For China’s companies with global aims, the acquisition of European firms has clearly paused in terms of both the number and size of deals. At least two principal forces—the absence of low-lying fruit in a post-emergency ownership environment, and a necessary shift from opportunistic to more genuinely strategic transactions on both sides—have shaped this. What is to some a disappointment (which Buddha reminded us is due to either failed or false hopes), is neither cyclical nor ephemeral. It’s what a veteran would expect.
To the seasoned eye it’s merely a reckoning of commercial physics with natural timing. Investment staying power can be funded by east-to-west expansion in precious few situations. The asset fire sales are over. The master stroke of acquisition was more appealing when Chinese players were fresher to the game, and when more than a few European companies looked unlikely to survive without a rescue.
Thus an increasing number of once-anxious suitors now find comfort in pondering deals that make more long-term sense, although they might be more difficult to find and close. Patient and visionary leadership is needed throughout an integration. A jackrabbit’s quick-eyed vista it is not.
Meshing the strengths of organizations is a crucial, multi-year process on both sides. Optimum clarity is needed to bring fresh resources to China’s tumultuously expanding markets, and to introduce its products elsewhere. Following an acquisition, patterns of internal communication are typically anything but smooth or instinctive. Energies are multiplied by confidence, trust and shared visions—all hard work to build. Simply assimilating one corporate culture to another, all too likely when East meets West, delays and even squanders the most valuable results.
As we shall also see, a large host of factors ranging from exuberant-vs-entrenched nationalism, respectively of hunter and hunted, to the natural learning curve and importance of thoughtful integration in validating any and all deals, promise us that many of the best ideas and most successful transactions are yet to come.
The first two quarters of 2011 witnessed a striking reversal in the trends of 2009-10. From a global standpoint, total amount deals announced dropped 17% relative to the first half of the previous year, for an aggregate figure of $46.3bn. This drop marks the first stall to a shimmering continuum of growth since 2003, when Chinese outbound M&As totaled a mere $2.9bn.
The European market was no exception to this pattern. Sixteen deals were closed by Chinese acquirers in 1H 2011, a definite loss of momentum compared to 39 transactions reported in 2010. The slide, can be better grasped, however, by looking at values rather than the deal count.
Excluding the mega-deals (> $1bn) completed by Wanhua Industrial Group ($1.74bn), China National Bluestar Co. ($2.56bn) and China Huaneng Group ($1.32bn) the aggregate deal value for the first half of this year reached totaled just $110.4m for 7 deals whose value was disclosed. (Six deals were reported but their values were not.) This represents a precipitous drop from more than $2bn attributable to 18 sub-mega acquisitions whose size was disclosed in 2010. Even more emblematically, average reported deal size plummeted from $123.3m to $15.8m. Since non-reported deal size is typically smaller, not larger, the true average size in 2010 may have been well under $100m, even as low as $50-60m, given more than 15 deals for which size was not reported, but still a hefty multiple of less than $16m.
What’s Wrong? Reasons Behind the Downfall
The natural question is: why? Certainly, with profits and home markets continuing to expand, the acquisition letdown was not due to a reduction in overall expansion aims of major Chinese corporations and entrepreneurs. Are opportunities which are so much better at home than abroad, together with the mild asset value recoveries in hardest-hit western markets, enough to quench the desire to expand empires? It’s suddenly as if, as the famous Broadway impressario once said, “When people don’t want to come, nothing can stop them.”
Growth-minded firms in China are still looking for good asset buys around the world and especially in Europe. However, factors both inside and outside China have continued to mount which obstruct and frustrate cross-border acquisitions.
Before delving deeper, we should clarify that struggles are distant for many Chinese firms who seek acquisitions from well-fortified strongholds of profits and cash. As the three mega-deals signed in the first half of 2011 suggest, the M&A door is still wide open for large firms, SOEs in particular, that operate in strategic sectors (e.g. energy, fine chemicals, automotive, etc.) and possess strong political ties, which include ample credit at home and even diplomatic support overseas when a deal is large or strategically important enough. The companies most affected by current constraints are SMEs, which were able to close fewer and dramatically smaller deals. The burgeoning PE industry is struggling more to find the right ones and meet their needs at a fair price, than to find the money to fund their expansion at home and abroad. (We reported on PE Funds in China, Part I, 11 July how over-funded and under-invested PEs have been since the start of the year.)
Among the forces within China, the largest impediment is a regulatory one. Chinese institutional bodies responsible, directly and indirectly, for governing M&A transactions outside China, a veritable handful of bureaus, ministries and agencies including MOFCOM1, SASAC2, NDRC3 and CSRC4, have broadly reshaped the practical dimensions of government policy. The rationale for this springs from the need perceived by Chinese authorities to encourage a more disciplined approach to M&A transactions and to avoid an uncontrolled wave of cross-border acquisitions by small players lacking the necessary experience to, among many lesser concerns, make them successful.
