A Sleeping Dragon Awakes: China Opens Its Doors to International M&A Opportunities

Source: M & A Advisor Volume 10, issue 2
Date: February 2002

by Franc Kaiser
Franc Kaiser has been working with Fiducia Management Consultants since November 2002. In cooperation with the University of Applied Sciences Solothurn Northwestern Switzerland he is researching on the topic M&A in China.

The article describes the breakthrough of new regulations setting a framework for foreign investors interested in M&A. Since a lot of new regulations came into effect in January 01, 2003, the article mainly tackles those regulatory innovations, but also gives an overview of the M&A market in China in general. Everybody expects the M&A activities to heat up in 2003, well, this article describes the basis on which these developments will take place.

After China's accession to the World Trade Organization (WTO) in December 2001, investment bankers, venture capital analysts and corporate executives expect the mergers and acquisitions market there to be huge. China's economy keeps on roaring with 7.8 percent GDP growth in 2002. The Foreign Direct Investment (FDI) inflow reached record highs with around US$50 billion (exceeding the United States as the main FDI magnet for the first time), and the number of M&A deals is increasing. In addition, no antitrust law exists in China. It seems like an attractive environment for any M&A player. But the Chinese M&A market cannot be compared with Western markets yet. New rules and regulations issued in December 2002 added new perspectives, as well as barriers to the Chinese M&A landscape.

Discovering M&A as the Third Way to Invest China

The current vibes in the cross-border investment market speak clearly for mergers and acquisitions as the new investment mechanics after joint ventures and wholly foreign-owned enterprises. The Peoples' Republic of China, which has pursued gradually political opening and economic reform since 1978, is increasingly tapping foreign investment. The evident attractiveness of China ¨C cheap production factors and a huge domestic consumption market ¨C was for two decades either partner- or quota-bound. Joint ventures had the disadvantage of limited control, whereas wholly foreign-owned enterprises were very restricted in their business scope. Acquiring existing businesses is now about to become possible. The immediate access to distribution channels, customers, licenses and market share is attractive, especially in a restricted and competitive market environment such as China. Since most Western multinational companies actually scuttled their investments in China during the 1990s, they are now very glad to embrace an alternative to the classic investment forms.

Including Taiwan and Hong Kong, China accounts for a massive 50 percent of Asian M&A transaction volume. Around US$13 billion was invested in China via M&A activities during the first half of 2002. And the appetite is growing. According to a survey by PricewaterhouseCoopers, 70 percent of surveyed investors are interested in putting money into China via M&A, preferably by acquiring private enterprises and foreign-invested enterprises.

PULL QUOTE: 70 percent of surveyed investors are interested in putting money into China via M&A.

Where M&A Heats Up in China

With the political and economic reforms of China, and due to the WTO agreements, many Chinese industries are likely to undergo structural change. Typically, M&A targets can be found in Chinese industries, which are very fragmented and governmentally protected. Furthermore, the ongoing boom in a number of China's industries presents foreign investors with attractive targets, as acquisition to obtain market share and portfolio diversity positions the acquirers well for future organic growth. For example, in the beer or fast-moving consumer goods industries, foreign companies are urged to grow more than the fast-growing industry average to gain market share at all. This can only be achieved by an aggressive acquisition strategy. In particular, logistics, fast-moving consumer goods, insurance, automotive parts & components, pharmaceuticals, media, and professional services are and will be the boom sectors for M&A. Chinese companies are already very active in consolidating their industries. In 2001, the domestic stock markets alone accounted for 600 M&A transactions between Chinese enterprises.

The M&A Process in China: Know How, Know Where

M&A in China is different from the rest of the world. It is important to know how the specific laws and regulations work, how tax issues can be handled, how to select and value a target, and how the complex and changing environment behaves. Acquirers must also be aware of issues like hidden liabilities of potential targets and the Chinese business culture.

According to the objectives of the acquirers, most Chinese targets possess either a leading market position, contain good distribution channels, promise access to licenses, or are just profitable. Furthermore, the location of the target is important. Since the economic motor of China is nestled at the East coast, factors such as infrastructure, personnel, and exposure to international business practices are easer to access in hothouses like Yangtze River Delta and Pearl River Delta. However, the economic growth of the last decade lifts these regions in questionable deal price levels. Investors seeking cheap factories are therefore about to spot regions in Western China for cost advantages.

Checking the Chinese Target

Once a Chinese company is identified, checking the ownership structure is the first step toward developing a negotiation tactic. These structures are normally intertwined with regulatory bodies. Here comes the famous Guanxi (Mandarin for ¡°interpersonal relationships¡±) into play. In China, businesses are made with good connections; furthermore, rules are man-made. Hence, knowing the right people and authorities can lead to acquisitions which would not be allowed according to official rules and regulations.

PULL QUOTE: Due diligence in China is more akin to peeling an onion.

Where due diligence of Western companies can be compared with peeling an apple ¨C peel the skin and you should find the truth ¨C Chinese companies cannot be x-rayed so easily. Due diligence in China is more akin to peeling an onion. Checking on the Chinese company involves many layers of truth and facts largely due to different accounting and business practices, educational backgrounds, and reliabilities. Needless to say, performing due diligence in China can cause one to shed tears.

State-Owned Enterprises are for Sale

As soon as state-owned assets or equity are involved, the value of a company has to be determined by government authorities. The selling price for a foreign acquirer results out of the net asset value, with a range of plus or minus 10 percent. In the past, this method tended to overprice antiquated assets, but did not involve tedious approval mechanics. Since January 2003, new interim rules on reorganizing state-owned enterprises (SOEs) new regulations, issued by the State Economic and Trade Commission (SETC), do not make acquisitions necessarily easier. Although the Chinese government aims at restructuring its SOEs with foreign money, these new rules obstruct the passage to attractive investments, especially because the acquirer is supposed to pay a settlement plan for the Chinese employees. Controlling SOEs, which are often notoriously overstaffed, can therefore be a bottomless pit. Targeting private and foreign-invested enterprises might be a sure bet, but private enterprises are neglected by authorities for listing, and struggle therefore with fund raising.

