By Drew Bernstein
As China steps up as a major deal player, companies and advisers need to be able to view the world through Chinese eyesIn just the past few years China has gone from the world’s largest destination for capital investment, to a net exporter of capital. This flood of outbound investment is a game changer for the global economy, and needs to factor into the strategy of every company that is seeking access capital or maximize value for its assets.
In the first nine months of 2016, China displaced the United States as the number one player in cross-border M&A, with $174 billion of deals, up 68% according to Dealogic. Just a few years ago, Chinese deals were few and driven primarily by State Owned Enterprises (SOEs) acquiring energy and raw materials assets to feed heavy industry. But recently, sectors like manufacturing, technology, consumer goods, and healthcare have all emerged as areas of focus. The U.S. was the number one destination for Chinese outbound M&A, accounting for nearly 30% of deals announced thus far in 2016, according to Thomson-Reuters.
In addition, China is emerging as an important source of venture funding, with Chinese internet giants Tencent and Alibaba opening offices in Silicon Valley to invest directly in companies that may be able to provide them with a technology edge and new Chinese venture and private equity funds seeking access to U.S. venture investments and even public company buy-outs.
The forces that are driving this global shopping splurge are likely to accelerate, rather than slacken. As China’s economy slows and its labor markets tighten, the Chinese government has mandated that its companies move up the value chain. Acquiring advanced technology and recognized brands is often faster and surer path than developing them internally.
Downward pressure on China’s currency has increased the attractiveness of dollar-denominated assets and cash flow, while the government has made it significantly easier for companies to get deals approved and deploy capital overseas. Loosening monetary policy and accommodative lending are fueling the deal binge, given that most sectors of the domestic economy are already overcapacity and overleveraged. Companies and wealthy business owners are hungry to diversify.
And while heated campaign rhetoric has caused some concerns about a potential U.S.-China trade war, this could actually increase the interest of China’s industrial companies to own manufacturing assets inside the American market as a hedge against future tariffs.
For all of these reasons, the management and boards of companies from early stage technology companies to mature industries need to consider how China’s emergence onto the global stage will factor into their own plans to grow and create value for shareholders. Taking advantage of this opportunity requires some adjustment in thinking and moving beyond the familiar cast of characters and deal structures.
Here are a few keys to making China investment deals work:
Evaluate Policy AlignmentUnlike in America, where companies largely chart their own M&A strategies, the Chinese government provides explicit guidance as to where overseas investment should be focused. This takes the form of direct control for state-owned companies and faster regulatory approvals and access to capital for private sector. The “Made in China 2025” plan that was released by the State Council in 2015 provides a clear roadmap of where the government would like to see capital flowing. Industry was mandated to become innovation driven, strengthen intellectual property, reduce environmental impact, build brands and upgrade its human capital. The plan also lays out specific sectors that have a high priority, including advanced information technology, robotics, electric vehicles, advanced materials, biotech and advanced medical products. Hardly surprising then, that there has been a surge in Chinese investment in the IT and robotics industries since the guidelines were promulgated. There is evidence that the $1.3 billion acquisition of Lattice Semiconductors by a newly-formed private equity fund, Canyon Bridge Capital Partners, operating out of Silicon Valley was funded by the State Council. Companies that have unique technologies in targeted sectors are likely to find an eager audience with Chinese buyers and investors.
Look Beyond the “Usual Suspects”One of the greatest challenges for a U.S. company is to understand who the Chinese players are that may be a fit to invest in or acquire their company and how to engage the decision makers. Further complicating this is that over the past few years, the M&A landscape has exploded well beyond large SOEs to include a wide range of non-state companies, Chinese private equity and venture funds, trust companies, and others. For example, more than 50% of outbound technology investment used to be dominated by just three players – Baidu, Alibaba, and TenCent – known as BAT. But this year nearly 75% of deals have been by non-BAT companies, as the number and size of outbound technology investment has surged. In the third quarter of 2016 alone, there have been 30 deals valued at over $1 billion, including the acquisition of Finnish game developer Supercell for $8.6 billion by Tencent, a $4.4 billion deal for Israeli online casino game developer Playtika by Shanghai Giant Network Technology and Jack Ma, and Ingram Micro’s $6.3 billion acquisition by HNA Group. Companies need to make sure that their advisors have a strong understanding of the universe of potential buyers in China to bring the right suitors to the table, and also be able to provide diligence on potential investors industry position and sources of funding.
