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A Practical Guide for M&A deals for Chinese Bosses

December 29th, 2012 No comments

Illustration from 中国企业跨境并购交易要点和流程浅析  or

 “What you need to know and do to complete an M&A deal”

 

Like the smart tv or a cheap fuel-efficient automobile, China M&A is the good business idea whose time never seems to arrive. There’s basically no one in the Chinese business community, or inside Wall Street investment banks, who doesn’t agree that China’s future must include a lot more M&A deals, both cross-border and domestic. Domestic industries are highly fragmented and in need of consolidation. Chinese manufacturers need to acquire brands and technology from abroad to keep growing at home and offshore.

Think of the China M&A market as a huge pile of dry sticks soaked in gasoline. You throw a lighted match on it, expecting it to explode into a spectacular bonfire. And then… nothing. M&A activity in China remains so subdued, particularly for an economy China’s size, it is almost an irrelevancy. Can this, will this, change? I’m certainly among those who think it must, and not because it promises to someday bring in fat fees for investment bankers. M&A needs to develop as a routine means to let some entrepreneurs (and the PE investors who backed them) exit, and allow others to accelerate growth and grab market share. Both should end up benefiting China’s economy.

So, where exactly are the stumbling blocks on the path to an efficient and dynamic market for corporate control in China? There are more than just a handful, and include psychological and national factors, as well as more typical business reasons. But, one of the key problems is actually a very practical, and very solvable, one — the fact most Chinese companies don’t often have a clear understanding of how to select and assess an acquisition target, and then how, if the will is there to do something,  to actually take control of another company.

Our most recent Chinese-language research paper offers some guidance here. For those with the requisite Chinese skills, you can download a copy by clicking here or visiting the Research Reports section of the China First Capital website. The research paper is titled ” 中国企业跨境并购交易要点和流程浅析“, which I’d loosely translate as  “What you need to know and do to complete an Offshore M&A deal” .

The main readership is the +4,000 Chinese company bosses and senior management of both private sector and SOE companies we have in our database. We’re also sharing it with those whose work sometimes involves facilitating or regulating M&A deals — partners at law firms, accounting companies, PE firms, brokerage houses and government officials. This adds about another 2,000 to the list of people we sent it to.

We have a reasonable amount of experience in  — and we hope knowledge of  — M&A involving Chinese companies, representing both sellers and buyers, cross-border and pure-play Chinese domestic transactions. In other words, all four quadrants on the M&A map in China.

The contents grew directly out of our client work. It’s light on theory. We’re not trying to compete with McKinsey or business school professors. Instead, we emphasize practical steps and offer a rather stripped-down timetable of how an M&A deal might go from concept to close. Investment banks, for reasons of self-interest as well as business efficiency,  are always telling companies why and how they should do M&A. You’ll need to believe me that this wasn’t our motive. I’ve been on both sides of M&A deals as a CEO and board member in the US, both as seller and buyer of companies. Now, I sit in the middle, as a banker in China. I wanted to provide a short operational guide to Chinese CEOs on when and why M&A might make sense.

A common thread among Chinese companies looking to buy is to use M&A as a way to beef up their company’s in-house technology. One example: a client of ours  is already China’s leader in the auto electronics industry but is well behind European, American, Japanese and Korean companies in developing systems to make using a mobile phone in your car both safe and efficient. That’s a very big market opportunity in China, which is now the world’s largest auto and mobile phone market by rather large margins. This client wants to buy, rather than build, to save time, and also make sure any product they eventually try to sell to their Chinese customers works smoothly, from the beginning.

This client found a good target in Europe but then got bogged down in technology DD — how to evaluate not just the obvious stuff like patents, but the trickier domain of “company know how”.  What can be learned, what can be transferred, what can walk out the door and into the arms of a competitor? So, another area our research paper tries to both explain and systematize is the process of technology due diligence. I doubt our simplification would satisfy the partners at McKinsey or the Big Four accounting firms who often get called into do this work, and make huge sums along the way. Our operative principle here is “better to light a candle than curse the darkness”. Again, we wanted to keep it practical, for busy folks mainly engaged in running companies. With few exceptions, I’ve yet to meet a Chinese company with a specialist in-house team to do M&A.

The Chinese word for M&A is 并购 , which joins together the characters for “to combine” and “to purchase”. Theoretically, it’s an appropriate choice of words. At this point, however, with M&A still very much in its infancy in China, the main requirements are “to understand” and “to execute confidently”.  I hope this research paper goes some way towards making both more common, more certain.

