Jonas Best 2014400633

China Roots Seminar -­‐ Reflection paper China’s outbound M&A: Explaining the low success rate

In recent years Chinese companies started to increasingly engage in M&A with foreign companies. China’s foreign currency reserves are the highest in the world and acquiring foreign targets is part of the PRC’s plan to reduce its current account surpluses. M&A is the preferred way of globalization for Chinese companies. Despite that, M&A with Chinese acquirers are often unsuccessful and the failure rate for Chinese acquirer exceeds the global average for cross border M&A significantly. The overall failure rate for cross-­‐border M&A with emerging market acquirers is 8%, whereas the failure rate for cross-­‐border M&A with a Chinese acquirer is 15% according to a study of Hawn (2013, p.95). In addition to that, there are various studies that suggest that not only the failure rate for Chinese acquirers is higher, they also tend to pay more for acquiring targets than their competitors from Europe and the US. This is especially true for State-­‐owned companies in the PRC.

The phases of China’s outwards foreign direct investment The history of China’s foreign direct investment can be divided into 6 different phases and dates back to the late 1970s (Rosen & Hanenmann, 2009):

Phase I: Tight controls OFDI was reserved for specially 1979 -­‐ 1983 designated trade corporations. Inexistence of regulatory frameworks; firms had to get direct, high-­‐level approval from State Council for each case. Phase II: Cautious encouragement Gradual encouragement of government 1984 -­‐ 1991 for OFDI projects that allowed acquisition of foreign technology, control over resources, and foreign currency. Phase III: Active encouragement With the goal to increase the 1992 -­‐ 1996 competiveness of Chinese companies the OFDI approval procedures were eased and decentralized. Phase IV: Stepping back The Asian financial crisis revealed that 1997 -­‐ 1999 many OFDI projects had illegal and speculative purposes that led to heavy losses of state assets and foreign exchange reserves. The government China’s outbound M&A 1 Jonas Best

Phase V: Formulation & implementation of the “going global” policy 2000 -­‐ 2006 Phase VI: Growing political support for transnational corporations and a new push for liberalization 2007 -­‐ present

hence decided to tighten regulatory processes. In anticipation of the WTO accession the government eased OFDI procedures again and announced a policy promoting Chinese firms to go abroad. The huge foreign exchange reserves increased the pressure on policymakers to introduce a new regulatory framework further easing foreign exchange management as well as broaden the sources of funding for overseas projects.

The impact of the governments gradually increasing opening and support for OFDI can also be seen in the numbers of M&A deals that has been steadily increasing over the past decade. This history also shows that China is fairly new to the global game of M&A and therefore inexperienced.

The development of Chinese outwards M&A

The value of outbound M&A soared during the last years. In 2005 the value of all outbound M&A was estimated to be around USD 2bn whereas in 2013 it was USD 51bn (Figure 1). This spike in deal value shows the global ambitions Chinese companies have today.

China’s overseas M&A are $ '70.0 bn estimated to account for almost $ '60.0 bn 10% of global M&A (Liu & Qiao, $ '50.0 bn 2011) and are expected to grow further in the future. During the $ '40.0 bn global financial crisis the volume $ '30.0 bn as well as the value of M&A conducted globally declined $ '20.0 bn significantly (36% decline in $ '10.0 bn Volume between H2 2008 – H1 2009). However the Chinese $ '0.0 bn outbound M&A flows remained relatively constant (Deloitte, 2009). This can be seen as a sign Figure 1: Deal Value of China Mainland Outbound M&A (Thomson Reuters) that Chinese companies took advantage to buy Western companies at a discount price.

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Targeted foreign industries by Chinese buyers