For such a broad re-think to have quickly taken hold, it is clear the full range of concerns have come into play: embarrassing failures that might seriously affect the ability of Chinese firms to undertake transactions in the future; financial risks at home compounded by borrowing overseas; negative impacts on SOEs that get mired in mergers-gone-bad that could tax or even compromise China’s diplomatic strength; creation of expectations for reciprocal permission to be given to foreign firms to enter state-managed industrial sectors in China—the list grows long in looking under the bed at night.
Certainly repercussions of bad deals or poorly managed relationships with everything from banks to labor unions to local governments, can all be costly to China if they manifest while Chinese firms have only begun to enter the game.
With potential winnings of markets, technology, know-how and scarce talent to be availed over the next 50 years, a natural preference to control risks and damage rather than give free rein to every public and private mercantile power, comes as no surprise. And as anyone who has worked across borders from Britain or France or Germany or the US, it sounds more like home than not.
The largely asymmetric impact the financial crisis had on China’s and Western economies in 2008 led these agencies to strongly encourage the acquisition of targets in Europe and in North America. The underlying rationale was to sustain the speed of Chinese economic expansion through attractive buys overseas. Chinese firms responded eagerly to governmental stimuli by rushing into Western asset marketplaces. It was a bloodshed. Acquirers from China were eager to grow. Excessively high bids and overpayments often resulted.
Government re-think not surprising
In 2009 the average premium paid for acquiring control of public targets was as high as 40% over the price of shares traded one month before execution of the deal. Unsurprisingly, many of the acquisitions made between 2008 and 2009 are now failing to create value. This has driven Chinese institutions to reconsider their political stance towards overseas M&A. The MOFCOM (Ministry of Commerce) and the SASAC (State-owned Assets Supervision and Administration Commission) realized that such unconstrained development of M&A activity, whether government-owned or private, could do more harm than good to the acquiring companies and, more broadly, to the Chinese economy. The result was a tightening of the procedures for approval of M&A transactions. SASAC had established a formal linkage between SOEs executives’ promotion and completion of M&A deals which lacked a thorough scheme of checks and balances. The Commission has now introduced regulation which will initiate a personal investigation of SOE chiefs whose acquisitions incur losses. The shift from a purely developmental approach to a more performance-conscious one could not be made more clear to those who commit the funds.
These recently introduced restrictions are added to administrative constraints which sometimes work to impede Chinese cross-border adventures. Among these, an M&A contract must be approved by the Chinese government. This often involves a sequence of sign-offs, not just a single agency’s approval. Critically, especially in competitive-bid situations, this requires that the two parties to the deal accept a 90 days suspension clause, so that all of the government agencies typically involved in the procedure (MOFCOM, NDRC, SASAC, CSRC, SAFE) can examine the transaction. This three-month delay results in painful liquidity premiums as high as 20% that Chinese acquirers must pay to target companies. Thus, mandated time delays can prevent timely closure and give faster-acting competitors a decisive edge, and significant added costs can push a fairly-priced deal into overpay. And let’s not forget the CE’s exposure to a personal investigation if the outcome is unhealthy for China’s coffers. Altogether, mute battle cries for men of action.
Much of the impetus for tighter reins, fairly enough, flowed from Chinese firms, SMEs in particular, having taken a somewhat swashbuckling approach in tackling M&A deals. In the heat of advance, many lacked proper risk-assessment procedures. Many are ill-equipped to recognize political and environmental risks involved in transactions. And even now, although Chinese firms pursuing Western targets face regulatory constraints that are even stricter than those confronted by Western firms seeking acquisitions in China, they embark unprepared.
Etiquette in The Hall of the Mountain King
For those who are armed with the dangerous presumption that they can approach European counterparts using the same practices and behaviors that are common at home, damage can be done to more than their own fortunes. In China everything can be bought. An expression of interest is always welcome, even when an ‘on sale’ notice is not explicitly posted.
In Europe, negotiation dynamics are much more subtle, and there is an etiquette to be respected. Companies are never ‘potentially on sale’, but become available only when the current owner ‘decides’ the asset should be offered. Proactive bids can be presented, of course, but ironically this must be done in a less confrontational way that has been traditionally characterized as ‘Chinese’. It typically involved courtship of managers and a host of other stakeholders before owners are approached, convincing each of the constituent groups that a sale is beneficial to them and to the company—to which each of them is bound by tradition to be loyal. This requires an extensive local network of local contacts the majority of Chinese firms don’t have and are ill-equipped to muster.
Perhaps more significantly to veterans of success and failure in acquisitions, too many Chinese companies that have performed M&As have exhibited disregard for the challenges of post-acquisition integration, something that in developed economies has become a non-debatable mantra. Views may differ as to how optimal integration should occur, across cultures and for any given deal, but obvious signs of a cavalier attitude toward the crucial post-deal process can poison a deal at least as quickly as a widespread reputation for imperiousness.
