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Turbulence and Paralysis: the Year Ahead in US-China Relations — Financial Times

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A month before his official inauguration, Donald Trump is already tossing diplomatic grenades in China’s direction. It is a sign of things to come. 2017 is shaping up to be a highly eventful, taut and precarious year for China-US relations. This is partly due to a simple scheduling coincidence.

2017 will be the first time ever when both the US and the PRC in the same year will usher in new governments. The US will kick things off on January 20th by swearing in Donald Trump as President. China, meanwhile, will undertake its own large political upheaval, its five-yearly change in political leadership, culminating in the 19th Communist Party Congress sometime late in the year. Virtually the entire government hierarchy, from local mayors on up, will be changed in a monumental job-swapping exercise orchestrated by Xi Jinping, China’s president.

The US under Mr Trump, with a Republican Congress at his back, seems intent to challenge China more assertively in trade, investment and as a currency manipulator while intensifying the military rivalry. China’s leadership, meantime, will become deeply absorbed in its own highly secretive, inward-looking and internecine political maneuvering. While Mr Xi tries to further consolidate his power, Mr Trump will likely be asserting his, leading to a globally ambitious US and an introspective China. This would represent something of a role reversal from recent precedent.

With the chess pieces all in motion, businesses should be plotting their moves in China with caution. The proposed Trans Pacific Partnership (TPP) trade deal is dead, leaving China’s still-evolving “One Belt,One Road” initiative as the main impetus for new trade flows in Asia. Donald Trump says he will push for what he claims to be more “more fair” bilateral trade deals. China, with its $365bn trade surplus with the US and high barriers to much inward investment, is clearly in his sights.

How will China react? The only certainty is that as the year progresses, China’s government apparatus will slow, and with it decision-making at policy-making bodies and many State-owned enterprises (SoEs). All will wait to hear what new tunes to march to, once the new ruling Politburo is revealed to the public in the fourth quarter.

Chinese officials at all levels are already jockeying for promotion. That means falling into line with Mr Xi’s anti-corruption campaign. The Party Secretary in Jiangsu province, one of China’s wealthiest, got an early head start. He instituted his own form of localized prohibition, ordering that government officials could no longer drink alcohol at any time, in any kind of setting, anywhere in Jiangsu.

The booze embargo did include one loophole. If senior foreign guests are present, alcohol can flow as before, like an undammed torrent.

As the Party Congress approaches, it will be even harder to get a deal with a Chinese SoE lined up and closed within any kind of reasonable time frame. Even after the Party Congress ends, it will likely take more months for any real deal momentum to return. Investment banking bonuses along with billings at global law, accounting and consulting firms are all likely to take a hit.

One other certainty: the renminbi will come under increasing pressure as the US ratchets up its moves to apply tariffs to Chinese exports and China’s own economy remains, relatively speaking, in the doldrums. How much pressure, though, is another question.

Anyone making predictions about the speed and degree of the renminbi’s decline is playing with a loaded weapon. A year ago some of the world’s biggest and loudest hedge fund bosses, including Kyle Bass, David Tepper and Bill Ackman, were proclaiming the imminent collapse of the renminbi. The renminbi, despite slipping by about 6 per cent during 2016, has yet to behave as the money guys predicted.

The Chinese government uses non-market mechanisms to slow the renminbi’s decline. A recent example: its abrupt move in November to tightly control outbound investment and M&A. But shoring up the currency will undercut one of China’s larger economic imperatives, the need to upgrade the country’s industrial and technological base. That will require a prodigious volume of dollars to acquire US and European technology companies such as recent Chinese deals to acquire German robot-maker Kuka and US semiconductor company Omnivision.

Chinese investors and acquirers not only face tighter controls on the outflow of US dollars. The US is also becoming more antagonistic toward Chinese acquisitions in the US and globally. Deals of any significant size need to pass a national security review overseen by a shadowy interagency body known as the Committee on Foreign Investment in the United States, or CFIUS.

CFIUS works in secret. In recent months, it has blocked Chinese investment in everything from a San Diego hotel, to Dutch LED light bulbs as well as US and European companies more explicitly involved in high-tech industry including semiconductor design and manufacturing. The strong likelihood is CFIUS will become even more restrictive once Mr Trump takes over.

Unlike most areas of bilateral tension between the US and China, this is one area where the Chinese have no room to retaliate in kind. China already has a blanket prohibition on investment by US, indeed all foreign companies, into multiple sectors of the Chinese economy, from tech industries like the internet and e-commerce all the way to innocuous ones like movies, cigarettes and steel smelting. So, for now, China quietly seethes as the US intensifies moves to prevent China investment deals from being concluded.

