China’s booming economic growth continues to attract huge flows of foreign investment. And the World Expo in Shanghai is drawing still more attention. As a result of this and other factors, the economy grew a robust 11.9 percent in the first quarter of 2010, on top of 8.7 percent growth in 2009. During this same period, the United States and Europe were still struggling.

Growing numbers of multinationals, both those in China for lengthy periods and newcomers, are keen to expand their China stake. For some time, mergers and acquisitions (M&As) have been a quick, easy and favorable means to achieve this. However, such deals are actually declining for Western firms as local Chinese companies grow stronger and more competitive in the M&A arena.

Western M&As Are Down

Foreign company M&As only accounted for 27 percent of total M&As in 2009, down from 55 percent in 2008. Chinese company M&As accounted for the remaining 73 percent in 2009, up from 45 percent.

This trend, which continued in the first quarter of 2010 and resulted in only 23 percent of M&As involving foreign companies, is due to a number of factors. These include a changing market environment, a failure by foreign companies to adopt suitable strategies for identifying good targets and concluding negotiations in a timely manner, and government encouragement of local mergers and takeovers to help consolidate weak and fragmented industries.

“The failure rate of M&A deals closure is very high... more than 70 percent, even after letters of intent are signed,” an M&A specialist said. I concur.

Question Assumptions

Even though the domestic M&A market is getting very competitive, foreign companies can succeed if they have clear cut strategies, realistic expectations about target companies, and flexibility in their approach. And they should act decisively and be prepared to pay a premium to win over targets. It’s important to understand that Chinese market realities are in constant flux and basic assumptions need to be questioned. As a result, a predetermined strategy usually does not satisfy this situation.

For example, one European food and beverage (F&B) company with several billion euro in annual sales had been in China for more than a decade when it decided to search for an M&A target: a large Chinese company making the same product. The European firm spent 1.5 years hunting for a partner, but found most large Chinese F&B makers unwilling to sell, since their profits were significantly up in the fast-growing market. Other targets identified did not make the same product line, and therefore, were not seen as a good fit.

With sound advice from an M&A consultant, the European company shifted its strategy and began looking for a small, regional player with different product lines. The result: it found several suitable targets and is currently negotiating an M&A deal.

For the F&B market, my firm, InterChina Consulting, strongly recommends seeking small, regional targets that—unlike the failed Coca-Cola-Huiyuan deal—will not exceed the threshold for an anti-monopoly law investigation.

Understand What Works

Deals fail for many reasons: unrealistic expectations on both sides, little flexibility of potential acquisition forms, lack of Chinese experience dealing with international companies, unreasonably high acquisition prices due to the extremely fast Chinese market growth, and a failure to comprehend the intentions of Chinese sellers. Why? Local executives often communicate in a vague manner to “save face.” Plus, an experienced deal professional required to read the situation and determine the sellers’ motivations and concerns is often overlooked.

In one case, an American industrial manufacturer was looking to take over a Chinese distributor. Negotiations were lengthy and constantly delayed by the Chinese firm. After six months of discussions over an ownership issue, it became clear that the seller wanted to retain a stake in the company to maintain his legacy and local social position. In the end, the American company came to understand this desire and allowed the owner keep a small percentage.

In another example, a European equipment maker spent little time building the relationship with its a Chinese equipment maker. Instead, it focused on collecting company information and financial data, which the seller often withheld. Eventually, the foreign company realized the Chinese firm had no intention of selling, but instead, was trying to determine the value of the company.

Consider Non-Financial Factors

In the western context, an acquisition often is viewed simply as a business transaction. In China, there are many concerns, such as the type of relationship, as well as legacy and face issues.

As such, it is important to put non-financial issues on the table and accurately address Chinese concerns. For a typical Chinese company considering an M&A, the motivation to sell often is driven by a succession issue, a desire for some liquidity or equity funding for additional growth, or to cash out to invest in other more attractive industries. Keep in mind that most first-generation entrepreneurs are not actively seeking to sell their companies. Therefore, it is crucial to determine early on why the target company wants to sell.

The China Premium

Multinationals often believe Chinese targets are too expensive. The valuation benchmark typically employed is based on methods used to calculate corporate values in home countries. The problem: many Western firms fail to grasp the growth disparity between companies in China and overseas. For example, a company in Europe will grow 2-3 percent per year, compared to 20-30 percent for a similar firm in China. On a growth adjusted basis, the valuation on a forward basis should be comparable.

