M&A the Chinese way: buying first and paying later
Peter Fuhrman, China First Capital | May 08 03:15 | Comments | Share
China is in the early stages of a domestic M&A boom unlike any
other elsewhere in the world. Deal pricing, timing, terms, financing
and structure are all markedly different than in other major
economies, with likely consequences, good and bad, for global
corporations and buyout firms eyeing M&A transactions in China.
For these two, as well as companies wishing to find a buyer in China,
the game now is to learn the new rules of China M&A and then learn
to use them to one’s advantage.
Chinese companies mainly pursue M&A for the same reasons others do – to improve margins,
gain efficiencies and please investors. The main difference, and it’s a striking one, is that in most
cases domestic Chinese corporate buyers, especially the publicly-quoted ones who are most
active now trying to do deals, have no money to buy another business.
Outside of China, there are three known ways to pay for an acquisition – with cash, borrowed
money, or shares. All three are generally between excruciatingly slow and impossible for
publicly-listed Chinese companies. The reason: companies’ retained earnings are just about
always insufficient.
Banking and securities rules in China severely restrict the way publicly-traded companies in
China can finance acquisitions using debt or by issuing new shares. Deals financed with leverage
are basically forbidden. So, Chinese companies have invented two convoluted ways to get M&A
done. They display a certain genius. Both involve trying to buy first and pay later.
Method One is for the acquirer to first negotiate a purchase then ask the Chinese stock market to
suspend trading in its own shares. The acquirer will announce the deal publicly and if all goes to
plan its share price will surge, often by as much as 50 per cent to 75 per cent.
This predictable outcome is the result of the fact almost all shares quoted in China are owned by
small retail investors, commonly called Chinese brokers “old grandpas and grandmas”. Most
have never cared to look at a company’s financials or studied its competitive position. Instead,
they trade in and out of stocks depending mainly on rumor and hype fed to them by brokers or
online tip sheets.
In China, an announced M&A deal is now always a market-moving event. The movement tends
to be all in one direction. Up.
Once trading in the acquirer’s shares resumes and the price duly jumps up, the acquirer then
initiates the laborious process of applying to the Chinese securities regulator, the China
Securities Regulatory Commission (CSRC), for permission to do a secondary share offering.
This will then, it’s hoped, yield the cash to complete the acquisition. The approval process will
generally take six months or longer. Chinese securities rules are cumbersome and mandate that
the new shares be issued at a discount to the share price at the time of application.
The result: the sequence of “announce first, then apply” means the acquirer can raise the cash
needed to buy the target on more favorable terms for the acquiring company, lowering the
amount of dilution.
Method Two, a close cousin, is to persuade a friendly domestic investment fund to buy the target
company then hold onto it for as long as it takes the intended final owner to get the money in
place through the secondary offering. In other jurisdictions, this might be deemed a “concert
party” and so likely to land everyone in jail. In China, it’s becoming common practice.
In fact, a new form of investment fund has come into being especially to do deals like this. They
call themselves “市值管理基金” which you can translate as “market cap management funds”.
They exist to help publicly-traded companies do M&A deals that will lift the company’s share
price, and not much else.
They make money buying and selling shares, as well as marking up for resale companies they
buy on behalf of publicly-traded companies. They are not buyout funds as understood elsewhere,
since these market cap management funds are buying on behalf of a specific company and have
no particular industry expertise or experience managing an acquired company. They act purely as
a temporary custodian.
Most often, the acquirer will contribute a small amount of limited partner capital to the “market
cap management fund” as a way to bind the two organisations together. It can take a year or
more from when the market cap management fund first buys the target company then sells to the
publicly-traded acquirer, and from there, several more years before this acquisition starts to have
an impact, if any, on the acquiring company’s earnings. In other words, a very long timetable.
That by itself is not a problem for the acquirer, since it is as eager to give a shot of adrenalin to
its own share price and maintain it on this higher plane as it is to get control of the target
company and integrate it into its business. Market cap management trumps industrial logic as a
reason to pursue M&A.
I’ve yet to see evidence of much skepticism from Chinese stock market investors that an
announced M&A deal may not benefit the acquirer. In the US and other more developed capital
markets, it’s frequently the opposite. An acquiring company will as often as not see its shares fall
when it announces plans for a takeover. That’s because in most cases, as far as hard empirical
evidence can determine, the main beneficiaries of any M&A deal are the target company’s
shareholders. Too often, for acquirers M&A deals prove to be too expensive and synergies
elusive.
We’ve been invited by domestic listed companies in China to help consult on M&A deals where
“market cap management” was an explicit purpose. Finding an attractive target is also a
consideration, but a somewhat secondary one.
