M&A in China and Australia could push regional activity to record highs

Mergers and acquisitions in Asia-Pacific are hurtling ahead at full speed, and continued private-equity interest in China and Australia is likely to push activity to fresh records this year.
In 2006, deal volumes in the region--excluding Japan--surged more than 50% to US$385.4 billion, smashing the previous record of US$249.5 billion set the prior year. Australia and China led the drive, fueled by an influx of funds from private-equity players and buyout houses. And the brakes are unlikely to
be applied just yet.

Standard & Poor's Ratings Services expects M&A activity to accelerate this year, given favorable economic and market conditions. At the same time, increasing volatility in the credit profiles of potential acquirers and target companies may present new uncertainties for investors.

Attractive growth opportunities in the region lured some of the excess global liquidity to Asia-Pacific in 2006. Private equity and buyout firms accounted for more than US$45 billion worth of deals, or 12% of overall activity, according to Dealogic. Standard & Poor's expects M&A to remain strong in 2007 amid:

+ A resurgence of Japanese corporate activity
+ Banks' and insurers' desire for growth
+ Newly formed infrastructure funds looking to invest
+ Chinese companies' continuing expansion
+ Rapidly growing Australian LBO activity and
+ Interest from funds and corporations outside the region

Asia-Pacific entities are increasingly casting their nets beyond the region to search for growth and development opportunities. Many Asian companies enjoy unfettered access to funding because of the region's strong growth, benign credit conditions, and liquid markets. They are keen to build on solid
earnings and leverage their strong balance sheets to fund expansion, furthering the development of the high-yield market.

"Increasing risk-tolerance and appetite for debt to finance M&A will be a key risk to credit quality in 2007," warns Standard & Poor's credit analyst Chew Ping. But investors are unlikely to curtail their very high tolerance for debt leverage, nor are companies likely to ready themselves for an inevitable turn of the cycle. "We expect that M&A activity will help to deepen the region's high-yield market, but at the cost of a number of fallen angels, as well as a likely slight increase in the number corporate defaults, from what is
now a cyclically low number."

Utilities, banks are among hottest sectors

The region's key M&A attractions are consolidation, notably among utility sectors, and inter-regional activity, particularly in banking. Overall, the insurance sector continues to enjoy strong growth prospects, most prominently in the rapidly expanding and underinsured markets of China and India, with in-market consolidations and inter-regional plays accounting for the majority of transactions. In Australia, meanwhile, media plays are increasingly on the M&A radar.China: Deal Or No Deal?

China cemented its position as the second-biggest M&A market in Asia-Pacific in 2006, accounting for a record US$99 billion of deals. Top targets in the country included banks, metals, oil and gas, medical and pharmaceutical, and technology companies. Key drivers in 2007 will continue to center on:

+ Government attempts to push ailing state-owned firms into the private sector;
+ Potential lucrative returns in a fast-rising market;
+ Low-cost manufacturing opportunities;
+ Bid for scale among fragmented industries; and
+ Secure supplies of raw materials and energy.

Foreign money flooded into China's M&A market last year as the Chinese government opened up more sectors to overseas investment. Foreign investors are likely to be drawn to a wide range of sectors in 2007, such as in the retail, service, and consumer-goods markets, where competition is intense. Some of these sectors are viewed as less strategic to China and are therefore less protected, with foreign investors able to buy a large or controlling shareholding. Foreigners are even being lured to heavily protected sectors, such as banks, where they are limited to minority stakes.

Meanwhile, Chinese investors continue to seek expansion opportunities abroad. Oil and gas companies led the drive in an increasingly desperate hunt for secure energy supplies. Mining companies followed. And Chinese banks aiming to expand overseas are likely to set their sights on Hong Kong as a starting

Still, the biggest moves were among Chinese enterprises themselves. Foreign buyers snapped up 735 Chinese enterprises in the first 11 months of 2006, a rise of 1.3% in the year, while transaction volume rose 1% to US$30.2 billion, according to Dealogic estimates. That pales next to the 1,270 M&A deals
reported among Chinese enterprises--a rise of 25%, as transaction volume soared 77% to US$56.8 billion.

But perhaps the biggest M&A story of 2006 centered on the ones that got away, reawakening concerns about the ability or willingness of Chinese firms to see mega-deals through to completion. An estimated three-quarters of potential deals in China fail to see the light of day. Problems include wrangles over
pricing, poor transparency, issues stemming from the social obligations of former state-owned companies, and government vetoes in politically sensitive industries.

High-profile failures included Carlyle Group's withdrawn bid to buy an 85% stake in Xugong Group Construction Machinery Co. after the government ruled that the industry was too strategically important. (The offer has since been scaled down to US$200 million for a 50% stake.) Meanwhile, PCCW Ltd. shareholders torpedoed plans by Chairman Richard Li to sell off ownership of Hong Kong's biggest telecommunications company, and talks between Swedish telecoms operator Millicom International Cellular S.A. (B+/Watch Pos/--) and the parent of China Mobile Ltd. (A/Stable/--) collapsed over pricing terms, foiling what would have been China's biggest M&A transaction to date.
Taiwan: M&A Environment Cools The overall environment for M&A in Taiwan will likely be less welcoming this year than in 2006, given political and regulatory uncertainty. But it will continue to be the pivotal factor in the direction of ratings on financial institutions. Consolidation in the fragmented banking sector will continue over the medium term, if at a slower pace. In the insurance sector, M&A will be a key influence on ratings, and M&A activity by parent companies may have an impact on the credit profiles of some financial holding companies.

