At a recent Merrill Lynch dinner economist TJ Bond pointed out that in the US and Europe people were taken aback by the global economic crisis, frequently comparing it to the Great Depression, but in Asia cooler heads prevail, as the region has experienced similar events in the very recent past. That brighter outlook is particularly prevalent on the outbound mergers and acquisitions frontier in China.
M&A activity frequently reflects the stock market - when markets are up the pipeline for merger deals grows. And that's what we're seeing now. With the Hang Seng index generally moving upward since the end of February -- and the CSI 300 (which tracks the top 300 companies from Shanghai and Shenzhen's stock exchanges) mostly climbing since late October 2008 -- it's not surprising that Chinese companies are talking about going out and acquiring more businesses -- even in countries where the stock market trajectory is not as sky-high.
"The people sitting in the corner office are the same as the ones on the street," explained Bob Yang, managing director and head of advisory, China, global banking for HSBC. "When the market goes down they don't want to be blamed for something going down further and for losing money. Now that markets are more stable, there's more optimism about doing M&A."
Now, you're probably questioning if the recent high-profile case in which Rio Tinto rejected Chinalco's investment plan, has put a damper on that optimism - particularly given the subsequent detention of four Rio Tinto executives on July 5, who have since been charged with bribery and infringing trade secrets.
"I don't think people are scared off of doing M&A. There's certainly a heightened sensitivity to political factors. But Chinese buyers are getting more sophisticated and clients are getting a lot better about asking important questions earlier in the process," said Brian Gu, head of J.P. Morgan's greater China M&A team.
"Economic interests remain the prime driver for overseas investment," said Kathy Honeywood, partner at Clifford Chance who advised Chinalco on its proposed strategic partnership with Rio Tinto earlier this year. "The experience of the Chinalco deal will not deter Chinese investors -- they will simply adapt to the evolving M&A market , and continue to look for the right opportunity in the right place and at the right price."
Part of that adaptation may be evidenced by deal selection in the short term. Though the big deals are great for league table rankings, and are certainly headline grabbers, don't expect to see too many high-profile deals in the second half of the year. "Outside a few sectors, such as energy, the mega deals will be few and far between in the foreseeable future and small and medium sized deals will dominate in the current market," said Honeywood. "However, you can expect the size and the shape of deals to change in the medium term to respond to the recovering market."
Chinese companies may do lower-profile deals, or purchase assets rather than companies - so there's no public market valuation and therefore less public scrutiny over the valuation -- they may opt to do more portfolio investments -- through the China Investment Corporation or professional funds -- but they will be investing abroad, said Yang.
Indeed, the level of sophistication of these deals is on the rise. Tou-chen Chang, head of advisory and deputy head of coverage global banking at HSBC described one transaction his team is working on in which a Chinese state-owned enterprise is setting up a manufacturing facility in the US. The Chinese SOE is pairing up with a private equity fund to work out the deal. The PE firm is investing and helping the mainland company in the US but it also gets to invest in the parent Chinese SOE. The level of due diligence on the mainland company's part is impressive -- it visited many locations in the US to determine which suited it best. While manufacturing in the US may seem counter-intuitive at first hand -- from a landed cost perspective and from a future trade balance perspective, having a facility on the ground in America is a very proactive strategy.
While Honeywood concurs that the sophistication of deals has increased, she believes that successful partnerships between Chinese investors and foreign players remain challenging. "The differing aims of different parties are hard to balance, especially in the current economic climate. Foreign investors are also now competing for a place at the deal table with well resourced and increasingly sophisticated Chinese lenders."
Honeywood predicts that growing expertise of Chinese investors will see them evolve and become more agile in their response to market opportunities. "The last two years have been a valuable learning experience for all involved in China M&A. As the market recovers, I expect to see Chinese investors, in particular, adopting more and more sophisticated deal structures and strategies to achieve their goals."
If more of these deals get done, we will continue to see a rise in the number of outbound M&A transactions. Even despite the dismal end to last year on most investment banking fronts, outbound M&A transactions have been increasing based on value: there were 241 completed deals worth $50.4 billion in 2008, compared with 172 deals worth $25.4 billion the previous year, according to data-provider Dealogic. So far in 2009 there have been 113 announced deals worth $23.6 billion in the first half of 2009 with $7.5 billion completed from 88 deals in the same period.
Interest remains high amongst Chinese investors in natural resources, commodities and energy acquisitions. "We're also seeing new interest in the primary sector -- agricultural products and services -- and the manufacturing and production businesses serving those sectors," said Tim Wang, counsel in Clifford Chance's Beijing office, adding that interest remains muted in the financial services sector and the broader manufacturing and retail sectors.
The target countries reflect those sectors of interest, and perhaps where such investment is perceived to be welcome. Expect continued Chinese interest in Australia and Africa, and increasing interest in Canada and South America, Wang claimed.
However some challenges lie ahead. Philip Partnow, deputy head of the investment banking division for UBS Securities, explained that there are two issues that might make outbound M&A a bit more of a bumpy ride in the second half of the year. The first potential stumbling block is that in the last 12 months if someone overseas needed money, China was one of the only options. Now that commodities markets have rebounded and there is more access to capital markets, there may be more competition for deals from strategic investors outside of China or global capital markets that may slow the mainland's ambitions. "And the second issue is that it's not clear that Chinese companies are ready to accept a new world in terms of valuations -- no one likes paying a high premium, but Chinese acquirers are especially sensitive to the appearance of having overpaid," said Partnow. "So if the market continues to stay robust, Chinese companies will need to get used to paying more or more comfortable with competition if they want to stay competitive and win deals."
The irony, of course, is if the stock markets pause - which several economists predict -- then that will prove the Chinese companies who are hesitant of high valuations to be correct.