China M&A: Outbound boom set to slow

Outbound China M&A was path-breaking in 2007, both in terms of dollar volume and number of deals, but macro- and micro-economic factors suggest a slowdown is on the horizon.
Despite a strong 2007, fuelled by a rising renminbi, ChinaÆs outbound announced M&A performance has slowed down sharply in 2008. According to Dealogic estimates, Chinese companies announced $43.9 billion of outbound M&A deals so far this year, compared to $74 billion last year. That is still way ahead of India and Russia, on $21 billion and $14 billion respectively, but down on past years.

The trend is ominours. In the future, China will have to face the fact that the global economic landscape has changed and that other countries view its economic model, which involves numerous state-controlled entities, with suspicion.

ChinaÆs outbound M&A strategy is to a large extent derived from the nature of its political and economic system. Its global champions (or potential global champions) are invariably state-owned enterprises (SOEs). As such, the state has its own agenda, blended into, but also separate from, the SOE sector. To one side, but unavoidably affected by the stateÆs regulations and economic strategies, is the evolving private sector, which is historically strong in services but is now entering capital-intensive industries, often by way of hybrid arrangements with the state.

Clearly, each of these segments will have its own priorities. First, the government wishes to guarantee the supply of raw materials that underpin the growth rate of its energy-hungry economy. Its tools for doing this are SOEs in the Chinese commodities sector, such as CNOOC, PetroChina and Sinopec.

Second, giant SOEs in other sectors want to expand abroad, usually in areas where they combine existing large domestic scale and competence (such as the steel, auto, power and finance industries). Compared to the commodities companies, these firms tend to be more commercially-oriented, with more focus on improving shareholder value through their deals.

Third, ChinaÆs growing, privately-owned, corporate sector is looking to flex its muscles abroad. These latter deals, while very interesting, tend to be small and rare in their pure form. The biggest deals so far have been the $1.8 billion acquisition of IBMÆs personal computer unit by Lenovo (which is actually a hybrid private/public firm founded by government-employed academics) in 2005, and more recently, the $4.7 billion 2008 acquisition of Wing Lung Bank by China Merchants Bank (also not a pure private company, but with a very commercial approach to doing business and not under the direct supervision of the central government).

Fourth, the government has the fifth-largest sovereign wealth fund (SWF) in the world, China Investment Corp, with hundreds of billions of dollars from its foreign exchange reserves to use as passive investments.

This is a complicated and unattractive model to many countries that might otherwise be the recipient of investment from China. It is never clear if the state oil companies in particular (although other commodity companies are faced with the same suspicion) are seeking normal corporate growth or are playing a more strategic and political role.

ôWe have seen some significant cross-border deals ... but [actually] a lot of deals didnÆt get done,ö says Xu Yicheng, head of M&A at China International Capital Corporation (CICC). ôAlthough Chinese companies have a lot of cash, itÆs not just about money. Regulators in both countries need to be satisfied.ö

ôThis year has seen many outbound acquisitions in natural resources and financial institutions by state-owned Chinese companies,ö says Brian Gu, J.P. MorganÆs head of China M&A. ôAnd the deals have been getting bigger and more complicated.ö

While true of the first half of the year, it seems as if many of the factors driving the earlier deals will be less prominent during the next few months, with inevitable consequences on outbound M&A volume û unless a different segment of the Chinese corporate landscape, such as private (or semi-private) companies, decide to step in and fill the gap. However, the more purely private a company is, the harder it will be for it to secure the necessary funding to finance an acquisition.

The concern of China to secure raw materials, especially oil, is an old story, but a changing one. It is already three years since CNOOC was beaten back on a tide of nationalist sentiment when it tried to acquire Unocal in the US. But the urgency of the search for oil assets may well weaken now, given that oil prices have collapsed dramatically in past weeks, from a peak per barrel of Brent crude of $145 as recently as July to just $74 in mid-October û an extraordinary decline, and one which will make the Chinese government less concerned with securing supplies, especially with the Chinese economyÆs growth rate in the third quarter of 2008 plunging to below 10% for the first time in many years.