Understand Chinese Valuation MetricsChinese acquirers may be looking at valuations in a very different way than U.S. strategic or financial investors, which can be advantageous to informed sellers. Rather than looking only at publicly traded peers in U.S., it pays to look at the valuations of Chinese public companies in the sector, which may have vastly different multiples or be valued on different metrics (revenue as opposed to earnings or EBITDA, for example.) Chinese companies that have completed high profile overseas acquisitions have often seen outsized leaps in their share price in China. In general, Chinese management can afford to take a longer term view on an investment if they believe it is important to create a strategic advantage with domestic peers or if it aligns with government mandates. By failing to see a transaction through Chinese eyes or entertain Chinese bids, sellers may be leaving money on the table.
Prepare to Be PatientIn the past, Chinese companies had a reputation of being unprepared to move quickly enough to participate in global M&A deals. In addition, the financing for these deals was often highly complex and non-transparent, creating anxiety as to whether the deal was capable of closing. This is changing as Chinese management teams become more comfortable and proficient at completing overseas deals. But management and advisors still need to be prepared for more intensive education of Chinese counterparts, while needing to evaluate funding sources that can include government investment vehicles, unknown private equity funds, and trust structures. The use of escrow funding and increased availability of target level financing from foreign banks can help mitigate the funding risk. And the use of meaningful break up fees is becoming more accepted for deals that are likely to be subject to regulatory review by CIFUS (Committee on Foreign Investment in the United States) in the U.S. or Chinese regulatory approval.
Package Investment with “Sinofication” StrategyThe most powerful deals may be those that package a strategic investment in a U.S. company with a viable plan to scale the American technology or business model in the Chinese market. Foreign companies are learning the hard way that it is increasingly difficult to overcome the home court advantage that China provides to domestic players through the ability to shape regulations, offer economic incentives, and drive public opinion. As a result, foreign companies are increasingly adopting various approaches of Sinofication of their business model, such as the recent merger of all of Uber’s China operations into domestic competitor Didi in exchange for a minority 20% investment stake in the China business and a $1 billion investment by Didi into Uber’s global business. This stanched a reported $2 billion loss from Uber’s China business, and the Chinese government then legalized ride sharing services a week after the deal was announced. Expect to see a wide variety of creative deal structures that include Chinese outbound investment with the injection of overseas technology and business models so as to be able to capture part of the value of a Chinese market that would otherwise be out of reach in many fast-growing sectors of the economy.
The Human Factor
All these issues are important for companies that want to position themselves to attract the flood of capital investment that will be coming out of China as China Inc. seeks to recalibrate its economic model.
But the key as to whether these deals are ultimately successful will largely depend on how both sides are able to align incentives and meld their business culture. While M&A may provide a short cut to obtaining technology and expertise, capitalizing on these strengths will require careful integration. Chinese management is generally less familiar with the norms of operating a business and retaining key talent overseas. A successful deal requires that both sides invest the time leading up to and during a transaction to see if there can be a cultural fit and develop a post-closing operating framework and technology roadmap that can keep all parties onboard and committed to shared goals.
Attracting investment from Chinese sources may bring with it additional complexities and a steep learning curve. But the pay off, whether in the form of enhanced value for an asset or access to capital combined with entry into one of the world’s largest markets, will more than reward those who invest the energy to make it work.
About the author
Drew Bernstein is the Co-Managing Partner of Marcum Bernstein & Pinchuk (MarcumBP), and a recognized expert in issues related to doing business in China, accounting and financial due diligence, and cross-border M&A. MarcumBP provides a range of services to both Chinese companies looking to expand overseas and U.S. companies with operations in China, including audit, financial due diligence, internal controls, risk management, international tax strategy, and transactional support services.