M&A in China A New Generation of Investment Opportunities
Gone are the days when foreign investment in China was limited to Joint
Ventures or WFOEs (Wholly Foreign Owned Enterprises). The new alternative --
Mergers & Acquisitions (M&A) has emerged on the front lines, as the former
obstacles for foreign investment have been eliminated.
M&A deals occur in various versions: deals between two Chinese companies,
between two foreign companies in China or between a foreign company and a
Chinese company. China has a vast appetite for capital, especially
privately-owned companies. But their funding sources are limited: China's banks
continue to primarily allocate funds to the largely inefficient SOEs. And the
stock markets, as an alternative funding source, are fundamentally weak at the
moment (Shanghai, Shenzhen and the overseas markets). Currently some 500 to 1000
companies are waiting to be listed on the domestic market. This scenario is
ideal for M&A. As Mainland companies head for access to capital and expertise,
there is ample scope for deals. Foreign companies are increasingly looking for
ways to quickly gain access to the Chinese market, aiming to grow faster, to
capture a higher market share and to keep pace with competitors, especially
local ones. Another reason is to find new channels for distribution.
What international investors want is exposure to China's growing middle class
and to the low-cost export sector. "We see tremendous business opportunities in
China and aim to grow four to five times in China over the next few years", said
John Rice, president and CEO of General Electric Power Systems. However, natural
growth or new Greenfield projects take time to materialise and to prove
successful and profitable. Thus the advantages of Mergers (hebing or jianbing)
or Acquisitions (shougou) are obvious. Taking over a well-established, existing
company cuts the build-up phase and cuts the time to market period. In addition,
by acquiring an existing successful company the risk of failure is reduced.
By acquiring or merging with a Chinese company, (which produces, for example,
low-tech products with high-growth prospects) a foreign investor can run two
different product lines. Cheap labour costs spur this trend and high yields can
be achieved. If -- as analysts expect -- the China market and the Chinese
middle-class continue to grow, this double-tracked strategy may lead to a
strategic success. As a consequence, M&A deals are now considered to be a
suitable alternative approach and activities are on the upswing. The president
of a US-based investment bank said recently: "the market in China is in its
infancy, but the need for M&A is so substantial that the country may develop the
second-biggest M&A market in the world after the United States."
An acquisition (company A buys company B) can be carried out either by a
share deal or an asset deal. In the case of State Owned Enterprises (SOEs),
asset deals are more common. But there have also been share deals if, for
example, the SOE is a company limited by shares. Share deals help to avoid
existing and hidden potential liabilities.
Although the Chinese government has already passed laws, which facilitate
foreign investment, it is unlikely that China will, overnight, turn into a
country with a settled regulatory system comparable to international standards.
Also, some of China's rules and regulations still do not meet the market demand.
A strictly Western approach to Eastern deals may therefore not be a success.
Before a company starts searching for potential targets, it should determine
in detail its own goals. A comprehensive market analysis should be carried out,
such as the Porters 5-forces system, which evaluates the main market drivers --
competitors, customers, suppliers, substitutes and new potential competitors. In
China it makes sense to look at seven forces as government and guanxi also are
key factors in determining success. Also, the cornerstones of the intended deal
should be set in terms of size, value, the required financial resources etc.,
before the quest for potential candidates starts.
As recent history shows, there has to be a logical fit for the deal to make
sense and to be a success. A well-known Western producer of detergents, for
example, purchased a Chinese manufacturer of low-quality detergents. As it
turned out, there was no apparent fit to their premium-quality brands. The
acquired company could not support the premium brands with its established
distribution channels. Companies planning M&A projects should keep an eye on
possible challenges arising at the start of the M&A process. Also, the post M&A
integration is a major issue when it comes to turning the investment into a
successful one. Emerson's acquisition of Avansys Power Co has proven that it can
be done.
Beware, presumably minor details may hinder success: Even during the first
stage -- the negotiation process -- many companies make crucial mistakes, which
are often difficult to iron out later. It has proven wise not to put all the
cards on the table at the start of the negotiation. Before establishing contacts
with the target company, it is advisable to enter into contacts with the legal
owners in order to fathom whether they have any ambitions to make such a
significant deal. Managers of the company possibly fear the loss of their
influence or even their job.
"sleeping in the same bed but having different dreams."
The next step, the negotiation process itself, can be longwinded and often
frustrating. In order to prevent negotiations from getting out of hand, it is
advisable to fix a timetable before the actual start and also to set milestones.
Sophisticated valuation methods based on future cash flows or valuations based
on similar transactions in related industries are not yet very common. A
valuation based on actual net asset value is by far the norm. However, an
extensive due diligence study, which is also quite time consuming, is mandatory.
The first priority is a legal due diligence. Since the accounts often do not
reflect the actual situation of the company and the MIS is possibly not well
developed yet, data needs to be checked and verified carefully. It is also
common to restate the data in accordance with international accounting
standards, whereby special attention should be drawn to inventories and accounts
receivable. There are, however, hidden dangers for a successful deal; if, for
example, the company enjoyed preferential tax treatment – this may only come to
light in the post merger period.