By looking at Figure 2 4% 4% it is clear how much 6% Energy, Mining & Ujlijes importance China ascribes to securing Financial Services raw materials by 7% acquiring targets in TMT 13% energy, mining and Industrials utilities abroad. This 66% sector accounts for Consumer 29% of deals but 66% Others of value indicating that the average deal Figure 2: Sector Split of cross-­‐border M&A from China 2003-­‐09: value size is bigger than in (mergermarket) other industries. China sees resource investments as a valid alternative instead of investing its trade surpluses in (mainly US-­‐American) government bonds and therefore encourages its SEOs, with the provision of cheap capital to finance outwards M&A, to buy mineral and energy resources abroad because of its own limited supply. Financial services rank a distant second in industries targeted. Deals in this industry are driven by increasing regulation and the many reforms that force European and American banks to strengthen their capital base as well as the fact that state-­‐owned Chinese banks are interested in partners abroad to support future deal financings for future cross-­‐border M&A. Technology, Media & Telecommunications deals account for 7% of value. For its modernization efforts China is still dependent on foreign technologies and by acquiring foreign IP and knowledge Chinese companies can effectively reduce their dependency and speed up their own R&D. Another motivation Chinese companies can have is to get access to foreign markets. A well-­‐known example hereof is Lenovo’s acquisition of the ThinkPad brand of IBM in 2004 (Spooner & Kanellos, 2004). Measures of the low success rate of M&A with Chinese acquirers In many cases companies are looking for prospective targets but then are unable to follow through and complete the acquisition. This must not necessarily a bad thing. Not closing a bad deal is a good thing and potentially prevents the company from making losses with the acquisition. However, if the deal is already announced and then withdrawn, it can cause substantial losses for both target and acquirer. Failed-­‐deals cause out-­‐of-­‐pocket for advisors and due diligence expenses as well as absorb a lot of time from the management. According to research of Figure 3: Deal completion and deal duration (Hawn, Hawn the number of uncompleted 2013, p.95)

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announced deals for Chinese firms is twice as high as for companies from other emerging markets. 15% of announced deals are not completed in China. Zhang and Ebbers conducted similar research with a bigger sample (N=1324) and report that only 51% of announced Chinese outbound M&A attempts are completed. The global average was in their sample 69% (2010, p. 103). For Chinese companies this damages their ability to expand abroad and raises competitors’ attention in the market, which will eventually try to pursue other targets. Not only the percentage of announced deals that has effectively been closed is low, but also the outcome has, at best, been mixed: The value creation measured through the share price movements around the time of the announcement is mostly negative. Luedi (2008) uses deal value added (DVA) 1 and proportion overpaid (POP) 2 as indicators of the outcome. From figure 3 it can be seen that the proportion of overpriced deals is in line with the global average, however the average deal value added is significantly worse than the global average and suggests that most deals are not value creating but value destroying. Interestingly, transformational deals seem to do much better in that regard. Luedi suggests this is due to a more careful selection as a well as a significant enhancement in the overall operating and management capabilities (2008, p. 80).

Figure 4: Chinese outbound deal performance, 1995 – 2007 (Dealogic, McKinsey analysis, 2008)

Like all companies, Chinese companies face problems also in the post-­‐merger integration (PMI) process and according to research of Deloitte 60% of Chinese enterprises fail to achieve the anticipated value from their M&A activities (2009).

market movement, from 2 days prior to 2 days after announcement, as % of market value. 2 POP = proportion overpaid; defined as proportion of transactions in which share price reaction, adjusted for market movements, was negative for the acquirer from 2 days prior to 2 days after announcement of deal.

1 DVA = deal value added; defined as acquirer’s change in market capitalization, adjusted for

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Reasons for the lower success rate of outwards Chinese M&A Lack of international M&A experience Internationalization of Chinese firms remains at a primary stage. Even if most Chinese companies have M&A experience, many of them lack experience in international M&A. Zhang and Ebber found out that in all deals between 2004 and 2010 58% of deals took place without the acquirer having any experience abroad. Hence, the lack of international M&A experience turned out to be an important reason for the lower success rate of outwards Chinese M&A in their analysis (2010, p. 124). In addition, to the lack of experience China also has a culture that is very different from the Anglo-­‐ Saxon business culture predominant in most of the countries of the M&A targets, which lead to cross-­‐cultural issues that further complicate the M&A process. As Chinese firm gain more and more experience in M&A abroad this factor is going to decline quickly and in the future most companies might have international experience.