China will probably need to regroup and start playing the long game. That means investing more in earlier stage tech companies, especially in the Silicon Valley, and hoping some then strike it big. These venture capital investments generally fall outside the tightening CFIUS net. China wants to spend big and spend fast, but will find it often impossible to do so.

Even as political and military tensions rise between the US and China in 2017, one ironic certainty will be that a record number of Chinese are likely to go to the US as tourists, home buyers or students and spend ever more there. China’s ardour for all things American – its clean air, high-tech, good universities, relatively cheap housing, and retail therapy – is all but unbounded.

If informal online surveys are to be believed, ordinary Chinese seem to like and admire Mr Trump, especially for his business acumen. Mr Xi, understandably, may view the new US President in a harsher light. Xi faces cascading complexities as well as factional opposition within China. He could most use a US leader cast in the previous mold, committed to constructive cooperation with China. Instead, he’s likely to contend with an unpredictable, disapproving and distrustful adversary.

https://www.ft.com/content/b1801637-4219-3222-9f45-658740aa1187

Chinese Firms Are Reinventing Private Equity — Nikkei Asian Review

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July 26, 2016  Commentary

Chinese firms are reinventing private equity

Henry Kravis, his cousin George Roberts and his mentor Jerry Kohlberg are generally credited with having invented private equity buyouts after forming KKR 40 years ago. Even after other firms like Blackstone and Carlyle piled in and deals reached mammoth scale, the rules of the buyout game changed little: Select an underperforming company, buy it with lots of borrowed money, cut costs and kick it into shape, then sell out at a big markup, either in an initial public offering or to a strategic buyer.

This has proved a lucrative business that lots of small private equity firms worldwide have sought to copy. China’s domestic buyout funds, however, are trying to reinvent the PE buyout in ways that Kravis would barely recognize. Instead of using fancy financial engineering, leverage and tight operational efficiencies to earn a return, the Chinese firms are counting on Chinese consumers to turn their buyout deals into moneymakers.

Compared to KKR and other global giants, Chinese buyout firms are tiny, new to the game and little known inside China or out. Firms such as AGIC, Golden Brick, PAG, JAC and Hua Capital have billions of dollars at their disposal to buy international companies. Within the last year, these five have successfully led deals to acquire large technology and computer hardware companies in the U.S. and Europe, including the makers of Lexmark printers, OmniVision semiconductors and the Opera web browser.

So what’s up here? The Chinese government is urgently seeking to upgrade the country’s manufacturing and technology base. The goal is to sustain manufacturing profits as domestic costs rise and sales slow worldwide for made-in-China industrial products. The government is pouring money into supporting more research and development. It is also spreading its bets by providing encouragement and sometimes cash to Chinese investment companies to buy U.S. and European companies with global brands and valuable intellectual property.

While the hope is that acquired companies will help China move out of the basement of the global supply chain, the buyout funds have a more immediate goal in sight, namely a huge expansion of the acquired companies’ sales within China.

This is where the Chinese buyout firms differ so fundamentally from their global counterparts. They aren’t focusing much on streamlining acquired operations, shaving costs and improving margins. Instead, they plan to leave things more or less unchanged at each target company’s headquarters while seeking to bolt on a major new source of revenues that was either ignored or poorly managed.

So for example, now that the Lexmark printer business is Chinese-owned, the plan will be to push growth in China and capture market share from domestic manufacturers that lack a well-known global brand and proprietary technologies. With OmniVision Technologies, the plan will be to aggressively build sales to China’s domestic mobile phone producers such as Huawei Technologies, Oppo Electronics and Xiaomi.

The China Android phone market is the biggest in the world.  Omnivision used to be the main supplier of mobile phone camera sensor chips to the Apple iPhone, but lost much of the business to Sony.

In launching last year the $1.8bn takeover of then then Nasdaq-quoted Omnivision, Hua Capital took on significant and unhedgeable risk. The deal needed the approval of the US Committee for Foreign Investment in the United States, also known as CFIUS. This somewhat-shadowy interagency body vets foreign takeovers of US companies to decide if US national security might be compromised. CFIUS has occasionally blocked deals by Chinese acquirers where the target had patents and other know-how that might potentially have non-civilian applications.

CFIUS also arrogates to itself approval rights over takeovers by Chinese companies of non-US businesses, if the target has some presence in the US. It used this justification to block the $2.8 billion takeover by Chinese buyout fund GO Scale Capital of 80% of the LED business of Netherlands-based Philips. CFIUS acted almost a year after GO Scale and Philips first agreed to the deal. All the time and money spent by GO Scale with US and Dutch lawyers, consultants and accountants to conclude the deal went down the drain. CFIUS rulings cannot be readily appealed.

