Subprime impact in Asia: ripple or tsunami?

Ernst & Young shares its views on the impact of subprime on outbound Asia M&A and financial sponsor deals, especially with respect to financing.
We talk to Dave Read, global vice chair, based in London and Robert Partridge, managing director, transaction advisory services based in Hong Kong on what they are advising their clients in Asia with respect to the prevailing situation.

A trend of M&A in 2007 has been large outbound deals from Asian companies. To what do you attribute the increased activity?
Dave Read: Asian companies are looking to become global players, both by growing organically and simultaneously, given increased confidence, via aggressive acquisitions. Indian companies have been grabbing headlines and both the debt and cash facilities for them to do deals are available. Also, in more mature markets Asian companies are showing up more in auctions - investment banks are approaching Asian companies who were earlier perhaps not on their radar screen.

What peculiar issues does this raise?
DR: Cultural differences are huge from emerging markets into mature markets. The US and European markets have well-defined auction processes - understanding what you have to do to win is critical. Restructuring costs and risks have to be built into pricing. IÆd also note that post-deal integration issues and capturing synergies are key.

Robert Partridge: Human resource issues tend to be a monstrous concern for Indian and Chinese companies. To illustrate, China is a low-cost labour market and acquiring in a mature market could mean the average employee in the target makes 40-50 times what the peer, local employee makes. Korean companies are known for having strong employee workforces thus are in some ways more prepared, but in many ways just as naive as Indian and Chinese companies. France and some other European markets have highly regulated social costs and processes, which can be a tremendous challenge.

Do you think there will be a slowdown in M&A deals on account of tighter credit markets?
DR: In auction situations there is sometimes staple finance as part of the deal û although currently some of it could be collapsing. But local lenders are recognising that countries like China, India, Russia and Korea for example will yield some significant global players and it is important to build relationships with them.

Our view is there could be a temporary slowdown of the mega deals û the mid-sized deals up to $1 billion approximate will continue to get done, as will those involving minority stakes.

Financing will become difficult and expensive in the short term but will come back. Equity valuations will come down. Debt packages will have more covenants, greater terms and be more expensive. This will have an impact on overall valuations, which will go down.

Will there be a longer term impact on Asia deals?
DR: A lot of the reaction is lack of information û people donÆt know the impact of subprime. There is an over-reaction in the market ûprivate equity and corporate investors are in wait and watch mode. Our view is that financing packages will become available post September, when everyone is back from their holidays. Fundamentals still exist for Asian companies to pursue targets.

RP: Different countries will react differently. Deals out of India and Taiwan raise more leverage therefore will be impacted. Middle East deals will probably not be affected, as they do not require much leverage.

Similarly, China deals do not require significant gearing, so are unlikely to face a direct impact. Mega deals out of China have slowed down because difficulties faced by deals like CNOOC Unocal drove home that high profile deals - particularly where natural resources are involved - can be challenging. Deals have gone below the radar screen - we have seen a number of China outbound deals in the $20-$150 million range.

What is the trend you see for Middle East deals?
DR: Investors from the Middle East are looking across sectors at assets but I think resistance to strategically important assets is going to continue. Governments are putting up roadblocks in some cases.

The Middle East has both spending power and firepower. The way it is building up businesses suggest it is a very serious buyer. Further, investors in the region are opportunistic and will be successful in a number of areas.

How will the Japan landscape pan out?
DR: We predict an active M&A market going forward, with strong fundamentals for companies to acquire as well as a number of financial sponsors actively looking at the market.

What extra protection are lenders likely to insist on within the current environment?
DR: Non-recourse transactions could be more difficult. The debt packages we had 12-24 months ago are likely to come back rather then some of the more relaxed lending which had started to gain momentum. We will end up with more traditional, historical debt packages rather then the covenant-lite which was being talked about.

Huge pools of liquidity still exist in countries in the middle east, in China as well as amongst private equity players.

Has the financing environment for sponsor-led deals changed?
DR: Large buyouts could slowdown but in Asia the size of buyout deals is typically below the threshold. Large names are having no problems raising new funds even in the current environment. PE has a proven track record and PE right now will probably allocate more money to Asia then you will to the US and Europe. The large buyouts in these markets are certainly on hold and there is so much competition for the mid-sized buyouts.

RP: Australia probably has more traditional buyouts then the rest of Asia. The slowdown in financing puts an interesting perspective because a number of large assets are trying to be packaged for sale. Deals could be impacted and it will be interesting to see how Australian banks respond with staple financing packages. For example will they take the view that they are more insulated from the US?

China does not have any traditional buyouts. In Taiwan a few deals have been attempted û they will be affected. The buyouts in Singapore could also be affected.But overall we see this as more a repricing of the risks of financing, rather then a change in the fundamentals.

What are the specific fallouts of the subprime situation you are alerting your clients in Asia to?
RP: There may not be a large, direct impact on Asia but the question is how big will the indirect impact be. Clients in Asia are asking the question how big is the ripple? Is it a ripple or is a tsunami coming our way?

The Chinese government policy will also have an impact û will they be more or less supportive of transactions?

What are your views on currency strategy for Chinese exporters at the moment?
RP: China is an emerging market and some smaller companies have not yet caught up with the implications of the dollar-renminbi parity to their businesses. Beyond the top layer, many companies do not realise the need to develop a view on currency.

Chinese exporters see volumes increase and this offsets the currency appreciation. This is lost among unsophisticated manufacturers who do not understand that. We see a clear difference between companies which only export and those which import and export. The latter, despite having a natural hedge, are forced to realise the implications of currency.
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