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Special Report: Mergers and Acquisitions

Acquisitions in China: A View of the Field

A rising tide of acquisitions of Chinese companies may signal that a third wave of FDI is washing up on China's shores

by Kim Woodard and Anita Qingli Wang

In the past five years, international companies, including highly visible American companies like Amazon.com, Anheuser-Busch Cos., Inc., and Eastman Kodak Co., have begun to make acquisitions of Chinese companies a key element of their business strategies in China. Though these deals still make up a small portion of total foreign direct investment (FDI), the purchase of existing local companies presents a new alternative to traditional investments in joint ventures or wholly owned subsidiaries.

Foreign acquisitions of local Chinese companies surged in the first half of 2004 (see Figure 1). Following three years during which foreign acquisitions ran about $5 billion per year (10 percent of FDI), acquisitions nearly tripled in the first half of this year to $7.3 billion and will likely reach 15 to 20 percent of FDI for the year, according to M&A Asia. Acquisitions of local companies are fast becoming a third wave of FDI in China, following the prevalence of joint ventures in the 1980s and early 1990s and the surge of wholly foreign-owned enterprises (WFOEs) during the past 10 years.

Why would a foreign buyer undertake a complex and potentially risky acquisition in China, rather than a simpler, more easily controlled investment in a WFOE? The answer may seem obvious to companies looking for a quantum leap in market share and broader distribution in highly fragmented and already saturated markets: strong regional brands can be acquired for less than it would take to build the same company from the ground up. On the other hand, stringent regulatory limits on foreign equity share in the banking, insurance, and automotive sectors are forcing large players like General Motors Corp., Hongkong and Shanghai Banking Corp., and Nissan Motor Co. to structure their investments as partial, rather than full, acquisitions of Chinese companies.

And why are Chinese companies relinquishing strategic state-owned assets to foreign investors? The answer is that they have little choice. China's State Council is engaged in a fundamental and systematic restructuring and privatization of all but the largest and most strategic state-owned enterprises (SOEs) and is aggressively looking for both domestic and foreign investors (see Another Step Toward Privatization).

To that end, the State Council formed the State Assets Supervision and Administration Commission (SASAC) in March 2003 and handed over equity in 185 national and thousands of provincial and municipal SOEs to this new commission. As the state owner of record, SASAC and its provincial branches will undertake a large-scale equity restructuring and divestment of underperforming SOEs at every level. This effort is visible in every region of the country, but is particularly intense in the crumbling industrial cities of China's Northeast and in the western provinces. The Great Western Development Strategy and Revitalize the Northeast initiatives are reaching out to foreign companies and business associations to promote foreign acquisitions of SOEs in virtually every industry. A wave of new regulations has been issued to facilitate both foreign and domestic acquisition of state assets.

Inbound acquisitions: A promising option for growth

A trickle of small foreign acquisitions began in the early 1990s. In 1996, Itochu Corp. and Suzuki Motor Corp. acquired control of Beijing Tourist Coach Co., marking the first foreign purchase of a domestically listed company's state shares. Driven by two major acquisitions of offshore-listed shares in PetroChina Co. Ltd. and China Petroleum and Chemical Corp. by BP and Exxon Mobil Corp., respectively, foreign acquisitions surged in 2000 to 165 deals with total transaction value of $7.2 billion, or 18 percent of FDI that year. China acquisitions then eased to about $5 billion a year between 2001 and 2003, but have grown very strongly in 2004 and will probably end the year in the $10 to $12 billion range.

This jump in foreign investment signals the convergence of two emerging trends: SASAC's sale of large portions of the state-owned sector and the expansion of companies already well established in China through the acquisition of local competitors. But the level of foreign acquisition in China is still relatively low, running just 10 to 20 percent of total annual FDI compared to well over 50 percent of FDI in most developed economies. In 2003, China ranked behind Japan ($16.9 billion) and South Korea ($6.6 billion), and about even with Hong Kong ($5.4 billion) in inbound mergers and acquisitions (M&A), according to KPMG LLP. China will probably rank second in the Asia Pacific region in 2004 behind Japan.

China is the number-one recipient of FDI in the world and captures about 10 percent of global FDI, but hosts only 2 to 3 percent of global cross-border M&A activity. As foreign buyers and Chinese sellers become more comfortable with the acquisition process, the ratio of foreign M&A activity to total FDI should increase substantially over the next five years.

China sees around 200 foreign acquisition deals a year, of which 70 to 80 percent are publicly disclosed. Small acquisitions of private companies often go undisclosed and unreported in the financial media. Although a research group under the Ministry of Commerce has started keeping internal data on individual acquisition cases, China publishes no official M&A data. Average deal size has been small by international standards, running $30 to $35 million per transaction from 2001 to 2003. But average deal size reached $53 million in the first half of 2004—a 50 percent jump over the previous year—approaching the average international cross-border deal size, which fell from $145 million in 2000 to $83 million in 2002, according to data released by the United Nations Conference on Trade and Development.

Though no precise sectoral breakdown of foreign acquisitions is available, the banking and insurance, beverage (primarily beer), retail, information technology, and automotive sectors have dominated recent lists of deals worth more than $100 million per transaction (see Table 1). There are also increasing numbers of mid-sized foreign acquisitions ($20 to $100 million) of local companies in traditional manufacturing sectors such as industrial equipment, auto parts, electrical and electronic components, and specialty chemicals. Small deals of less than $20 million are concentrated in food processing, textiles and apparel, toys, services, software, and entertainment.

