBC concluded that while most U.S. companies still hold strong commitments to the Chinese market and stayed profitable in China over the past year, the market is generally less FDI friendly compared to three years ago. The report shows that government policy is one of the major factors responsible for the deterioration of FDI opportunities in China.

The study listed the top 10 investor concerns surrounding the Chinese market. Rounding out the top three concerns that hindered U.S. investment in China were human resource issues (roughly 8 percent of companies consider “insufficient personnel” as the leading restraint on profit growth), competition with state-owned enterprises and licensing approval. Additionally cited were intellectual property rights enforcement, cost increases (primarily increasing labor costs), government procurement, market access in services, transparency, protectionism risks, and standards of conformity assessment.

Of those surveyed, 27 percent of companies consider Beijing’s policies as the top restraint, and 24 percent of them chose domestic competition as the biggest hindrance. The report highlights China’s Anti-monopoly Law as a major obstacle to M&A procedures, which, in a less friendly FDI environment, has become the focus of foreign companies for further growth in China. In contrast to a very pro-foreign enterprise attitude that defined the first two decades of Deng Xiaoping’s economic reforms, the study notes that current policies favor Chinese companies. Specifically, Beijing-backed indigenous innovation has contributed to the increasing competition between foreign and Chinese enterprises.

As China’s economy continues to grow at an average of 8 to 10 percent a year at a time when the developed world looks set for a period of prolonged stagnation, it is no surprise that foreign companies concerned about their future growth in the region, attempt to ride China’s wave. And with more than 300,000 foreign firms investing in China, finding strategies and solutions to continue their growth there has become vital. This is an issue we see an increasing number of our client engagements focusing on.

What are the proven strategies and solutions for ensuring deal success?

From a cultural perspective, companies need to show an effusive respect for China’s traditions and business culture. Despite experiencing several decades of shared growth, given the West’s tumultuous history with China, the Chinese are highly suspicious of foreigners. This means that foreign companies need to be willing to make a commitment to China for the long-term. It took nine years for L’Oreal to become profitable in China and KFC spent ten years perfecting its business model – something competitors like McDonalds have failed to do – before becoming the mainstay now with 2,100 restaurants in 450 cities.

Investing in China today has its challenges and obstacles but is not so different to doing transactions in other developing markets. In addition to significant competition vying for market share in an emerging market, investors face extensive red tape in the form of regulatory obstacles and lengthy approval processes – all of which should be factored into an acquisition plan.

Foreign firms are up against Chinese buyers, international competitors and private equity houses (most of which in Asia still have high liquidity). With such ardent attention from investors and arguably generous valuations of listed Chinese companies, the valuation gap between buyer and seller can quickly expand. This gap can be reduced by effective due diligence, negotiating valuation adjustments, and earn-out payment mechanisms that link payment with post-closing performance targets.

After identifying the sector and company of interest, businesses have to endure the government approval process. If the business is in a sector that is not heavily regulated, then the main approval authority is the Ministry of Commerce, with other agencies becoming involved in more-regulated sectors. However, even if MOFCOM is the sole agency involved, they can still restrict a foreign firm's ability to acquire control of a company, particularly with larger deals, in which case the government can restrict a foreign firm’s ability to acquire control of a company. Additionally, a more common problem is that processing of an acquisition is often slowed as there are various agencies that oversee the sale of state-owned assets, often resulting in investors having to undertake various legal and financial restructurings of the business. For example, to enable a foreign investor to purchase an acquisition target might first require a restructuring of the business, followed by a backdoor listing of the listed company by another player. These delays and restructurings can be very costly to a company hoping to operate in the fast-paced market that is China. At the recent National People’s Congress, Chinese Premier Wen Jiabao set a modest 8 percent target for GDP growth in 2010, compared to last year’s actual 8.7 percent GDP growth. He emphasized that the “quality” of the growth was of greater importance than volume. What this means for investors is that merely bringing money to the table may not be enough for the bigger M&A deals. This was largely the case when the ministry of commerce supposedly rejected Tengzhong’s acquisition of Hummer in February this year. Satisfying the government’s criteria for quality is an important part of the process. Investments that share valuable technology, address energy issues, reduce greenhouse gas emissions, or enhance domestic manufacturing, will be encouraged. Conversely, investments in sectors that are suffering from overcapacity or are divergent to technological and environmental concerns will be discouraged.

What has China learned from the financial crisis and what does it mean for foreign companies interested in inbound Chinese M&A?

Most notably, the financial crisis encouraged the government to reduce its reliance on exports (which took a hit in the past year). With export industries so dominant in the economy – and supporting approximately 90 million jobs – the government has recognized the risk and wants to induce a shift towards self-sufficiency and production for domestic consumption. While this inward-looking policy may appear to spell bad news for inward investment, it actually strengthens the domestic market thus making the conditions for investment more desirable.

Furthermore, the government wants to consolidate industry players and to create a number of market leaders. For foreign multinationals targeting the same companies to fold into their global portfolio, the stakes have become even higher as the competition gets stronger.

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