The discussions, in the main, are unlike anywhere else where M&A deals are being planned and
executed. They revolve around how to get the money together, when and for how long to halt
share trading, and by how much the listed company’s shares will likely go up, and stay up, once
the M&A announcement is made.
Where the publicly-listed company has private sector, rather than State-owned enterprise
background, the chairman will usually be the largest single shareholder. The chairman’s net
worth stands to get the biggest boost if market cap management works as planned.
Opportunities for global buyout funds
The lengthy, roundabout nature of Chinese M&A is creating attractive opportunities for global
corporations and buyout firms. They are the only participants in the M&A arena in China both
with cash in hand or easily accessed to close deals and the experience to manage a company well
once it’s bought.
From the perspective of potential Chinese sellers, both of these are extremely valuable, since
they remove much of the uncertainty in agreeing to sell to a domestic acquirer. Global corporates
and buyout firms will thus often be buyers of first choice for sellers.
For now, few global corporates and buyout firms are busy closing M&A deals in China. There
are a host of reasons, including China’s slowing economic growth, the perception China is
becoming more hostile towards foreign investment, the difficulty persuading owners of better
Chinese companies to give up majority control. All valid concerns. But, there are larger forces
now at work that make it attractive to expand through acquisition in the world’s largest fastgrowing market.
First, in almost all industrial and service industries, China is beginning at last a process of
rationalisation and consolidation. Costs are rising quickly, especially for labor, energy and debt
service. These are applying vice-like pressure on margins. Markets for most products and
services in China are no longer growing by +25 per cent a year and suffer from overcapacity.
Scale, efficiency, quality, modern management are the only ways to combat the punishing
margin pressure. This plays directly to the strengths of larger global corporations and buyout
firms. They know how to do this, how to transform a capable smaller business into a large
market-share leader.
It’s something of a well-kept secret, but some of the world’s most successful M&A deals have
seen large global corporations buying private sector businesses in China. The successful buyers
generally prefer it this way, that few know how well they are doing after buying and upgrading a
Chinese domestic company.
Why tip off competitors? For every well-publicized horror story there are at least three quiet
successes. Indeed, one can find within a single Fortune 500 company three great examples of
how to do domestic M&A well in China, and achieve a big payoff. The company is Swiss food
giant Nestle.
They first opened an office in China in 1908. The big transformation began a hundred years later,
in 1998, when they decided to buy an 80 per cent ownership in a Chinese powdered bullion
company Taitaile. That company is now more than twelve times the size it was when Nestle
bought in.
They followed that up with two other large acquisitions of domestic Chinese food and beverage
brands, drinks company Yinlu and candy brand Hsu Fu Chi. In all cases, Nestle bought majority
control, but not 100 per cent. They kept the founder in place, as CEO and a minority owner.
That has proved a brilliant model for successful M&A in China, and not only at Nestle. When
discussing with Chinese business owners the advantages of selling control to a capable global
company, we often share details of Nestle’s M&A activity in China, including the fact that the
Chinese owner stays but gets to spend Nestle’s money, leverage its resources, to build a giant
business. That’s a pretty attractive proposition.
All three acquisitions have thrived under Nestle’s ownership and now enjoy significant market
shares. Thanks largely to these acquisitions, China is Nestle’s second-largest market overall. It
was number seven just four years ago.
From my discussions with the China M&A team at Nestle, they are frank that it’s not always
been smooth sailing. The M&A deals all involved trying to blend one of the world’s most
fastidious, slow-moving and more bureaucratic cultures with the free-wheeling, “ready, fire, aim”
style common to all Chinese domestic entrepreneurs. Corporate culture gaps could not get any
wider. And yet, it’s worked out well, better in fact than Nestle hoped when going in.
Nestle tells us it is hungry to do more acquisitions in China. Chinese still spend half as much on
food per capita as Mexicans. That’s where the growth will come from. Market dynamics in
China are also moving strongly in Nestle’s favor, as food quality and safety become paramount
concerns. Further acquisitions should help Nestle gather in billions more in revenue in China
along with higher market shares.
Across multiple industries, the circumstances are similar in China, and so favor smart, bold
acquirers. Choose good targets, buy them at a good price, convert great entrepreneurs to great
managers and partners, don’t script everything from your far-off global headquarters. Do these
right and M&A can work in China. No market cap management required.
Peter Fuhrman is Chairman & CEO China First Capital
http://blogs.ft.com/beyond-brics/2015/05/08/ma-the-chinese-way-buying-first-and-paying-later/