Improving the Odds for M&A Success in China

Printer version  PDF

by Raymond Tsang & Frank Leung

Merger and acquisition activity in China has been heating up in recent years, particularly since China’s accession to the World Trade Organization. Despite the appeal of M&A to both foreign and domestic firms as a way to improve competitiveness or to grow, these deals often fail to deliver on their promise. To raise the odds of success, companies can learn from best practices and implement a framework that addresses China’s unique business and regulatory environment.

At one time, foreign companies looked to China primarily as a source of low-cost labor. M&A in these cases were not the most effective means of investment, as foreign firms had difficulty maintaining the low cost structures of the companies they had acquired. As Chinese manufacturers have grown more sophisticated and product quality has improved, however, foreign companies have glimpsed an opportunity to create greater value through exports and have stepped up the pace of acquisitions. The auto parts sector, for example, has been a hotbed of M&A activity.

China’s rapid growth has also led to the emergence of a middle class with considerable purchasing power and enormous potential. Foreign companies are eager to tap into this market, and are investing in R&D centers to better understand local customer preferences and develop targeted products. These firms can also leverage the availability of inexpensive talent to develop products for overseas markets

Domestic companies, on the other hand, are being driven by market forces to consider M&A. Particularly for firms in fragmented industries, increasing scale through M&A may be the only means of protecting their position in markets characterized by overcapacity and shrinking margins. Intensifying competition and industry consolidation are encouraging competing firms to merge or be acquired, especially in sectors such as high technology, industrial goods, materials, and consumer staples.

Over the past five years, total M&A transactions in China have risen by an average 30 percent a year (see exhibit 1). In 2005, the total value of M&A amounted to $33 billion, versus $24 billion through July 2006.¹ (For this article, we define M&A to include all investments that provide a controlling stake in an operating company in China, either by foreign or Chinese entities.) Although M&A activity tends to be cyclical in nature, it will likely continue to expand in China over the short to medium term based on several factors, including WTO obligations, consolidation of fragmented industries, influx of capital into the private equity sector, and the increasing importance of private companies.

While it seems likely that the pace of M&A activity in China will not slow soon, the outlook for the value that these transactions should generate is less clear. Evidence from a wide range of industries suggests that reaping the benefits of M&A is proving to be more challenging than expected. In fact, global surveys by publications such as Business Week and The Economist have estimated that roughly 60 to 70 percent of M&A ventures have failed to increase shareholder value.

One reason for the mediocre record of M&A ventures thus far may be that companies often spend fewer resources justifying an M&A initiative in China, as the average deal size is relatively small compared to that of the United States or Europe. What is not taken into account, however, is that a failed M&A represents not only a loss of invested capital but also a lost opportunity to profit in the future from the rapidly expanding Chinese market.

It follows that companies seeking to make acquisitions in China need to devote greater time and effort to minimize the risk of failure. They must put the right process in place, given China’s distinctive regulatory and business environment. In our experience, there are specific best practices that raise the odds of success substantially. These apply whether the acquirer is a short-term financial investor looking to build value quickly and then exit, or a corporate investor focused on the longer term and with a portfolio strategy in mind. Although each type of investor has different considerations and metrics for gauging success in a transaction, the process involved shares many similarities. Let’s review each practice in turn.

1. Conduct extensive target screening to ensure strategic alignment.

A company seeking an acquisition in China must design a rigorous process for screening and selecting acquisition candidates. Foreign companies under pressure to establish or rapidly grow their presence too often focus only on the largest or most prominent targets. And even seasoned executives have selected acquisition targets on the basis of simplistic factors such as “they understand Western culture.”

To be sure, market leadership, a strong reputation, or a Westernized management team can be desirable traits in a target, but this should not be the starting point of the process. First, the prospecting firm’s management needs to develop a strategy for achieving its vision in China, assess the capabilities required for that strategy’s success, and identify capability gaps.

With this information in place, the company can develop an initial list of candidates to fill these gaps and winnow it down to a relatively short list of targets. The company can then initiate discussions to identify firms that share the same strategic vision and would offer complementary strengths. Next, these high-priority candidates can be slated for more in-depth examination.

2. Choose the right deal structure.

A wide range of deal structures can be considered in an M&A situation, including share deals, asset deals, contractual joint ventures, and majority equity joint ventures with either more or less than a two-thirds stake (minority joint ventures are another option not discussed here). Exhibit 2 provides a brief description of each of these deal structures, including their pros and cons.

Depending on the nature of the industry and the acquisition candidate in question, it is important to identify the structure that will be most advantageous to the acquirer. Key considerations include regulatory requirements, degree of control, importance of intellectual property, importance of access to customers, management model and problem resolution, and portfolio strategy.

