"A M&A deal in China rarely proceeds smoothly"

STEFAN KRACHT, EXECUTIVE DIRECTOR OF FIDUCIA'S CHINA CONSULTING TEAM, TALKS TO CHINA FOCUS ABOUT INDUSTRIAL M&A IN CHINA.

CHINA FOCUS (CF): How do you assess the current situation of the Chinese M&A market?
Stefan Kracht (SK): Despite the Sub-prime crisis in the US the M&A sector in China observes constant growth, while in addition Private Equity (PE) investments are gaining importance. There is stable growth, particularly in the raw material, steel, engineering and consumer goods industries. However, the focus is shifting away from overseas transactions towards the domestic market. Today, two thirds of all M&A transactions in China are completed within Chinese borders.

CF: How have the legal conditions concerning M&A in China developed in recent years ?
SK: All in all the legal security is increasing which is good for foreign investors. A step in the right direction for example is the introduction of different M&A and PE laws that help solve disputable questions related to foreign investments in China. There are, however, less positive developments such as restrictions and additionally required approvals on investments in certain sectors.

CF: What economic factors drive M&A activity in China in particular?
SK: By now there is an abundance of attractive companies in China that have reached critical mass and are interesting acquisition targets. This is of particular interest to foreign investors that aim for quick market access and want to reach new customer groups. Yet Chinese buyers profit from the increase in potential target companies. Chinese investments in foreign countries are however mainly executed by state companies and -funds in the context of securing resources and energy supply.

CF: M&A markets in Europe and the US are currently taking a break. How does this affect the Chinese market?
SK: The interest of foreign corporations to buy equity stakes in China has been weakened drastically by the downturn of the global financial markets. In addition, the buying power of listed Chinese businesses is sinking rapidly since their stock prices have dropped by approximately 70% over the last twelve months. At the same time many private companies are on offer because their margins have turned negative due to high competition, tax increases and rising costs for commodities, real estate and labour.

The inside of a factory.

CF: What do buyers currently focus on?
SK: Securing market share in different quality and customer segments remains essential. Furthermore, investments into businesses with strong focus on domestic sale in China are favoured, less so investments in export-oriented manufacturers.

CF: What are the key challenges?
SK: The two biggest challenges for foreign investors are determining the exact value of the company and the process of negotiating the acquisition price. The main reasons for this are the lack of accounting data as well as revenue and profit projections that are difficult to assess and prove. Another factor is the fundamental deficiency of adequate external financing resources in China for local Chinese companies. By the end of 2007 the unmet demand for growth capital of Chinese SMEs was more than RMB 260 billion.

CF: How much do cultural differences matter when negotiating with Chinese partners?
SK: Chinese owners often negotiate less structured and very opportunistically. It may happen that details that have already been set out in writing are renegotiated at a later stage. It is therefore advisable for investors to always keep several options open and have alternative targets at hand. Moreover, a generous amount of time should be taken into account for the negotiation process and following approval, with deal negotiation and execution often taking 6-12 months.

CF: Can you describe a "typical Chinese" M&A transaction?
SK: An M&A deal in China rarely proceeds smoothly from beginning to end. During the negotiation stage difficulties may appear due to the shareholder structure which is often made up by family members, state investors or higher ranking members of the Communist Party. Moreover, important corporate departments like Key Accounts, Human Resources and Accounting are often completely controlled by the owner which can result in a post-merger information vacuum, the loss of trade secrets or employee loyalty issues. Paying M&A transactions almost exclusively with cash is another "typical Chinese" thing to do which leaves no chance for "leveraged buyouts".

CF: What are your expectations concerning the development of the M&A market in China?
SK: In the medium run a constant growth of the M&A market in China can be expected, based on the necessary consolidation of many highly fragmented industries. The maturity process within the M&A sector will only enhance these effects.

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