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An insider’s view of Chinese M&A — Intralinks Deal Flow Predictor

Leave a Comment / December 8, 2015

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Intralinks Dealflow Predictor

 

Intralinks: The meltdown of China’s equity markets that began in the summer, despite measures by officials in Beijing aimed at calming investors’ nerves, has left many global investors jittery. Is this just a correction of an overheated market or the start of something more serious, and how would you describe the mood in China at the moment?

 

Peter Fuhrman: Never once have I heard of a stock market correction that was greeted with glee by the mass of investors, brokers, regulators or government officials. So too most recently in China. The dive in Chinese domestic share prices, while both overdue and in line with the sour fundamentals of most domestically quoted companies, has caused much unhappiness at home and anxiety abroad. The dour outlook persists, as more evidence surfaces that China’s real economy is indeed in some trouble. I first came to China 34 years ago, and have lived full-time here for the last six years. This is unquestionably the worst economic and financial environment I’ve encountered in China. Unlike in 2008, the Chinese government can’t and won’t light a fiscal bonfire to keep the economy percolating. The enormous state-owned sector is overall on life support, barely eking out enough cash flow to pay interest on its massive debts. Salvation this time around, if it’s to be found, will come from the country’s effervescent private sector. It’s already the source of most job creation and non-pump-primed growth in China. The energy, resourcefulness, pluck and risk-tolerance of China’s entrepreneurs knows no equal anywhere in the world. The private sector has been fully legal in China for less than two decades. It is only beginning to work its economic magic.

 

Intralinks: Much has been made of slowing economic growth in China. What are you seeing on the ground and how reliable do you view the Chinese official growth statistics?

 

Peter Fuhrman: If there’s a less productive pastime than quibbling with China’s official statistics, I don’t know of it. Look, it’s beyond peradventure, beyond guesstimation that China’s economic transformation is without parallel in human history. The transformation of this country over the 34 years since I first set foot here as a graduate student is so rapid, so total, so overwhelmingly positive that it defies numerical capture. That said, we’re at a unique juncture in China. There are more signs of economic worry down at the grassroots consumer level than I can recall ever seeing. China is in an unfamiliar state where nothing whatsoever is booming. Real estate prices? Flat or dropping. Manufacturing? Skidding. Exports? Crawling along. Stock market prices? Hammered down and staying down. The Renminbi? No longer a one-way bet.

 

Intralinks: What impact do you see a slowing Chinese economy having on other economies in the APAC region and elsewhere?

 

Peter Fuhrman: Of course there will be an impact, both regionally and globally. There’s only one certain cure for any country feeling ill effects from slowing exports to China: allow the Chinese to travel visa-free to your country. The one trade flow that is now robust and without doubt will become even more so is the Chinese flocking abroad to travel and spend. Only partly in jest do I suggest that the U.S. trade deficit with China, now running at a record high of about $1.5 billion a day, could be eliminated simply by letting the Chinese travel to the U.S. with the same ease as Taiwanese and Hong Kong residents. Manhattan store shelves would be swept clean.

 

Intralinks: With prolonged record low interest rates and low inflation in most of the advanced economies, many multinational companies have looked to China as a source of growth, including through M&A. Which sectors in China have tended to attract the majority of foreign interest? Do you see that continuing or will the focus and opportunities shift elsewhere? Is China a friendly environment for inbound M&A?

 

Peter Fuhrman: The challenges, risks and headaches remain, of course, but M&A fruit has never been riper in China. This is especially so for U.S. and European companies looking to seize a larger slice of China’s domestic consumer market. The M&A strategy that does work in China is to acquire a thriving Chinese private sector business with revenues in China of at least $25m a year, with its own-brand products, distribution, and a degree of market acceptance. The goal for a foreign acquirer is to use M&A to build out most efficiently a sales, brand and product strategy that is optimized for China, in both today’s market conditions, as well as those likely to pertain in the medium- to long-term.

The botched deals tend to get all the headlines, but almost surreptitiously, some larger Fortune 500 companies have made some stellar acquisitions in China. Among them are Nestle, General Mills, ITW, FedEx and Valspar. They bought solid, successful, entrepreneur-founded and run companies. Those acquired companies are now larger, often by orders of magnitude. The acquirer has also dramatically expanded sales of its own global products in China by utilizing the localized distribution channels it acquired. In Nestle’s case, China is now its second-largest market in revenue-terms after the U.S. Four years ago, it ranked number seven.

Chinese government policy towards M&A is broadly positive to neutral. More consequential but perhaps less well-understood are the negative IPO environment for domestic private sector companies, as well as the enormous overhang of un-exited PE invested deals in China. These have transferred pricing leverage from sellers to buyers in China. Increasingly, the most sought-after exit route for domestic Chinese entrepreneurs is through a trade sale to a large global corporation.