For instance, in a North American pharmaceutical company negotiation with a Chinese target, the seller’s expectation was 13x EBITDA (earnings before interest, taxes, depreciation and amortization). However, the buyer was only willing to pay 9x EBITDA. Consequently, the negotiation took two years. During that period, the Chinese target experienced 35 percent annual growth, resulting in the doubling of the acquisition price. The target eventually became aware of a greater potential and chose not to sell, even though the acquirer was willing to pay more than twice the original valuation. Disagreements over price are frequent deal killers.

In an environment where sellers are not motivated and their growth prospects are bright, acquisition firms have to decide early on if they are willing to pay premiums to get in the market. They also need to clearly understand potential synergies to be gained from a deal. A seller will rarely budge on price when a company is growing quickly. And in this scenario, prolonged negotiations will not only jeopardize the deal, but could result in higher price expectations.

In this example, a European F&B company found a Chinese F&B firm to be a perfect fit—all the right synergies and a complementary distribution network. However, the two could not agree on price. At one point negotiations were halted while the European company sought other candidates. In the end, the European firm decided the best target was the original Chinese firm. But due to the elapsed time, the purchase price more than doubled and required new terms.

Speed and Clarity of Objectives

In Chinese M&A deals, time is key. Unfortunately, many foreign companies fail to understand that prolonged negotiations tend to destroy deals. And common misunderstandings, due to differences in working styles, cultures and perspectives, lengthen the process. And poorly defined objectives certainly don’t help.

In one example a European retail company identified two M&A targets. But due to its own mixed priorities, it could only meet with each target every three months. The discussions were generally noncommittal and lacked specifics. As a result, after a year the Chinese targets lost interest and pulled out.

Western companies tend to view the M&A process as a “cookie cutter” standardized process, and often complicate matters by withholding decision-making power or interfering in the process. The result: 80 percent of negotiating time is spent on internal decisions, while 20 percent is spent negotiating with the target.

Chinese entrepreneurs are very effective, practical and nimble. And private companies typically have one or few owners. Consequently, decisions can be made quickly. In turn, Chinese owners expect decisions to be made by Western firms in a similar fashion.

One year in China equals five to 10 years in Europe, according to a Chinese proverb. And it can be difficult for foreign companies to realize just how quickly and dramatically market conditions can change there. As a result of this, as well as cultural norms and behaviors, Chinese targets prefer to deal with Chinese acquisition firms. To overcome this and get the deal done, it is important for American firms to be decisive and utilize sound intuitive judgment to recognize the right moment.

Different Approaches

Another important factor in closing a Chinese M&A deal is the ability to identify, assess and allocate risks correctly. For example, Western buyers tend to be data driven and information oriented. They typically do not make decisions until all vital information—which is deemed to reduce risk—has been gathered and analyzed.

Information gathering in China can take an exceptionally long time to complete. And the process is difficult since Chinese firms typically do not keep information in centralized locations or store it in a systematic way.

When making decisions, Chinese entrepreneurs do not appear to rely on data to the same extent. Instead, they tend to make decisions based on gut instinct and intuition. Additionally, from a cultural perspective, when a foreign buyer meets a successful Chinese target, the foreign buyer often sees risks, whereas the Chinese target identifies possibilities.

In many cases, Chinese and Western views are diametrically opposed. As a result, it is burdensome to achieve a “meeting of the minds” and relatively easy to sow the seeds for future disagreements. Thus, once equal weights are assigned to important but solvable issues, such as compliance and historical/legacy issues of the target, a deal can become even more difficult to close.

Assistance Is Available

The M&A advisory community in China can help corporate investors bring deals to successful closure. In the long run, professionals also influence how the M&A game is played in terms of educating Chinese targets about the proper process for deals.

As noted above, advisors to Western acquisition firms are not effective if they recommend the same process and employ the same metrics used in the home country.

This article appeared in Impact Analysis, July-August 2010.
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Barry Chen
About The Author Barry Chen
Barry Chen is Corporate Practice Director for InterChina Consulting in the Shanghai Office.




www.interchinaconsulting.com


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