Among top targets for investors are high-tech companies, as integration into key components and broadening product coverage leads the drive--and private-equity players have focused on these companies simply because of their cheap valuations. The most notable example is Carlyle Group (The)'s acquisition of ASE Inc., the world's largest outsourced semiconductor assembly and test company.

Australia: Marquee Names Hog M&A Spotlight

Australia remains the biggest M&A market in Asia-Pacific, accounting for US$100 billion worth of deals in 2006. The entry of cashed-up private-equity funds--which have made buyout tilts at a number of highly rated marquee corporations, including supermarket giant Coles Group Ltd. (BBB/Stable/A-2) and Qantas Airways Ltd. (BBB+/WatchNeg/A-2)--added a new element to the M&A arena. Funds have been attracted by the size and maturity of the Australian market, and the ease of operating there compared with China or South Korea, for example. This dynamic will further re-enforce the trend toward balance-sheet optimization, as these funds are expected to leverage their investments to enhance returns.

Key targets are in the media, health care and retail sectors--although, as the Qantas bid shows, no sector is immune from private-equity attention. M&A will drive the increasing leverage of corporate balance sheets, even if it's only to ward off unwelcome approaches. The media sector is particularly exposed in
this regard.

Australia's position at the forefront of the M&A trend in Asia-Pacific is reflected in a high number of downgrades (15), with a further 27 corporate and infrastructure ratings carrying a negative outlook. As it stands, 10 counterparties are on CreditWatch Negative, with eight attributable to M&A. This trend should continue in 2007 given the recent interest of private-equity firms in Australia's leading companies.

India: Overseas M&A Activity Revs Up

As some Indian companies attain domestic market dominance and productivity levels comparable with that of global and Southeast-Asian peers, many are now looking overseas to propel growth. Expansion through large-scale acquisitions has the broad objective of harnessing the power of growth opportunities
in overseas markets and low-cost manufacturing in India.

Indian companies spent US$21 billion on acquisitions abroad in 2006, up from just US$4.5 billion a year earlier. One of the most notable forays was Tata Steel Ltd.'s (BBB/Watch Neg/--) US$10 billion bid for U.K.-based Corus Group PLC (BB/Watch Dev/B). Top targets in India now include metals and high-tech

M&A activity likely will improve business-risk profiles over the medium term, but the immediate effect of higher debt and leverage in financing such deals places material downward pressure on the credit profiles of acquirers. For this reason, a management team's approach to growth and risk tolerance has become a greater determinant of future credit quality than the likely impact of softening market conditions and rising interest rates.

Southeast Asia: M&A Activity Puts Credit Profiles At Risk

The search for non-organic growth--driven by easy liquidity and capacity constraints in existing manufacturing facilities, for example--last year fueled large-scale acquisitions in Southeast Asia. Top targets include conglomerates, and investment and real-estate companies.

While such deals may improve business profiles and provide economies associated with consolidation, they present a key risk to credit quality. The vast majority of debt issuers reported negative discretionary cash flows in 2005 and 2006, despite stronger funds from operations. Rising debt levels incurred to fund M&A have been partly offset by a trend of strong growth in sales, profits, and operating cash flows supported by benign economic conditions. Given early signs of an economic slowdown, business conditions may weaken in 2007, increasing credit volatility over the medium to long term. Aggressively pursuing acquisitions could put downward pressure on ratings.
Japan: Caution Warranted As M&A Step Up Given improving market conditions, Japanese M&A activity will likely continue to rise in 2007, with a focus
on electronics and food companies. High-profile deals in 2006 included telecom and tobacco companies.

Softbank Corp. (BB-/Stable/--) acquired Vodafone Group PLC's (A-/Stable/A-2) Japanese operations for about Ñ1.69 trillion (US$14 billion), while Japan Tobacco Inc. (AA-/Watch Neg/--) made a friendly takeover bid for Gallaher Group PLC (BBB/Watch Pos/A-2), a U.K.-based tobacco firm, for about Ñ1.73
trillion. Of the 22 corporate credit ratings placed on Credit Watch in the year to Sept. 30, 2006, 12 were attributable to M&A, including management buyouts. M&A activity accounts for the majority of the 17 negative outlooks on ratings. As deals could lead to an increase in total debt, the overall pace of
improvements to credit measures may slow down in 2007.

South Korea: Banks Ignite Feeding Frenzy

Integration risks from Korean M&A in 2007 should be marginally offset by a steady earnings performance and strengthened capital structures. We expect banks and banking groups involved in major deals to need time to recover their capital strength back to pre-transaction levels. It may take some banks several years to lower the geared leverage resulting from aggressive M&A. Completion of big deals is likely to trigger fierce competition among major banks. The lower likelihood of financial institutions realizing growth through acquisitions is likely to pressure management to focus on internal growth and strive for leading market positions while sacrificing asset quality and margins.

Given such growth dynamics across the Asia-Pacific region, M&A activity should continue to rewrite the record books in 2007.

Additional Contact: Yoshiyuki Mitsugi, Tokyo (81) 3-4550-8721;
[email protected]
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