Because of existing weaknesses in financial data the soft facts of the
company, such as the market position, management and staff qualities and
performance, the sales network, product quality etc., are of paramount
importance. A detailed SWOT analysis of the business provides the potential
investor with an all-embracing overview. Western companies prefer to be
intimately involved in the post M&A phase as the soft facts are very important
to the deal itself.
In October 2001, Emerson Electric Co., a public US company, bought Avansys
Power Co. from privately held Huawei Technologies (Shenzhen-based) for USD 750m
in cash, while the net book value of Avansys was USD158m. This takeover turned
out to be a strategic acquisition par excellence and was then the biggest deal
in China involving a foreign company, and could be regarded as a major ignition
for future China-related M&A activities.
By acquiring Avansys, Emerson increased its market share in power systems
from 3% to 32%. Thus the strategic advantages of the deal are obvious: a perfect
product fit, economies of scale and a growth platform for developing other
markets. In conclusion, this deal was successful as Emerson applied a
comprehensive SWOT-analysis. Emerson screened the companies' soft facts in
detail. After the completion of the deal little was changed by the new owners
and the existing management team continued to head the company. This proved to
be a decisive factor in preserving Avansys' strength. To sum it up, in-depth
analyses, well-crafted documents, knowledge of the Chinese business culture and
expert advice help to minimise the dangers associated with M&A.
The Australia-based brewery Lion Nathan witnessed a fast growing Chinese beer
market in 1992-1995 and as a result invested about USD 300m in one of the
world's most modern breweries in Suzhou near Shanghai. At that time, China was
the second largest beer market in the world. After a 3-year planning and
building period the brewery was opened in early 1998. In the meantime the
Japanese competitor SUNTORY set up a Joint Venture, established a brand name and
secured exclusive channels of distribution. Competition was tough for Lion
Nathan. The lack of customer acceptance, a well-introduced brand name as well as
a solid distribution infrastructure made it impossible for Lion Nathan to gain
ground and to catch up with the Japanese competitor. As a consequence, Lion
Nathan has been having a difficult time.
If analysts are not proven wrong, China will develop into one of the world's
biggest markets for M&A deals. However, more sophisticated laws will have to be
passed to make such deals more calculable. On the other hand, bargain deals will
become available and will be attractive for the quick decision maker. To grow in
China and to stay competitive is one of the major challenges. Using M&A may help
to find the right window of opportunity in this challenging market.
If you would like to know more about M&A in China, please contact Mr. Juergen
Kracht
(email jkracht@fiducia-china.com tel: (+852) 25282259.)
Lending to Foreign Direct Investments (FDIs) in China
As of February 2002, the total contracted investment in China was around USD
737.5 billion. The foreign sector now employs more than 23 million people,
roughly 10 % of the urban population. However, China's banking system has not
been keeping pace with the developments in the economy. Bank assets have grown
enormously over the last 20 years, but their quality has not improved. Local
financial institutions are still heavily protected from global competition.
The government's policy segregation and control has always placed more
emphasis on propping up the state sector rather than modernization of the
financial services industry as a whole. For this reason, the large domestic
banks have been heavily influenced by government policies and do not have the
same degree of freedom in developing services and skills when compared to their
global counterparts.
Why do foreign companies borrow so little?
- Perception of foreign investors’ funding arrangements
Investors setting up a presence in China are generally assumed to bring in their own funds
and maintain a rudimentary account relationship with whatever bank is available nearby
their registered office. Less than 3% of the domestic lending in 2000 has been extended
to FDI in China with the bulk of nearly 89% going to the state sector.
- Restrictions on foreign banks
Although more than 200 foreign banks have set up a presence in China, they are
subject to service and geographical restrictions. The foreign investor may find
their preferred bank to be inaccessible for certain types of services, because
these banks have limited business scope.
- Legal requirement – debt /equity ratios
China's mandatory debt /equity ratios put a limit to the amount a foreign
enterprise can borrow. For example, an investment of USD 3million or less
must have at least 70% in the form of equity.
- Capital Conversion rules affect bank loans
China has practiced current account conversion since 1996. Bank loans and
equity investments are considered capital items, which require approval for
conversion. Equity conversion has always been a matter of procedure, whereas
loan conversion has been dependent on prevailing government policies. This has
created the general impression that bank loans should perhaps not be used.
Notwithstanding the problems mentioned, the National Bureau of Statistics
reported that FDIs normally have a higher success rate in applying for bank loans.
In a survey published in March 2002, foreign enterprises, particularly wholly-owned
subsidiaries of foreign companies have a level of satisfaction in loan applications
of 81.6%, even higher than the average rate of 68.5% for state enterprises. This
seems to be an indication that despite the rules and restrictions in China today,
foreign investors are actually the preferred category of bank customers.
They
enjoy privileges not available to either the state or private borrowers, for
example, earlier this year BP awarded the mandate for a $ 1.8 billion foreign
currency loan to a consortium of mainly domestic banks. The loans were used for
the construction of a 900,000 tonne petrochemical complex. So the local banks
are finally gearing up to compete for quality business in foreign currency,
which used to be the domain of foreign banks unable to provide services in RMB.
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