 

 

China First Capital’s new website

December 18th, 2012 No comments

China First Capital (中国首创) has a new website. Actually two, Chinese and English. Please have a look by clicking here or navigating to www.chinafirstcapital.com

Putting together the new text for the website, in two languages that share little in common in terms of grammar, word order and the logic with which ideas are expressed,  was an enjoyable and intricate challenge, both for me and my CFC co-workers. It also functioned as a kind of stay-at-home corporate retreat across two weekends, time outside of the office thinking rather deeply about what actually takes place there every day. Don’t get me wrong. I’m very hands-on, and keep myself and my co-workers fixed to a precise strategic direction. We don’t gravitate away from our nucleus: as the website puts it, “we actively assist the fundraising activities of China’s private companies, state-owned enterprises and financial sponsors. We are equally active in M&A, domestic as well as cross border transactions both inbound and outbound.”

Doing these things is actually a lot more intuitive and straightforward than explaining them in text on a website. The writing took a lot of wrong turns, and required a lot of revision.  I wanted to stay away from the kind of self-promoting puffy and imprecise language that appears on so many company websites. I’m not sure I succeeded fully, or even in part. A lesson I’ve learned over the last 25 years, having tried both, is: it’s easier as a journalist to write about someone else’s company than it is as a boss to write about one’s own.

The two websites look similar, but aren’t mirror images. The Chinese website is not a translation. It actually has more content, more pages, more pictures, more description. The reason is, the Chinese website is mainly aimed at our core client base, domestic Chinese entrepreneurs and the senior management of SOEs. Investment banking, private equity, capital markets all have rather shallow roots in China. Twenty-five years ago, none of these things existed in any practical sense in China. So, part of the Chinese website’s purpose is to place CFC’s activities in a broader context of explaining how companies get funded, both by institutional investors like PE firms and by stock markets,  and how and why they can accelerate growth through acquisitions.

Company websites in China are also a rather new phenomenon.  Five years ago, when I started the company, few domestic private Chinese companies or PE firms had a corporate website. Today, more do. Most are pretty awful. They function mainly as a kind of online business card. The usual style is to include a rather bland letter from the chairman, drab photos of the different wall plaques awarded by government agencies, and a button that says “English”, that if clicked on, often leads to a blank page or, in some cases, to a site whose content bears no relationship to the Chinese company’s.

It’s rare for me to meet a Chinese company boss who spends much time online, let alone uses web search to locate potential business partners or opportunities. But, this too is starting to change. Recently, the CFO of one of China’s largest domestic cookie and cracker companies sent an email to our catch-all email address saying he’d learned about our business, read through our website, and wanted to discuss retaining us to raise capital. Within the space of a few weeks, we were able to lock in the mandate. One nice perk: lots of free snacks, salty and sweet, to nibble on in the office.

The English-language website serves a different purpose and a different audience.  It’s mainly visited by the private equity firms we work with, as well as people looking to get hired. It also is a convenient way for me to try to answer the question I get most often from friends and family in the US, “Just what exactly are you doing over there in China?”

Anyone with even a rudimentary knowledge of Chinese will quickly see that the English website homepage says CFC has four main business areas, while the Chinese site lists only three. A sign of strategic or linguistic confusion? No. I’ve been spending quite a lot of time recently building up CFC’s research and database on current PE investments that may be suitable for exit through a secondary transaction, the kind of deal where one PE sells its investment to another. We’ve done deal work in this area of “secondaries”, and expect to focus far more on such transactions in the future. The English-language site seems a more suitable place to mention this activity. To my knowledge, there isn’t a recognized Chinese word for “secondaries”, nor will such deals be of much practical interest to domestic entrepreneurs.

As the website says, “Working with people we genuinely like, trust and respect is what makes our business lives worthwhile.” This goes also for the talented Guangzhou-based American website designer who worked on our new site. He prefers to remain anonymous, as he did this during his limited weekend spare time. His superiors don’t like him moonlighting. I’m quite pleased he did.

 

Cornerstone Investing: Brilliant New Idea or Mistaken Strategy for China Private Equity Firms?

December 10th, 2012 No comments

Cornerstone investing is among the latest new investment strategies favored by some in the private equity industry in China. It is still early. But, cornerstone deals may prove to be among the least successful risk-adjusted ways to make money investing in Chinese companies.  Cornerstone investing involves putting big money up to buy shares in a company at the time of its IPO. In essence, it’s no different than buying any other publicly-traded share through your stockbroker, except a little worse in one respect. The cornerstone investors usually accept restrictive covenants that prevent them from exiting until months after the IPO. The investment strategy, such as it is, amounts to hoping the stock price will go up.

This is obviously quite a departure from the way PE firms typically operate in China: discovering a great private company, putting money in while the company is still illiquid, then nurturing their growth for several years up to and beyond a public offering. Done well, this process will earn a PE investor returns of 500% or more. Generally, PE firms also can indemnify themselves against losing money by exercising a put to sell their shares back to a company that fails to IPO successfully. It’s hard to imagine any scenario where cornerstone investing can do as well, and many where it will be significantly worse. One example: the possibility that the overall stock market performs poorly,  as it has in Hong Kong for the last year or so.