A persistent reluctance of Chinese banks to finance M&A transactions is exacerbated by the current caution toward SMEs in particular. As part of its effort to fight mounting inflation the PBOCs three rate raises since January 2011 have pushed the one-year deposit benchmark rate from 3.5% to 6.56%. Furthermore, reserve requirement ratios have become significantly tougher to abide by. Many consider further increases likelier than not. As rates rise and prospects cool in any economy, lenders look to borrowers with broader asset bases, not rapid growth rates that are credit-hungry and more easily stopped by a darkening outlook. True to this pattern, China’s banks have progressively shut their doors to SMEs, limiting themselves to lending to large corporations and SOEs. Debt scarcity has made it virtually impossible for small players to acquire overseas targets, especially significant ones. This is reflected in the drop in average size of transactions, which have decreased to a mere eighth of the average in 2010.
Constraints for Chinese outbound M&A don’t arise exclusively from within. The bubble that inflated worldwide oil and commodities prices until May-June 2011, together with the increased volatility of the same prices, greatly magnified uncertainty, leading Chinese firms to be more cautious in planning future acquisitions. Overpriced commodities were particularly harmful for several sectors considered as strategic by the Chinese government vis-à-vis international economic expansion, most notably traditional energy and automotive. Executives of major Chinese energy groups such as PetroChina and China National Petroleoum Company have recently agreed that, given the currently unfavorable economic outlook, the second half of 2011 will bring an increased focus on consolidation and operational enhancement of overseas assets acquired during the last three years. Although this outlook will broadly reduced overseas M&A activity, the option to acquire overseas targets is still open for large government-backed firms. A case in point is the 50% stake in Massachusetts-based InterGen NV bought by China Huaneng Group for $1.32bn in April 2011, which gave it control of power plants in the U.K. and the Netherlands, as well as in Australia, Mexico and the Philippines.
Insiders note the progressive decline in the availability of high-quality targets. Although ‘recovery’ is still elusive in most European economies, especially given the current concerns for the solvency of several Southern-European countries, it is as if a subtle combination of lending, however stingy, and sharply cut expenses have brought pauses to quests for salvation. Good buys in the West are not as easy to find as they were two years ago, both on stock exchanges and in private transactions. Prices are higher and the reduced population of candidates means fewer glimmers of ‘a perfect fit’. A landscape of scarcer deals often pitches acquirers into a competitive froth. The resulting spirals erase the potential for arbitrage and makes transactions less attractive.
What’s Next? Opportunities for Chinese Acquirers
The relatively higher difficulty faced by Chinese SMEs in mastering the art of cross-border deal-making is not a peculiarly Chinese phenomenon. The same asymmetrical pattern was observed when Western firms started eyeing China as a buying terrain. In the beginning, regulatory hindrances and lack of local political and economic connections cut small fish out of the game. Over time, however, as knowledge of the Chinese market improved and sufficient resources of intermediaries (consultants, PE groups and law firms) specialized in facilitating cross-border M&A originated, SMEs gradually sneaked into the game.
Some media and practitioners naively expected, in a suspension of the laws of physics, that Chinese firms would not follow the two-stage pattern of haste followed by multiple braking. They predicted a massive upsurge of China-Europe transaction for 2011 and 2012, spurred by lush liquidity, a willingness to overpay, and a shimmering inventory of bargains—all of which have dulled and dwindled. As noted, and clearly felt by Chinese regulators as well, an uncontrolled wave of deals is neither likely nor desirable.
SMEs will participate, but the Chinese government is keenly aware that genuine success hinges on support players able to bring rationality and discipline to the process—a professional infrastructure that remains awaited. Chinese overseas M&A will certainly recover, and likely flourish as Nature would have it, but on a different schedule of pursuit, one that embraces smaller players more gradually, and with more strategic targeting than the bargain-driven and frenzied behaviors seen in 2008-09. The development of support infrastructure is likely to serve more growth, and more intelligent deals with higher success achievement, than mere financial resources such as local lending, and a settling-in of the current regulatory verve. There can be little doubt of a long-term rebound. Chinese companies can derive too many obvious benefits from acquiring or merging with European companies, for the current loss of momentum to revise the broader outlook.
Access to superior know-how which is vital to building value-added equations and differentiation of products in diverse markets, enabling Chinese firms to outperform competitors at home, where market strategies tend to be homologous and therefore often poorly fitted to realities. Scientific expertise, to technological resources, design competence and a host of specific IPs are all rich with experience, natural competitive evolutions and traditions of management thought and training.