 

Intralinks: After years of being seen mainly as “an interested party”, rather than an actual dealmaker, Chinese players are increasingly frequently the successful bidder in international M&A transactions. What has changed in their approach to dealmaking to ensure such success?

 

Peter Fuhrman: Yes, Chinese buyers are increasingly more willing and able to close international M&A deals. But, the commonly-heard refrain that Chinese buyers will devour everything laid in front of them stands miles apart from reality. It seems like every asset for sale in every locale is seeking a Chinese buyer. The limiting factor isn’t money. Chinese acquirers’ cost of capital is lower than anywhere else, often fractionally above zero. The issue instead is too few Chinese companies have the managerial depth and experience to close global M&A deals. There are some world-class exceptions and world-class Chinese buyers. In the last year, for example, a Chinese PE fund called Hua Capital has led two milestone transactions, the proposed acquisition for a total consideration north of $2.5bn, of two U.S.-quoted semiconductor companies, Omnivision and ISSI. Hua Capital has powerful backers in China’s government, as well as outstanding senior executives. These guys are the real deal.

 

Intralinks: When it comes to doing deals, what are the differences between private/public companies and SOEs?

 

Peter Fuhrman: With rare exceptions, the SOE sector is now paralyzed. No M&A deals can be closed. Every week brings new reports of the arrest of senior SOE management for corruption. In some cases, the charges relate directly to M&A malfeasance, bribes, kickbacks and the like. SOE M&A teams will still go on international tire-kicking junkets, but getting any kind of transaction approved by the higher tiers within the SOE itself and by the government control apparatus is all but impossible for now. That leaves China’s private sector companies, especially quoted ones, as the most likely club of buyers. We work with the chairmen of quite a few of these private companies. The appetite is there, the dexterity often less so.

 

Intralinks: China has long been a fertile dealmaking environment for PE funds – both home-grown and international. In what ways does the Chinese PE model differ from what we see in other markets?

 

Peter Fuhrman: Perhaps too fertile. For all the thousands of deals done, Chinese PE’s great Achilles heel is an anemic rate of return to their limited partner investors, especially when measured by actual cash distributions. Over the last three, five, seven years, Chinese PE as a whole has underperformed U.S. PE by a gaping margin. It’s a fundamental truth too often overlooked. High GDP growth rates do not correlate, and never have, with high investment returns, especially from alternative investment classes like PE. If there is one striking disparity between PE as practiced in China as compared to the U.S. and Europe, it’s the fact that that Chinese general partners, whether they’re from the world’s largest global PE firms or pan-Asian or China-focused funds, too often think and act more like asset managers than investors. The 2 takes precedence over the 20.

Intralinks: What opportunities and challenges are private equity investors facing?

 

Peter Fuhrman: The levels of PE and venture capital (VC) investing activity in China have dropped sharply. What money is being invested is mainly chasing after a bunch of loss-making online shopping and mobile services apps. The hope here is one will emerge as China’s next Alibaba or Tencent, the two giants astride China’s private sector. PE investment in China’s “real economy,” that is manufacturing businesses that create most of the jobs and wealth in China, has all but dried up. Though out of favor, this is where the best deals are likely to be found now. Contrarianism is an investing worldview not often encountered at China-focused PE and VC firms.

 

Intralinks: As in many other markets, PE investors are having to deal with a backlog of portfolio companies ready to be exited. Do you feel that PE’s focus on minority investments in China could prove a challenge when it comes to exiting those investments? What do you see as the primary exit route?

 

Peter Fuhrman: Exits remain both few in number and overwhelmingly concentrated on a single pathway, that of IPO. M&A exits, the main source of profit for U.S. and European PE firms, remain exceedingly rare in China. In part, it’s because PE firms usually hold a minority stake in their Chinese investments. In part, though, the desire for an IPO exit is baked into the PE investment process in China. Price/Earnings (P/E) multiple arbitrage, trying to capture alpha through the observed delta in valuation multiples between private and public markets, remains a much-beloved tactic.

 

Intralinks: Finally, what is your overall outlook on China and advice for foreign companies and investors seeking opportunities to engage in M&A or invest there?

 

Peter Fuhrman: Yes, China’s economy is slowing. But the salient discussion point within boardrooms should be that even at 5% growth, China’s economy this year is getting richer faster in dollar terms than it did in 2007 when GDP growth was 14%. That’s because the economy is now so much larger. This added increment of wealth and purchasing power in China in 2015 is larger than the entire economies of Taiwan, Malaysia, Thailand, and Hong Kong. Much of the annual gain in China, likely to remain impressively large for many long years to come, filters down into increased middle class spending power. This is why China must matter to global businesses with a product or service to sell. M&A in China has a cadence and quirks all its own. But, the business case can often be compelling. The terrain can be mastered.