Worrying about CFIUS approval isn’t something KKR or Blackstone need do, but it’s a core part of the workload at Chinese buyout funds. Hua Capital ultimately got the okay to buy Omnivision five months after announcing the deal to the US stock exchange.

The Chinese buyout firms see their role as encouraging and assisting acquired companies to build their business in China. This often boils down to business development and market access consulting. Global buyout firms say they also do some similar work on behalf of acquired companies, but it is never their primary strategy for making a buyout financially successful.

Chinese buyout funds count on two things happening to make a decent return on their overseas deals. First is a boost in revenues and profits from China. Second, the funds have to sell down their stake for a higher price than they paid. The favored route on paper has been to seek an IPO in China where valuations can be the highest in the world. This path always had its complications since it generally required a minimum three-year waiting period before submitting an application to join what is now a 900-company-long IPO waiting list.

The IPO route has gotten far more difficult this year. The Chinese government delivered a one-two punch, first scrapping its previous plan to open a new stock exchange board in Shanghai for Chinese-owned international companies, then moving to shut down backdoor market listings through reverse mergers.

The main hope for buyout funds seeking deal exits now is to sell to Chinese listed companies. In some cases, the buyout funds have enlisted such companies from the start as minority partners in their company takeovers. This isn’t a deal structure one commonly runs across outside China, but may prove a brilliant strategy to prepare for eventual exits.

There is one other important way in which the new Chinese buyout funds differ from their global peers. They don’t know the meaning of the term “hostile takeover.” Chinese buyout funds seek to position themselves as loyal friends and generous partners of a business’s current owners. A lot of sellers, especially among family-controlled companies in Europe, say they prefer to sell to a gentle pair of hands — someone who promises to build on rather than gut what they have put together. Chinese buyout funds sing precisely this soothing tune, opening up some deal-making opportunities that may be closed to KKR, Blackstone, Carlyle and other global buyout giants.

The global firms are also finding it harder to compete with Chinese buyout funds for deals within China, even though they have raised more than $10 billion in new funds over the last six years to put into investments in the country. They have basically been shut out of the game lately because they can’t and won’t bid up valuations to the levels to which domestic funds are willing to go.

The global buyout giants won’t be too concerned that they face an existential threat from their new Chinese competitors. It is also unlikely that they will adopt similar deal strategies. Instead, they are getting busy now prettying up companies they have previously bought in the U.S. and Europe. They will hope to sell some to Chinese buyers. Along with offering genial negotiations and a big potential market in China, the Chinese buyout funds are also gaining renown for paying large premiums on every deal. No one ever said that about Henry Kravis.

Peter Fuhrman is the founder, chairman and CEO of China First Capital, an investment bank based in Shenzhen.

Abridged version as published in Nikkei Asian Review

Smithfield & Shuanghui: One little piggy comes to market — Week In China

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A record bid for America’s top pork producer isn’t quite as it first appears

“What I do is kill pigs and sell meat,” Wan Long, chairman at Henan Shuanghui Development, told Century Weekly last year.

It’s an admirably succinct job description for a man who has been lauded by China National Radio as the “Steve Jobs of Chinese butchery” (Jobs, a vegan, probably wouldn’t have approved).

Starting out with a single processing factory in Luohe in Henan province, Shuanghui is now the largest meat producer in China, having benefitted in recent years from a shift in the Chinese diet away from rice and vegetables towards more protein.

So the announcement that it is now making a bid for the world’s largest hog producer, Smithfield Foods from Virginia in the US, prompted a flurry of headlines about the significance of the deal; its chances of getting security clearance from the Committee on Foreign Investment in the United States (CFIUS); and the broader implications for the meat trade in both countries if the takeover goes through.

Yet although Wan makes his profession sound like a simple one, Shuanghui’s bid for Smithfield turns out to be rather more complicated than many first assumed. Far from a case of a Chinese firm swooping in on an American target, the takeover reflects more complex trends too, including some of the peculiarities of the Chinese capital markets.

What first made headlines on the deal?

Privately-owned Shuanghui International has bid $7.1 billion for Smithfield Foods (including taking on its debt) in what the media is widely presenting as the biggest acquisition yet by a Chinese company of a US firm.

