China Goes Shopping: The Compelling Logic of Doing M&A Deals in the US
Selling a business in the US? Chinese can pay top dollar.
We are entering a golden age of Chinese M&A deals in the US. There is certainly a sharp pick-up in activity going on – not so much of announced deals yet, though there have been several, but in more intensive discussions between potential Chinese acquirers and US companies. There is also a lot more shopping and tire-kicking by Chinese buyers. I certainly see it in our business. We’re engaged now in several M&A deals whose goal is sale of a US company to a Chinese buyer. I expect to see more.
The reasons for this upsurge are many – including the recent appreciation of the Renminbi against the dollar, the growing scale and managerial sophistication of Chinese companies (particularly private as opposed to state-owned ones), attractive prices for target US companies, the launch in 2009 by the Shenzhen Stock Exchange of the Chinextboard for fast-growing private companies.
The best reason for Chinese buyers to acquire US firms is one less-often mentioned – to profit from p/e arbitrage. The gap between stock market valuations in the US and China, on price-earnings basis, are wide. The average trailing p/e in the US now is 14. On China’s Chinext board, it’s 45. For fast-growth Chinese companies, the p/e multiples can exceed 70. This gives some Chinese acquirers leeway to pay a higher price for a US business.
In the best cases, a dollar of earnings may cost $10-$15 to acquire through purchase of a US business, but that dollar is immediately worth fifty dollars or more to the Chinese firm’s own valuation. As long as the gap remains so large, it makes enormous economic sense for Chinese acquirers to be out buying US businesses.
This is equally true for Chinese companies already quoted on the Chinese stock market as well as those with that ambition. Indeed, for reasons unique to China, the incentive is stronger for private companies to do this p/e arbitrage. In China, public companies generally are forbidden from doing secondary offerings, nor can they use their own shares to pay for an acquisition. When a Chinese public company consolidates a US acquisition’s profits, its overall market value will likely rise. But, it has no way to capitalize by selling additional shares and replenish the corporate treasury.
For a private company, the larger the profits at IPO, the higher the IPO proceeds. An extra $1 million in profits the year before an IPO can raise the market cap by $50mn – $70mn when the company goes public on Chinext. Private Chinese companies, unlike those already public in China, can also use their shares to pay for acquisitions. The better private companies also often have a private equity investor involved. The PE firms can be an important source of cash to finance acquisitions, since it will juice their own returns. PE firms like making money from p/e arbitrage.
In M&A, the best pricing strategy is to swap some of my overvalued paper to buy all of someone else’s undervalued paper. At the moment, some of the most overvalued paper belongs to Chinese companies on the path to IPO in China.
Most M&A deals end up benefitting the selling shareholders far more than the buyers. That’s because the buyers almost always fail to capture the hoped-for savings and efficiencies from combining two firms. Too often, such synergies turn out to be illusory.
For Chinese acquirers, p/e arbitrage greatly increases the likelihood of an M&A deal paying off – if not immediately, then when the combined company goes public.
If the target company in the US has reasonable rate of profit growth, the picture gets even rosier. The rules are, a private Chinese company will generally need to wait three years after an acquisition to go public in China. As long as the acquired business’s profits keep growing, the Chinese companies market value at IPO will as well. Chinese acquirers should do deals like that all day long.
But, as of now, they are not. One reason, of course, is that things can and often also go wrong in M&A deals. Any acquirer can easily stumble trying to manage a new business, and to maintain its rate of growth after acquisition. It’s tougher still when it’s cross-border and cross-cultural.
Another key reason: domestic M&A activity in China is still rather scant. There isn’t a lot of experience or expertise to tap, particularly for private companies. Knowing you want to buy and knowing how to do so are very different beasts. I’ve seen that in our work. Chinese companies immediately grasp the logic and pay-off from a US acquisition. They are far less sure how to proceed. They commonly will ask us, investment bankers to the seller, how to move ahead, how to work out a proper valuation.
The best deals, as well as the easiest, will be Chinese acquiring US companies with a large untapped market in China. Our clients belong in this camp, US companies that have differentiated technology and products with the potential to expand very rapidly across China.
In one case, our client already has revenues and high profit margins in China, but lacks the local management and know-how to fulfill the demand in China. The senior management are all based in the US, and the company sends trained US workers over to China, putting them up in hotels for months at a time, rather than using Chinese locals. Simply by localizing the staff and taking over sales operation now outsourced to a Chinese “agent”, the US company could more than double net profits in China.
The US management estimates their potential market in China to be at least ten times larger than their current level of revenues, and annual profits could grow more. But, to achieve that, the current owners have concluded their business needs Chinese ownership.
If all goes right, the returns on this deal for a Chinese acquirer could set records in M&A. Both p/e arbitrage and high organic profit growth will see to that. Our client could be worth over $2 billion in a domestic IPO in China in four years’ time, assuming moderate profit targets are hit and IPO valuations remain where they are now on China’s Chinext exchange.
Another client is US market leader in a valuable media services niche, with A-List customers, high growth and profits this year above $5mn. After testing the M&A waters in the US, the company is now convinced it will attract a higher price in China. The company currently has no operations now in China, but the market for their product is as large – if not larger – than in the US. Again, it needs a Chinese owner to unlock the market. We think this company will likely prove attractive to quoted Chinese technology companies, and fetch a higher price than it will from US buyers.
The same is true for many other US companies seeking an exit. US businesses will often command a higher price in China, because of the valuation differentials and high-growth potential of China’s domestic market.
China business has prospered over the last 20 years by selling things US consumers want to buy. In the future, it will prosper also by buying businesses the US wants to sell.