M&A often represents the optimal strategy for Chinese firms to gain access to European markets, if not the only one for which investment can be assured of winning success. Low growth rates, high labor and capital costs, and mature customer markets make greenfield market entry daunting to a rational eye. The scales of investment required in the face of countless uncertainties keep even the ablest multinationals in merely wishful mode. The entrant, properly advised, knows he faces several years to breakeven at best, and the intensity of entrenched competition draining parent-company resources for an indeterminate time.
Only lastly, if most obviously, acquisition of a European target can help a Chinese firm to increase scale and satisfy genuine ambitions to move toward global status. But more immediate resource gains which serve every sector of management concern at home are the prize most profitable to measure. These can be measured more precisely and quickly than ‘rapid expansion into foreign markets’—the expectation of an upstart if one were ever heard, though ever-fitting as a long-term goal.
European M&As are more attractive for some sectors than for others. The natural protagonists of the China-Europe M&A success tale, both now and in the near future, come from industries such as precision mechanics, advanced machine tools, automotive, traditional and alternative energy and pharmaceuticals. In all these sectors, the more advanced development of European segments suggests ample room for transferring superior knowledge to China and leveraging it into the booming but rapidly ‘commoditizing’ domestic marketplace of fierce competitive forces.
What’s Missing? An Infrastructure of Specialized Support Players
The current picture makes clear that the outbound M&A game is dominated by large companies which are either state-owned or benefit from strong political backing. These firms can most easily obtain institutional approval and borrow or float debt to finance acquisitions.
Conversely, SMEs face much higher uncertainties regarding approval and capacity. Scarcer internal resources for planning and analysis, say less of case study comparisons, often translates into a ruinously unstructured approach to the entire pre-and-post M&A process. Smaller Chinese firms seeking to expand in Europe through acquisition must therefore rely on a support infrastructure aimed at helping them with everything from financing of the operation to the crucial tasks of conducting a professional M&A process. Even at home most don’t have and need this. A venture into the great beyond is not responsibly countenanced without a surfeit of it.
During the target selection and bidding phases, Chinese firms tend to lose the best buying opportunities to more connected and swifter-acting players from Western countries. When they head towards Europe, they seem to leave behind them mastery in one of the crucial aspects of business interaction in China, namely, guanxi. A successful acquisition requires a strong network of local relationships, both from a business and a political perspective. All to often, however, Chinese acquirers adopt something of a “Texas ranger” approach, abruptly knocking at rivals’ doors and bursting out with “I wanna buy!” Another problem is represented most keenly by difficulty in complying with bidding deadlines. SOEs are naturally slow in decision making, encumbered by serial administrative procedures and internal politics. Private enterprises, on the other hand, face a high degree of uncertainty vis-à-vis financing, and approval of the transaction by China’s governing agencies. Therefore, although potentially faster in decision making, they are slowed by external hindrances.
During the post-acquisition phase, Chinese enterprises too often disregard the importance of integration, during which the new reality for both firms is formed in psychic as well as practical terms. European firms are characterized by radically different organizational structures. Their managers represent a rich and complex array of national and corporate cultures, as well. Failing to appreciate this mosaic brocade which arises from mature organizational designs and a mingling of many cultural traditions can seriously impair strategic and operational coordination.
It would be incorrect to say that a professional M&A support infrastructure does not exist in China. The problem is that the infrastructure currently available does not adequately respond to the needs and challenges faced by Chinese companies venturing towards Europe in the M&A journey, especially as far as SMEs are concerned.
So far, Chinese enterprises have tended to select investment banks or large international PE funds as partners in the M&A process. Most of these financial intermediaries, although able to provide funds and ongoing financial expertise, are suboptimal in terms of non-financial contributions. Given their sheer scale and global scope, their network of relationships, powerful at the international level and useful for large SOEs negotiating with national governments or large multinational enterprises, is scant to none at local levels. And since these large financial intermediaries tend to see partnerships with small players as second-class deals, they are reluctant to ‘open the taps’ for much-needed attention and commitment. What small acquirers really need, instead, is a strongly committed and dedicated partner, one who possesses localized ties in the target country and specialized in managing the M&A process, from initial screening all the way through integration.
In order to foster a more disciplined and effective participation by SMEs in the China-Europe M&A process, the Chinese financial system must evolve to encompass a richer array of domestic financial intermediaries, and more specifically those which are focused on developing two-way interaction between Chinese and European companies. Private Equity funds are, by their structure, the optimal tool that can be used to achieve this goal. Only when a sufficient number of these intermediaries are actively in service will the Chinese government be able to retract the ‘iron fist” it with which it currently restrains, in practice, all Chinese overseas M&A. What remains to be seen is whether these players will emerge spontaneously, spurred by the current excess of demand over supply, or if they will have to be bred through specific regulatory incentives, wisely designed to invite them, as the obvious tools through which compliance can be more assuredly and speedily achieved.