3. Understand the regulatory environment; create competitive advantage by anticipating shifts.

China is still heavily regulated, and one of the challenges foreign companies face is navigating this regulatory maze. Successful companies typically have a finger on the pulse of the regulatory environment and a knack for anticipating shifts before they happen.

M&A activities in China’s restricted industries or those requiring large capital investments also typically require approval from both local and central government authorities. Many high-profile deals have progressed to an advanced stage, only to stall during the approval process. In addition to recent provisions by the Ministry of Commerce and National Development and Reform Commission aimed at protecting national economic security, the China Securities Regulatory Commission also published a set of updated measures that gives the Commission greatly expanded powers to rule on takeover activity. This will provide the commission with more discretionary control. Companies conducting M&A transactions must assess the potential obstacles in the approval process and be fully aware of the various regulations and authorities that could come into play. It may take aggressive lobbying to obtain regulatory approval.

4. Conduct extensive due diligence.

In developed markets, due diligence usually consists of a legal team to verify the legal status of the acquisition candidate and identify potential legal liabilities, and an accounting team to conduct financial due diligence. In China, one must take a much broader and more detailed approach to verify the strategic and operational value of an acquisition candidate and expose potential deal breakers. In addition to financial and legal due diligence, some problematic areas for in-depth investigation include the overall business and market, operations, sales and distribution, suppliers, HR^*, and key management.

Extensive due diligence should uncover problems early enough in the M&A process for the acquirer to determine whether they are worth the time and effort to resolve, or if they are insurmountable and will kill the deal. Due diligence serves as a “sanity check” for the acquiring company, enabling it to reassess and back up its initial interest in the target. Due diligence findings should then be incorporated into the business case and reflected in the expected return on investment.

5. Avoid paying an unreasonable premium.

The premiums being paid for acquisitions in China have been increasing at an astonishing rate over the past few years. The multiple of enterprise value (EV) to earnings before interest, taxes, depreciation, and amortization (EBITDA) has risen from roughly 17 in 2001 to over 31 by 2005. ² This represents a 16 percent yearly increase in average valuations. Contrast this with a historical average ratio for acquisitions in the United States of around 15, or the ratio of the Shanghai Stock Exchange, which is trading at a multiple of 11 to 15.

This dramatic rise in valuations can be attributed to growing investor confidence in prospects for the Chinese market, combined with the increasing scarcity of suitable investment opportunities in some sectors. The downside of high premiums is that they drastically reduce the potential return from an acquisition.

In light of this, executives must avoid getting caught up in the thrill of the chase. They must establish a ceiling price based on the lowest acceptable return on investment and stick with that position. It is also important to tentatively agree to a general set of terms with the acquisition candidate prior to investing time and resources in the due diligence process.

6. Develop post-merger integration planning in detail.

The post-merger integration process should focus on combining two different organizations into one organization with a shared vision, operations and processes, a single organizational structure, and a unified culture and management system. The change processes involved are complex, so planning should take place as early as possible. Such planning will compel senior executives to rationalize the investment and acknowledge potential challenges.

Several principles are helpful here:

• Establish an optimal degree of integration across all organization functions to balance the focus on cost synergies with growth of the newly combined company.
  
  
• Create a plan to retain key employees early in the process to ensure that employees do not leave en- masse, especially for deal structures with one year earn-out periods.
  
  
• Build a formal management structure to develop and execute the integration plan, which will ensure focused and efficient efforts.
  
  
• Make sure the integration plan takes advantage of ongoing initiatives, best practices, and the tangible and intangible assets of both companies.
  
  
• Address employee issues in addition to structuring the formal organization, with an emphasis on effective and timely communication.
  
  
• Integrate the two companies quickly to ensure the effective transition of daily operations.
  
  

The stakes involved in executing M&A transactions in China successfully are only likely to rise in the future, as more and more companies enter the fray, shrinking the pool of desirable targets, pushing up valuations, and making it more difficult to get the level of return on investment needed to justify an acquisition. The companies that stand to win at this game are those that commit the resources and effort the M&A process requires and that adhere to a best-practice strategy that minimizes the inherent risks.

¹ “Chinese M&A,” The Economist, August 3, 2006

^* For more information on the Human Capital issues affecting mergers and acquisitions in China, visit the MMC Knowledge Center (www.mmc.com/knowledgecenter) and download the Mercer Human Resource Consulting white paper “M&A in Emerging Markets — A Focus on China.”

² Thomson Banker One, Mercer analysis