 

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M&A the Chinese Way: Buying First and Paying Later — Financial Times

Leave a Comment / May 9, 2015

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FT article

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China is in the early stages of a domestic M&A boom unlike any other elsewhere in the world. Deal pricing, timing, terms, financing and structure are all markedly different than in other major economies, with likely consequences, good and bad, for global corporations and buyout firms eyeing M&A transactions in China.

For these two, as well as companies wishing to find a buyer in China, the game now is to learn the new rules of China M&A and then learn to use them to one’s advantage.

Chinese companies mainly pursue M&A for the same reasons others do – to improve margins, gain efficiencies and please investors. The main difference, and it’s a striking one, is that in most cases domestic Chinese corporate buyers, especially the publicly-quoted ones who are most active now trying to do deals, have no money to buy another business.

Outside of China, there are three known ways to pay for an acquisition – with cash, borrowed money, or shares. All three are generally between excruciatingly slow and impossible for publicly-listed Chinese companies. The reason: companies’ retained earnings are just about always insufficient.

Banking and securities rules in China severely restrict the way publicly-traded companies in China can finance acquisitions using debt or by issuing new shares. Deals financed with leverage are basically forbidden. So, Chinese companies have invented two convoluted ways to get M&A done. They display a certain genius. Both involve trying to buy first and pay later.

Method One is for the acquirer to first negotiate a purchase then ask the Chinese stock market to suspend trading in its own shares. The acquirer will announce the deal publicly and if all goes to plan its share price will surge, often by as much as 50 per cent to 75 per cent.

This predictable outcome is the result of the fact almost all shares quoted in China are owned by small retail investors, commonly called Chinese brokers “old grandpas and grandmas”. Most have never cared to look at a company’s financials or studied its competitive position. Instead, they trade in and out of stocks depending mainly on rumor and hype fed to them by brokers or online tip sheets.

In China, an announced M&A deal is now always a market-moving event. The movement tends to be all in one direction. Up.

Once trading in the acquirer’s shares resumes and the price duly jumps up, the acquirer then initiates the laborious process of applying to the Chinese securities regulator, the China Securities Regulatory Commission (CSRC), for permission to do a secondary share offering.

This will then, it’s hoped, yield the cash to complete the acquisition. The approval process will generally take six months or longer. Chinese securities rules are cumbersome and mandate that the new shares be issued at a discount to the share price at the time of application.

The result: the sequence of “announce first, then apply” means the acquirer can raise the cash needed to buy the target on more favorable terms for the acquiring company, lowering the amount of dilution.

Method Two, a close cousin, is to persuade a friendly domestic investment fund to buy the target company then hold onto it for as long as it takes the intended final owner to get the money in place through the secondary offering. In other jurisdictions, this might be deemed a “concert party” and so likely to land everyone in jail. In China, it’s becoming common practice.

In fact, a new form of investment fund has come into being especially to do deals like this. They call themselves “市值管理基金” which you can translate as “market cap management funds”. They exist to help publicly-traded companies do M&A deals that will lift the company’s share price, and not much else.

They make money buying and selling shares, as well as marking up for resale companies they buy on behalf of publicly-traded companies. They are not buyout funds as understood elsewhere, since these market cap management funds are buying on behalf of a specific company and have no particular industry expertise or experience managing an acquired company. They act purely as a temporary custodian.

Most often, the acquirer will contribute a small amount of limited partner capital to the “market cap management fund” as a way to bind the two organisations together. It can take a year or more from when the market cap management fund first buys the target company then sells to the publicly-traded acquirer, and from there, several more years before this acquisition starts to have an impact, if any, on the acquiring company’s earnings. In other words, a very long timetable.

That by itself is not a problem for the acquirer, since it is as eager to give a shot of adrenalin to its own share price and maintain it on this higher plane as it is to get control of the target company and integrate it into its business. Market cap management trumps industrial logic as a reason to pursue M&A.

I’ve yet to see evidence of much skepticism from Chinese stock market investors that an announced M&A deal may not benefit the acquirer. In the US and other more developed capital markets, it’s frequently the opposite. An acquiring company will as often as not see its shares fall when it announces plans for a takeover. That’s because in most cases, as far as hard empirical evidence can determine, the main beneficiaries of any M&A deal are the target company’s shareholders. Too often, for acquirers M&A deals prove to be too expensive and synergies elusive.