Shuanghui has processing plants in 13 provinces in China and produces more than 2.7 million tonnes of meat each year. But the plan is now to add Smithfield’s resources to the mix. “The acquisition provides Smithfield the opportunity to expand its offering of products to China through Shuanghui’s distribution network,” Wan announced. “Shuanghui will gain access to high-quality, competitively-priced and safe US products, as well as Smithfield’s best practices and operational expertise.”

What’s behind the move?

Most analysts have chosen to focus on Shuanghui’s desire to secure a more consistent supply of meat. Currently, it raises 400,000 of its own hogs a year, only a small share of the 11 million that it needs. That makes it reliant on other breeders in a country where the latest scare about contaminated meat is never far from the headlines. In the most recent case in March, the carcasses of thousands of pigs suddenly started floating down the Huangpu river upstream of Shanghai, after an outbreak of disease in nearby farms and a clampdown on the illicit sale of infected meat (see WiC186).

Now Shuanghui is said to be looking further afield to secure meat, and from a source that would allow it to differentiate its product range from that of its competitors.

“They’re a major processor who wants to source consistent, large volumes of raw material. You want to look at the cheapest sources and in the US, we’re very competitive,” Joel Haggard from the US Meat Export Federation told Bloomberg. Average hog prices in China are currently about $2.08 per kilo or a third higher than in the United States, Haggard also suggested.

How about changes in the industry in China?

A second theory is that Shuanghui is developing a more integrated supply chain in China and wants Smithfield’s help to complete the process.

This was something that C Larry Pope, chief executive at Smithfield, cited as a key factor in its willingness to pay a 31% premium for Smithfield stock. If so, that’s something of an irony: Continental Grain, Smithfield’s largest investor, has been pushing for a break up of the business to unlock more value for investors.

Still, an argument can be made that industry conditions are different in China, where the supply chain is shifting away from its reliance on more traditional household farming (the Mandarin character for “home” depicts a pig under a roof, for instance) to one in which large-scale, industrialised production begins to dominate.

Food safety concerns and the need to improve quality standards are also driving change across the industry. Yet despite signs of consolidation in hog breeding and slaughtering, integration across the full supply chain is a challenge. Shuanghui has already been trying to develop more of its own cold chain rather than rely on third parties (it operates seven private railways to transport its goods to 15 logistics centres, for instance, and has also invested in hundreds of its own retail outlets). But the Smithfield acquisition could help further with the integration effort, especially in areas such as adopting technology that tracks meat from farm to fork.

Paul Mariani, a director at agribusiness firm Variant Capital Advisors, told the Wall Street Journal last week that these systems have huge food safety benefits, allowing producers to track meat back to “where it was grown”. By contrast, Chinese suppliers struggle to achieve the same level of control, especially for meat sourced from the large number of smaller, family-owned firms.

How about in the US? Are Americans pleased with the deal?

The bid has already been referred to CFIUS, the committee that reviews the national security implications of foreign investments in US firms. But Smithfield’s Pope sounds confident, saying that he doesn’t expect “any concern” from the regulatory committee.

“We’re not exporting tanks and guns and cyber security,” he told reporters. “These are pork chops.”

All the same, the regulators will look at Smithfield’s supply contracts with the military, as well as whether any of its farms and factories are close to sensitive locations, an issue that has led to transactions being blocked or amended in the past.

For instance, the Obama administration intervened in the purchase of four Oregon wind farms by a Chinese acquirer this year because they were too close to a naval base.

“There’s a difference between a foreign company buying Boeing and one buying a hot dog stand,” Jonathan Gafni, president of Compass Point Analytics, which specialises in security reviews of this type, told the New York Times. “But it depends on which corner the stand is on.”

The committee will also look at whether Shuanghui could be in a position to disrupt the distribution of pork to American consumers. Indeed, Charles Grassley, the Republican Senator of Iowa, has already urged regulators to look closely at whether the Chinese government has any influence on Shuanghui’s management.

More ominously on Wednesday the chairwoman of the Senate’s Agriculture Committee expressed her concerns. Debbie Stabenow said those federal agencies considering the merger must take into account “China’s and Shuanghui’s troubling track record in food safety”. She further added that those agencies must “do everything in their power to ensure our national security and the health of our families is not jeopardised”.

Despite such concerns, the food security argument looks limited in scope, although some of the Chinese newspapers don’t expect the review to pass without issue. “Even the conspicuous absence of national security factors can hardly guarantee that US protectionists will not poke their noses into it,” the China Daily suggested pointedly.

Back in Washington, Elizabeth Holmes, a lawyer working for the Center for Food Safety, has also called for regulators to consider the bid from the wider perspective of food safety. “They’re supposed to identify and address any national security concerns that would arise,” she warned. “I can’t imagine how something like public health or environmental pollution couldn’t be potentially construed as a national security concern.”