Cornerstone investing is a well-established practice in Hong Kong IPOs. Previously, it was only rich Hong Kong plutocrats who did these deals, at a time when most IPOs were heavily oversubscribed and likely to record a big first day jump in price. Now, the plutocrats are gone, new IPOs have fallen steeply,  valuations are way down, and PE firms have taken their place. What is it they say about fools going where wise men dare not tread?

How popular are these cornerstone deals now in Hong Kong? Hundreds of millions of dollars of PE capital have already been deployed. According to data from Bank of America Merrill Lynch cited by the Wall Street Journal, “private-equity funds… [make] up 41% of cornerstone investors in Hong Kong IPOs in 2012, compared with just 5% last year.” The only limiting factor seems to be the big falloff in the number of Chinese companies going public in Hong Kong this year. PE firms appetite to do these deals seems, if anything, to be getting stronger.

Finding a cornerstone investor is usually a great deal for the company staging an IPO, since it means there are fewer shares that need to be sold to the general public, and the lock-in provisions provide comfort to other investors that the company should be worth more later than it is at time of IPO. So, price volatility is reduced.

And the corresponding benefits for the PE firm are? Good question. The PE firms will claim they are buying into a good company at a comparatively good price, that they’ve done extensive DD and are confident of long-term stock price appreciation, with moderate to low risk. In other words, it’s a good place to invest their LPs money. That might be more plausible if cornerstone investing was producing large returns of late. It hasn’t. The Hong Kong stock market remains at a very low level. Yes, maybe the Hong Kong stock market will rally, and so lift these shares, conveniently after the lock-in has expired, allowing the PE firms a nice trading profit.

As an investment strategy, this basically amounts to market timing. And as most financial theory teaches us, all market timing is as likely to lose money as earn it. The PE firms will argue otherwise, that they are acting like good “value investors”, buying the shares at what they deem to be a low IPO price. As the company grows, its stock price will as well. Could be. But, there is an argument that this is what hedge funds and mutual funds are designed to do. They bet on the earnings momentum and so share price direction of publicly-traded equities. Is PE investing in China so difficult, so profit-constrained that PE firms now need to appropriate someone else’s business model? And do so without having much, if any, of a track record in this sort of investing?

That’s really the challenge here. Why should PE firms do these deals if there are still many outstanding pre-IPO equity investment opportunities available in China? PE firms can acquire a meaningful ownership stake in a dynamic private Chinese company, at low valuation, enjoy all kinds of special investor rights and privileges, including that guaranteed buy-back, that aren’t available to cornerstone investors.

With cornerstone investing, a PE firm is mainly at the mercy of the stock market. Will overall share prices go up or down or stay the same? It’s passive. With typical PE investing, the potential rewards, as well as downside protections, are obviously much better. But, so is the work you need to do.

That may explain a lot of the appeal of cornerstone investing. Cornerstone investing is simple. You get the IPO prospectus from a well-known underwriter, parse the audited financials, study other quoted comps, maybe talk to management about their growth prospects and how the IPO proceeds will be spent. You then make a determination about whether the company looks to be a good medium-to-long term bet. You never need to leave the office.

Compare that to PE deals in China. Due diligence is messy, slow, expensive and hazardous. Many deals never close because the PE firm discovers, during DD, that a Chinese firm’s financials are not compliant with tax laws, or the founder’s main supplier is his cousin’s husband or the company has failed to acquire the appropriate licenses. In these cases, the PE firm has to swallow the cost of the DD, which can run to $250,000 or more per deal. Too many examples of this kind of loss-making and a PE firm will start to find its LPs are less willing to commit money in the future.

This kind of “DD risk” is largely absent from cornerstone deals. A company staging an IPO has gone through multiple rounds of vetting, approval and audits. All paid for by parties other than the PE firm. So, cornerstone investing can look, from a certain crooked perspective, like typical PE investing minus all the costs and hassle of “DIY DD”. After all, the companies going public are usually similar in scale, business model and growth to purely-private deals the PE firm will look at in China.

Cornerstone investing is suddenly popular with some PE firms because stock market valuations have fallen so far in Hong Kong. Valuations, in p/e terms, are usually lower now in a Hong Kong IPO than for a comparable company raising money in a private placement in China: 4-8X this year’s net income for the HK IPOs, and 8-10X for the private placements.

PE firms are given money by investors, and usually paid an annual management fee, to take on this risk and trouble of finding good companies, screening them, negotiating a good deal, and then remaining actively engaged, after investment, on the board, to help the company achieve its targets and an eventual exit. This is where the big money has been made in China PE, not in betting on the direction of publicly-traded share prices.

As a stock picking strategy, it’s not unreasonable to suppose that Hong Kong stock prices are now at a cyclical low, and will start to move closer to the valuations on China’s domestic stock markets. If so, then some cornerstone deals may end up making decent money.

But, PE firms are not, or should not be, stock-pickers, market-timers, valuation arbitrageurs. This is truest of all for those PE firms that raised money to invest – actively and passionately — in China’s outstanding private entrepreneurial companies.