We’ve been invited by domestic listed companies in China to help consult on M&A deals where “market cap management” was an explicit purpose. Finding an attractive target is also a consideration, but a somewhat secondary one.

The discussions, in the main, are unlike anywhere else where M&A deals are being planned and executed. They revolve around how to get the money together, when and for how long to halt share trading, and by how much the listed company’s shares will likely go up, and stay up, once the M&A announcement is made.

Where the publicly-listed company has private sector, rather than State-owned enterprise background, the chairman will usually be the largest single shareholder. The chairman’s net worth stands to get the biggest boost if market cap management works as planned.

Opportunities for global buyout funds
The lengthy, roundabout nature of Chinese M&A is creating attractive opportunities for global corporations and buyout firms. They are the only participants in the M&A arena in China both with cash in hand or easily accessed to close deals and the experience to manage a company well once it’s bought.

From the perspective of potential Chinese sellers, both of these are extremely valuable, since they remove much of the uncertainty in agreeing to sell to a domestic acquirer. Global corporates and buyout firms will thus often be buyers of first choice for sellers.

For now, few global corporates and buyout firms are busy closing M&A deals in China. There are a host of reasons, including China’s slowing economic growth, the perception China is becoming more hostile towards foreign investment, the difficulty persuading owners of better Chinese companies to give up majority control. All valid concerns. But, there are larger forces now at work that make it attractive to expand through acquisition in the world’s largest fast-growing market.

First, in almost all industrial and service industries, China is beginning at last a process of rationalisation and consolidation. Costs are rising quickly, especially for labor, energy and debt service. These are applying vice-like pressure on margins. Markets for most products and services in China are no longer growing by +25 per cent a year and suffer from overcapacity.

Scale, efficiency, quality, modern management are the only ways to combat the punishing margin pressure. This plays directly to the strengths of larger global corporations and buyout firms. They know how to do this, how to transform a capable smaller business into a large market-share leader.

It’s something of a well-kept secret, but some of the world’s most successful M&A deals have seen large global corporations buying private sector businesses in China. The successful buyers generally prefer it this way, that few know how well they are doing after buying and upgrading a Chinese domestic company.

Why tip off competitors? For every well-publicized horror story there are at least three quiet successes. Indeed, one can find within a single Fortune 500 company three great examples of how to do domestic M&A well in China, and achieve a big payoff. The company is Swiss food giant Nestle.

They first opened an office in China in 1908. The big transformation began a hundred years later, in 1998, when they decided to buy an 80 per cent ownership in a Chinese powdered bullion company Taitaile. That company is now more than twelve times the size it was when Nestle bought in.

They followed that up with two other large acquisitions of domestic Chinese food and beverage brands, drinks company Yinlu and candy brand Hsu Fu Chi. In all cases, Nestle bought majority control, but not 100 per cent. They kept the founder in place, as CEO and a minority owner.

That has proved a brilliant model for successful M&A in China, and not only at Nestle. When discussing with Chinese business owners the advantages of selling control to a capable global company, we often share details of Nestle’s M&A activity in China, including the fact that the Chinese owner stays but gets to spend Nestle’s money, leverage its resources, to build a giant business. That’s a pretty attractive proposition.

All three acquisitions have thrived under Nestle’s ownership and now enjoy significant market shares. Thanks largely to these acquisitions, China is Nestle’s second-largest market overall. It was number seven just four years ago.

From my discussions with the China M&A team at Nestle, they are frank that it’s not always been smooth sailing. The M&A deals all involved trying to blend one of the world’s most fastidious, slow-moving and more bureaucratic cultures with the free-wheeling, “ready, fire, aim” style common to all Chinese domestic entrepreneurs. Corporate culture gaps could not get any wider. And yet, it’s worked out well, better in fact than Nestle hoped when going in.

Nestle tells us it is hungry to do more acquisitions in China. Chinese still spend half as much on food per capita as Mexicans. That’s where the growth will come from. Market dynamics in China are also moving strongly in Nestle’s favor, as food quality and safety become paramount concerns. Further acquisitions should help Nestle gather in billions more in revenue in China along with higher market shares.

Across multiple industries, the circumstances are similar in China, and so favor smart, bold acquirers. Choose good targets, buy them at a good price, convert great entrepreneurs to great managers and partners, don’t script everything from your far-off global headquarters. Do these right and M&A can work in China. No market cap management required.

(Originally published Financial Times BeyondBrics)

http://blogs.ft.com/beyond-brics/2015/05/08/ma-the-chinese-way-buying-first-and-paying-later/

http://www.chinafirstcapital.com/en/FT.pdf

 

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