China extends its overseas reach

Private and listed Chinese companies have also started making acquisitions outside of China. Outbound foreign acquisitions began in the late 1990s and reached 20 to 30 deals a year, logging $344 million in 2000 and $507 million in 2001. Outbound M&A jumped to $2.8 billion in 2002, but this leap was driven by offshore acquisitions of oilfields by China's major oil companies and does not represent a broader trend (see Figure 2). China's outbound M&A was $1.6 billion in 2003 and will probably range from $1.5 to $2.0 billion again in 2004, excluding another resource acquisition, a $4.2 billion deal in which China Minmetals Corp. will likely acquire Canada-based Noranda Inc.

Overseas acquisitions are viewed with some suspicion by the Chinese government and must be approved on a case-by-case basis, since they involve foreign exchange transactions on the capital account. The State Administration of Foreign Exchange has blocked a few such acquisitions on the grounds that they were efforts to illegally transfer foreign exchange holdings to offshore destinations. Most overseas acquisitions by Chinese companies, however, are legitimate efforts to expand into overseas markets by acquiring companies that have established distribution networks or to introduce acquired foreign technology to the domestic market.

Problems in transparency

Inbound foreign acquisitions have only accounted for 10 to 20 percent of total M&A activity in China in the 2000-03 period. Thomson Financial reports that total China M&A activity, including both inbound and domestic acquisitions, reached 1,504 transactions worth $28.5 billion in 2003 (see Table 2). Of this total amount, a reported 925 transactions with a value of $9.3 billion were acquisitions by domestic listed companies, and 152 acquisitions with a value of $5.3 billion were inbound foreign acquisitions. The balance, about $14 billion, consisted of a few large asset restructurings by SOEs listed offshore (such as China Mobile's restructuring of domestic wireless telecom companies) and domestic acquisitions by privately owned Chinese companies.

Part of SASAC's motivation in seeking foreign acquisitions of selected SOEs is to introduce competition to domestic investors, driving them to higher standards of financial management and transparency. The domestic M&A market has been spearheaded by listed companies and by large, rapidly growing local conglomerates, such as New Hope Group, Wanxiang Group, Oriental Group, Fosun High-Technology Group, and D'Long Group. These and other privately owned investment groups began with a regional base and are quietly supported by local government and Chinese Communist Party interests. They wield increasing power in both the local and domestic economies, yet are run as private fiefdoms with little transparency or accountability.

The D'Long Group, for example, started as a family-controlled film processing business in Xinjiang in 1986 and grew largely by acquisition of both listed and unlisted SOEs. By 2003, D'Long Strategic Investment Co. managed $2.5 billion in assets, controlled six domestically listed companies, had built a new headquarters in Shanghai, and boasted national reach and extensive government connections at all levels. But D'Long's acquisitions were financed largely by a pyramid of short-term bank debt built on a platform of loans and guarantees from its subsidiaries. Refusal of its major lenders to roll short-term debt at the end of 2003 led to a sudden collapse of its listed subsidiaries' share prices and to D'Long's financial collapse in the first quarter of 2004. Fearing a domino effect on other large, private conglomerates, the central government stepped in to restructure D'Long's tangled assets through Huarong Asset Management Co., a subsidiary of the Industrial and Commercial Bank of China, a major D'Long creditor.

The D'Long case illustrates some of the challenges facing the domestic M&A market—lack of transparency, complex interlocking debt and equity relationships among parent firms and their subsidiaries, and increased volatility in public stock markets for listed companies that are involved in M&A transactions. The China Securities Regulatory Commission is working to make public equity markets, where the bulk of such transactions takes place, more open and stable, but new regulations without adequate monitoring and enforcement will leave most foreign investors on the sidelines.

Acquisitions in the years to come

This year's surge of foreign acquisitions in China foreshadows growth to come in the number and size of such deals. China's implementation of its World Trade Organization commitments has opened key sectors such as finance, trade, and distribution to greater foreign participation. For example, this year China has published regulations that will for the first time permit foreign firms to establish trading and distribution companies outside of the coastal bonded zones. Some companies may choose to do so by acquiring existing local trading and distribution firms in relevant product areas. Such acquisitions will permit more effective integration of domestic manufacturing operations in China with imported product distribution and global product flows.

Gradual liberalization of the foreign currency regime and the relaxation of foreign exchange restrictions on the capital account will also support continued growth of cross-border M&A activity. One of the greatest concerns of private equity funds attempting acquisitions in China is that their capital will be "locked down" by foreign exchange restrictions, rendering financial investors incapable of exiting their deals. And Chinese companies must clear a daunting series of government approvals to invest overseas. Liberalization of currency controls will favor stronger cross-border capital flows in both directions.

Above all, future growth in foreign acquisitions, and indeed in domestic M&A activity, will be driven by the presence of a rich field of acquisition targets. The restructuring of the state sector is a high priority in China's economic reform program. After a decade of consolidation, China still has 50,000 state-owned enterprises that must be restructured and re-capitalized. At a minimum restructuring cost of $10 million per enterprise, that implies a capital requirement of at least half a trillion dollars or 40 percent of China's annual GDP. This cost cannot be funded either by China's debt-burdened state banks or by the central government, which is already running chronic budget deficits. Rather, the capital to restructure the state sector must come from China's private sector, public stock markets, and foreign investment.

Kim Woodard and Anita Qingli Wang are chair and CEO, and project manager, respectively, of Javelin Investments (www.javelinchina.com), an investment consulting firm based in Shanghai and Beijing with a specialized acquisitions advisory practice. A companion article on acquisitions strategy and process will appear in the next issue of the CBR.

The authors wish to thank the Asia Venture Capital Journal and M&A Asia for their permission to use the data reported here on cross-border acquisitions in China.

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