Tame Dragons: The Chinese Stock Exchange Markets

China has protected its 1,200 listed companies with three different kinds of shares. Only one third of the shares have been tradable on the stock exchanges (individual shares), the other two thirds remain non-tradable. These non-tradable shares are either owned by SOEs (legal person shares) or by government departments (state-owned shares). It is widely perceived that foreign companies and private Chinese companies are limited to acquiring the tradable shares, with foreign companies further limited to around 100 companies with individual shares denominated in USD/HKD. However, an estimated 200 private Chinese companies have already acquired controlling stakes in listed firms by purchasing the non-tradable legal person shares. And as for foreign companies, the new M&A regulations will not dispense with case-by-case approvals, and therefore only time will tell whether the new regulations will really lead to changes in practice.

PULL QUOTE: The new M&A regulations will not dispense with case-by-case approvals.

The Chinese government is aware of the weakness of the once hated, then adored, and now shamefully muted stock exchange markets. In fact, the system of the A shares, which are denominated in the Chinese currency Renminbi and were not for sale to foreigners before December 2002, is clearly out-of-date. Because the A share market developed into the shape of a bubble investment (most of the IPOs are five-times oversubscribed), and the abusive practices of certain Chinese companies, the issuance of new A shares lost its credibility. This causes problems for refinancing the SOEs. Indeed, both A and B shares markets have been falling since months. In 2002, the Shanghai Composite Index and the Shenzhen Composite Index fell 8.3 percent, and 7.5 percent, respectively.

Also Chinese investors have discovered that the Chinese SOEs are struggling with massive problems. The Return on Equity (ROE) of SOEs is very low, said to be typically just over one percent, while private firms provide an average return of more than five percent. But just these private firms are not allowed to issue shares on the more attractive A share markets, because the Chinese government wants to boost the former rice bowls liquidity first. The Chinese securities market system is facing serious challenges.

An Invitation for the Riches: QFII Measures

To parent the premature securities markets, the Chinese government is promoting foreign capital injections. This regulation will enable a restructuring of the listed corporations, and help improve their operations and enhance the market transparency. Furthermore, the government hopes to raise money for the thinly stretched national welfare fund ¨C in 2005, around 10 percent of China's total population will be beyond the age of 60, but only around 160 million urban workers are currently included in the pension planning.

Where foreign investors were previously banned from buying A shares, measures in the securities investment of Qualified Foreign Institutional Investors (QFII measures), issued by the CSRC and effective since December 2002, pave a leeway for bigger investors: Strategic investments in big Chinese A share players is now officially permitted.
This leeway has potholes, too. A QFII cannot buy more than 10 percent of the total shares issued by a listed Chinese company, and the aggregate percentage of shares held by all QFIIs in a single listed company must not exceed 20 percent of the total shares of that listed company.

Furthermore, to be able to purchase A shares, foreign institutional investors must meet specified qualifications. A fund management institute, for example, must look back on a track record of five years or more, and have managed no less than US$10 billion in the last accounting year. Similar requirements restrict commercial and investment banks and insurance companies, from getting blessed with the QFII status. A qualified foreign investor can only open one special account denominated in the Chinese Renminbi currency to facilitate securities trading in China. And lastly, lock-up periods of between one to three years before any returns can be repatriated make a fast exit difficult.

Acquiring A Shares: A Clever Decision?

Ironically enough, after years of anticipating the A share market to be accessible for foreigners, the enthusiasm among foreign investors is very limited. A UBS Warburg survey found only 11 percent of financial institutions to be willing to apply for the QFII status; the rest prefer to invest in more attractive and mature markets. Small players are prohibited by a minimum US$50 million investment hurdle. But what really determines the attractiveness of the Chinese security market is the overpriced stocks (at about 40 times earnings). Better-quality, mainland-related stocks listed in Hong Kong often trade at less than 10 times earnings and are subject to greater regulatory disclosure. Financial investors need to rethink their A share acquisition strategies with very basic profitability and benefit calculations.

Transfer of State-Owned and Corporate Shares of Listed Companies to Foreign Investors

That's as far as tradable A shares are concerned. Two thirds of China's US$500 billion stock market capitalization consists of non-tradable shares. Very motivated to invite foreign money spenders to China in the post-WTO era, the CSRC, the Ministry of Finance, and SETC jointly issued the Notification on Relevant Issues of Transferring State-owned Shares and Corporate Shares of Listed Company to Foreign Investors in November 2002. This notification technically opens up possibilities for investors like the U.S. private equity fund Newbridge Capital, which aims to acquire 20 percent of Shenzhen Development Bank's state-held stakes. The Chinese government expects high returns by selling the non-tradable shares through public tenders. After the full payment for the shares, foreign investors are subject to a lock-up period of 12 months.

Big Players Conquer the Chinese Markets

Events in 2003 will prove how effective the new governmental codes will be. In the meantime, multinational companies keep on entering or expanding in China via acquisitions. The last five years shaped real China-M&A-pioneers such as. Interbrew and Danone. In particular in serving the domestic consumption market, most companies have no other way than applying M&A practices in order to cope with the fast learning and increasingly efficient Chinese competition. With good relationships with the local and central authorities, and with great expertise, these acquisitions can be successful. Their long-term perspective excludes short-term ROI objectives, but creates a strategic juggernaut, aiming at market leadership and national presence.

For further information, please contact Fiducia at info@fiducia-china.com