Other strategic commodities have also been the focus of Chinese M&A, but the same doubts adhere to demand being as strong, and hence the Chinese government feeling the same strategic urgency to acquire assets, as the world heads into its first synchronised slowdown in economic history. One of the most dramatic events in the commodities sector was the $14 billion Aluminum Corp of China spent on taking a 14% stake in mining giant Rio Tinto in February 2008. This blocked a takeover by BHP Billiton at the time and as CICCÆs Xu says: ô[The strategy] ensured Chinalco will have a seat at the table in a rapidly consolidating industry.ö An interesting deal, in the sense that it might reflect a change in the governmentÆs tactics in the commodities area, was the State Administration of Foreign ExchangeÆs (Safe) acquisition of 1% in UK oil and gas firm BP for $2 billion in April. Such a passive and purely financial investment encountered no hostility.

The continuing crisis in the financial sector is also changing the priorities of ChinaÆs acquirers. Recently, and not surprisingly in an era when financial companies have been the most profitable entities on the planet, Chinese financial institutions have invested in foreign counterparts, such as Bank of ChinaÆs acquisition of a 20% stake in La Compagnie FinanciFre Edmond de Rothschild of France for $340 million and China MerchantÆs BankÆs $4.6 billion acquisition of Wing Lung Bank.

Interestingly, the financial sector has attracted all the different categories of Chinese outbound M&A players, namely its SWF, its SOEs and its privately owned enterprises. But given the stunning collapse of Bear Stearns, Lehman Brothers, AIG and Merrill Lynch, not to mention the nationalisation of the UK, German and French financial sectors, the international finance industry is looking anything but a good investment. As a result, as Japanese companies such as MUFG and Nomura have acquired a 21% stake in Morgan Stanley and parts of Lehman BrothersÆ franchise respectively, the Chinese firms have not dared move from the sidelines, given the heavy criticism they have taken for loss making investments earlier. (CITIC Securities was negotiating a $1 billion stake in Bear Stearns weeks before the US investment bank collapsed, for example, while CIC put $3 billion in private equity firm, Blackstone Group last year, and $5 billion in Morgan Stanley, both of which investments have declined massively in value).

Boston Consulting Group says in a recent report, ôStrategic implications of Chinese outbound M&Aö, that Chinese exporters will be likely to acquire foreign assets, as technology equipment manufacturer Huawei tried to do with 3Com early in 2008, and as TCL did with French TV company Thomson (via a joint venture) in 2004, and as Lenovo did with IBM in 2005. However, with exports facing a tightening itÆs unlikely Chinese exporters will be able to prop up the outbound M&A market. Not everybody is pessimistic.
As CitiÆs head of Asian M&A, Steven Wallace, points out: ôChinese companies remain well placed to be net acquirers given their strong capitalisation and strong cash positions. Chinese companies are also looking for international distribution, to move their products up the value chain ... and to develop global brand recognition.ö

J.P. MorganÆs Gu adds that private companies, such as Wuxi Pharma and Mindray ôare successful private companies which have the liquidity and the strategic ambition to buy assets abroadö.

Post-merger integration remains a worry û the only deals that offer good value for shareholders, argues BCG in its report, are those where Chinese and foreign management remain strictly apart. That lesson appears to have been learned, however. ô[Lenovo shows that] Chinese managers understand the importance of keeping non-Chinese talent on board to manage the acquired business,ö says Gu. Indeed, Lenovo is to all intents and purposes run by (American) refugees from Dell, including its CEO Bill Amelio.

The bottom line is that the wave of outbound M&A from China looks likely to slow, as Chinese SOEs face lower earnings at home, a less urgent commodities situation and the need to learn from their earlier mistakes. Private companies may step into the breach to a limited extent, but lack of familiarity with foreign markets and funding issues may slow them down as well.

This story first appeared in the M&A supplement which was published together with the November issue of FinanceAsia magazine.
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