The implication is that the takeover might damage Smithfield’s operations in the United States in some way, even leading to contamination among its locally sold products. Hence the fact that Shuanghui was forced to recall meat tainted by the additive clenbuterol two years ago has been seized upon by the deal’s critics.

Again, the Chinese media response has tended to be indignant, with widespread reference to Smithfield’s own use of ractopamine, an additive similar to clenbuterol that’s banned in hog rearing in China but not by authorities in the US.

According to Reuters, Smithfield has been trying to phase out its usage of the drug, presumably to clear the way for an increase in sales to China. And in response to American anxiety about food safety post-takeover at Smithfield, both parties have gone out of their way to reiterate that the goal is to export more American pork to the Chinese, and not vice versa. Smithfield’s chief executive Pope has argued the case directly, citing the superiority of American meat. “People have this belief…that everything in America is made in China,” he told reporters. “Open your refrigerator door, look inside. Nothing in there is made in China because American agriculture is the most competitive and efficient in the world.”

Similarly, Shuanghui executives are insisting that nothing will change in how Smithfield serves up its sausages to American customers. The company will continue to be run on a standalone basis under its current management team, no facilities will be closed, no staff will be made redundant and no contracts will be renegotiated. Food safety standards will remain as today. “We want the business to stay the same, but better,” Wan said.

So it sounds like the Smithfield deal could turn out to be a major coup for the Chinese buyer?

Not really, says Peter Fuhrman, chairman of China First Capital, a boutique investment bank and advisory firm based in Shenzhen. He thinks that much of the analysis of the bid for Smithfield has completely missed the point. That’s because Shuanghui International – the entity making the offer – is a shell company based in the Cayman Islands. It isn’t a Chinese firm at all, he says.

Shuanghui International also has majority control of Shuanghui Development, the Shenzhen-listed firm that runs the domestic meat business in China. But it is controlled itself by a group of investors led by the private equity firm CDH (based in China but heavily backed by Western money) and also featuring Goldman Sachs, Temasek Holdings from Singapore and Kerry Group.

The management at Shuanghui, led by Wan, holds a small stake in the new, offshore entity. But as far as Fuhrman is concerned, Shuanghui International has no legal or operational connection to Shuanghui’s domestic operations.

“If the deal goes through, Smithfield Foods and Shuanghui China will have a majority shareholder in common. But nothing else. They are as related as, for example, Burger King and Neiman Marcus were when both were part owned by buyout firm TPG. The profits and assets of one have no connection to the profits or assets of the other.”

Of course, this raises questions about how the bid for Smithfield is being debated, especially its portrayal as the biggest takeover of a US firm by a Chinese one to date. It prompts queries too about the national security review underway in Washington, particularly any focus on the supposedly Chinese identity of the bidder. As it turns out, the Shuanghui bidding vehicle simply isn’t constituted in the way that people like Senators Grassley and Stabenow seem to believe.

So what is going on? Fuhrman says the bid for Smithfield is actually a leveraged buyout, made during a period in which private equity firms have been prevented from exiting their investments in China by blockages in the IPO pipeline (see WiC176 for a fuller discussion on this).

Instead, the investors that own Shuanghui are borrowing billions of dollars from the Bank of China and others to fund their purchase, with Fuhrman noting speculation that the plan is to relist Smithfield at a premium in Hong Kong in two or three years time.

How Shuanghui International is going to meet the interest payments on its borrowings in the meantime is less clear. But one possibility is that it will lean on Shuanghui Development, the operator in the Chinese market, to share some of the financial load. That could be problematic, raising hackles at the China Securities Regulatory Commission. It also prompts questions about the potential conflicts of interest (“among the most fiendish I’ve ever seen,” says Fuhrman) in the relationship between the investors that own Smithfield and the fuller group of shareholders at Shuanghai in China.

Ma Guangyuan, an economics blogger with more than half a million readers, takes a similar view. “If Shuanghui International acquires Smithfield Foods and sells the meat at high prices to Shuanghui Development, this will increase profits for the privatised Smithfield, but may not do much to help Shuanghui Development,” he predicts.

A further possibility is that having to service the LBO debt could curtail much of the investment envisaged by those who see the Smithfield purchase as a game-changing move for the industry. Of course, if it all goes to plan, the bid for Smithfield might turn out to be a game-changer for a small group of highly leveraged investors.But the jury must still be out on whether it will be quite so transformational for China’s domestic meat industry at large.

 

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