Download Shanghai Flash N° 3/2007 pdf-version

Emerging M&A Trend

The Shanghai led Yangtze Delta Region has been the “land of promise” since China’s economic reform and has been attracting considerable foreign investors. The continuous influx of FDI was mainly in the form of greenfield investment by the end of last century, whereas mergers and acquisitions (M&A) has constantly been on the rise since the past couple of years.

Based on local observation and analysis of series publications, this report aims at underlining the general considerations and key factors that are certainly relevant for the whole China market.

According to the World Investment Report complied by UNCTAD, the value of China’s cross-border M&A by foreign investors was USD 2.25 billion in 2002, accounting for only 5.5% of its annual FDI. The percentage increased significantly in 2004 and 2005 to 11.16% and 13.68% with M&A values topping USD 6.67 billion and USD 8.25 billion respectively. The M&A frenzy continued to gain momentum in 2006, with around 1,300 transactions approved by Chinese authority. It is expected that the tide will keep on at the growth rate of 25% to 30% for the next several years.

The emerging trend of M&A in China is the result of many elements:

• Many new industries develop fast and become mature, which provide better quality target companies with market competence and human resources

• Evolving regulatory framework, defined ownership system and more open capital market make it more practical for M&A transaction

• Excess liquidity from the worldwide excess of capital as well as the expectation of RMB appreciation

• Privatization and restructuring of State Owned Enterprise (SOE) provide opportunities to access to restricted sectors and nationwide distribution network

• Chinese private companies seek for international market expansion, advanced management and new technology through M&A

China-Specific Factors

However, different from the complete and integrated system of M&A which has been established in the international market through long-time practice, Chinese M&A market developed from a bare site for just a few years. Overlooking the China specific factors may lead to difficult or failed transactions. Several recent studies indicate that among all the attempts to make a successful deal in China, the majority never even pass the due diligence stage. Of those that do, an even smaller percentage end up creating value for the acquiring entities. The key element behind the high failure rate, or in other word, to increase the level of success, is to know the China-specific issues in the domestic M&A market:

• There is a high level of government participation in M&A transactions. Despite the recent relaxation of foreign investment restrictions, pervasive approval requirements remain a distinctive feature of M&A transactions in China. As foreign mergers and take-overs are still new things in China, some departments tend to adopt a cautious approach in dealing with the issue, especially when the deal is related to sensitive industries.

• Although rapidly evolving, the complex and immature legal framework and regulatory infrastructure still pose obstacles to the M&A transactions. China released the Regulations On Acquisition of Domestic Enterprises by Foreign Investors on 8th September 2007, in an effort to provide guidelines for the domestic M&A market. However, the rules are still too general and lack detailed implementation structures. In the meantime, the law stressed the supervision and regulatory power of the central government, probably due to the rising concerns that foreign takeovers may jeopardize China’s industrial securities. The ambiguous legal environment not only adds uncertainties to foreign acquirers, but also discourages the government official to shoulder the responsibility to approve new types of deals or sensitive transactions.

• Publicly available records on many aspects of a Chinese company’s business, such as legal title to land-use rights, the existence of pending litigation, and priority security interests over assets, are often either unavailable or unreliable. Corporate accounting is also frequently lax by foreign standards. Some companies have separate accounting systems to manipulate the financial data, either to exaggerate the company performance, or to minimize the tax burden. On the other hand, company ownership structure in China, although has been undertaking series of reforms, remains complex, with sometimes hidden political or family relations, transfer pricing, or financial burdens. Therefore the whole process of M&A transaction is more complicated, from target company search, negotiation, to due diligence, accurate valuation and post deal integration.

• Due to those specific Chinese characteristics, M&A transactions in China are usually time-consuming. A study by InterChina Consulting shows that an M&A deal takes on average 12 to 24 months in China, whereas the timing expectation overseas is only 6 to 12 months. During the process, constant review including flexibility and adaptation is crucial for a successful transaction.

Working for a Successful Transaction in China

M&A transaction in China may be done through an equity purchase, an asset acquisition or a statutory merger. An acquirer may choose the most appropriate type with tailor-made approach. However, there are common key elements leading to success:

Pre- M&A

• Strategic plan with sound understanding of the market reality to avoid opportunistic approach, or overestimation of the M&A deal’s potential to increase value

• Adequate screening for target companies with field-work based approach and cross-checking

• Set up sufficient on-the-ground business development team and support them with framework instruction, constant communication and decision autonomy. Expectation gap may push the team to agree on less favorable terms in order to show progress

• Due diligence provides unique opportunities to increase the level of success, which goes beyond a data verification phase to other aspects such as the real intention of target company, its sustainable earning capability, the key sensitivities, or potential deal-breakers

• M&A in China requires higher level of empathy and attention to subjective aspect. Managing the relationship network is important. Cultural differences relating to environmental, health and safety will pose issues to the deal or post-deal integration.

Post- M&A

• Stabilize: Organisational fit to manage the change

• Integrate: Corporate cultural integration

• Grow: Manage to address different shareholders’ interest

Where opportunities lie

Investing in China is becoming increasingly achievable on commercially viable terms and opportunities abound as never before. The SOE restructuring in the last several years has boosted M&A in the machinery industry, which on the other hand also caused concerns about foreign monopoly may jeopardize national economic security. Recently M&A in retail, fast moving consumer goods, and logistic has been in rise, which provided the acquirers with fast gain to the market presence and distribution channels. With China’s further opening in accordance with the WTO commitments, finance, real estate and infrastructure would be the next potential fields for M&A activities.

In terms of types of target companies, both SOEs and private companies could offer M&A opportunities. The Chinese government is encouraging SOEs in a few industrial sectors to consolidate into large integrated conglomerates, attempting to be global leader in their fields, while in other sectors, the State is actively seeking to reduce the level of its equity holding. China’s 11th five-year plan indicates that new forms of FDI, such as M&A, stock holding and reinvestment will be encouraged.

China’s private family businesses, which have just developed in the past 20 years with the unprecedented economic reform, are also becoming available for M&A through their desire to exit or as a result of succession issues. They are seeking for additional capital and advanced management to realize their strategic expansion plan and are increasingly willing to consider to sell or ally.

Useful Contacts of Assistance for Swiss Companies

Swiss companies that are interested in strengthening or developing their business relations with China can get practical assistance and/or guidance in identifying potential partners from:

Swiss Business Hub China: (www.osec.ch/sbhchina, shbchina@bei.rep.admin.ch)

Swiss Chinese Chamber of Commerce: (www.sha.swisscham.org, info@sha.swisscham.org)

References

• Positive and Negative Impacts of Cross-Border M&A, PEI Changhong, LIN Jiang, China Economist, No. 7, March 2007
• China M&A: Piecing together an effective strategy, Anthony Lin, Shanghai Business Review, Issue 5, 2007
• Acquiring Companies in China: Hidden risks or just conflicting approaches? Eduard Morcillio, Jing Han, Brent Parsons, InterChina Opinion, May, 2007

Stella Nie
Economic Section

20.6.2007

Consulate General of Switzerland
for business related matters, please reply: sha.vertretung@eda.admin.ch