State-­‐owned enterprises are identified as investors Most of the Chinese outwards M&A are conducted be State-­‐owned enterprises (SEO) which are broadly defined as “enterprises with state-­‐capital” (Duan, 2011, p. 29). In M&A this is mostly an issue from a regulatory and national security point of view. • Technology-­‐oriented motivation When SEO or governement affiliated Chinese companies are trying to buy assets in the technology, media and telecommunications sector the regulators of the home country of the target might see the takeover attempt as a national threat and oppose to the deal. Huawei for instance tried several times to take over US-­‐American technology firms: In 2007, it joined Bain capital to make a USD 2.2 billion bid for 3Com corp. Allthough 3Com agreed to the deal and the company would stay in American majority lawmakers expressed concerns that this would allow a Chinese-­‐controlled entity to exercise control over a company that sold products and services to the US defense department (Benoit, 2012). Same happend with 3Leafs system that was supposed to sell for USD 2 million, a tiny deal by all standards, but the deal was still opposed by the US governement for unspecified security reasons (The Economist, 2012). Also in European markets Chinese SEOs face similar difficulties even though there is a number of deals in automotive, renewables etc. that have passed the regulators approval (Lee, 2010). • Natural resources are involved Similar as in the technology, media and telecommunications sector the involvement of a company owned by a foreign government can be seen as a threat to many government home to companies targeted by SEOs. But not only foreign approval is difficult to obtain, also domestic approval cannot always be taken for granted. According to a survey by Mergermarket the energy, resources and mining sector is seen by 39% as the most difficult sector to obtain domestic approval for M&A deals (2013, p. 14). The strategic importance of resources and energy-­‐related deals leads to

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involvement of both the domestic and foreign government in every deal, making these M&A difficult to succeed. The fact that involvement of government entities, especially Chinese SEOs, complicates resource M&A deals is also shown in studies, such as the one of Zhang and Ebbers, that report a lower probability of completion of outwards Chinese M&A for both SEO involvement and resource deals (2010, p. 123). Also in business practice this view seems widely accepted: Lawrence Chia, Head of Deloitte China M&A Services, was quoted that “Large Chinese bids for foreign assets in this space are likely to meet with increasing resistance. Chinese bidders will progressively need to learn how to divorce any political undertones from their offers if they want their bids to succeed” (Deloitte, 2009). Further factors There are further factors that result in a lower success rate of Chinese M&A. Most of them are, however, common for developing countries and in that sense not “China-­‐ specific”. • Trade intensity & economic relationship between China and host country Export-­‐ and import linkages can facilitate the deal making foreign countries. Companies that export in a country might better understand the county in terms of business environment and culture. In Zhang and Ebbers study this factor plays a small but statistically significant role (2010). • Lack of qualified advisors International deal advisors are expensive and many Chinese companies have chosen not to go with a big international advisor. However, deal advisor justify their price by lowering the probability of overpaying or failing to close a deal significantly. Failing to close a deal or overpaying is much more expensive than hiring an international advisor. According to a report of Mergermarket hiring professionals with experience clearing the difficult legal hurdles can help overcome what many consider the most difficult part of the M&A process: Getting the regulatory approval. In almost any outbound deal, there are regulatory issues that Chinese companies are not able to solve without the help of external advisors (2013, p. 15).

Conclusion Chinese M&A performance underwhelms the average global M&A performance for different reasons: One is that Chinese companies try to acquire targets in difficult regulatory areas such as high-­‐tech or resources to an extent much higher than their international counterparts. Another important reason is the involvement of SEOs. The vague legal definition of SEOs leads many host countries to oppose deals with SEOs involved. I believe that the success rate of Chinese outwards M&A will increase in the future. This is mainly because of the learning effects of Chinese companies in M&A. Also the public legal reforms and efforts to strengthen corporate governance will make acquisition targets more comfortable with Chinese acquirers. The large cultural difference between China and most of its host countries will continue to make Chinese outward M&A more difficult than for instance between acquirer and targets in European countries.

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Works Cited Benoit, D. (2012). Huawei Already Can’t Get Deals Done. New York City, New York, USA: Wall Street Journal. Deloitte. (2013). Graduating up the value chain: China's overseas revival. Beijing: Deloitte Press. Deloitte. (2009). The emergence of China: New frontiers in Outbound M&A. Beijing: Deloitte Press. Duan, X. (2011). Global Rethinking of Chinese State-­‐owned Enterprises Outbound M&A. Vallendar: WHU Otto Beisheim School of Management. Hawn, O. V. (2013). Organizational Legitimacy: Different Sources – Different Outcomes? Durham: Duke University Press. Lee, C. (2010). A brave new world: The climate for Chinese M&A abroad. The Economist Intelligence Unit . London: The Economist. Liu, H., & Qiao, X. (2011). Cause Analysis of Failure of China Enterprise Overseas M&A. School of Econmics, Capital University of Economics and Business, Beijing. Luedi, T. (2008). China's track record in M&A. The McKinsey Quartely (3), 75 -­‐ 81. Mergermarket. (2013). China Outbound M&A Outlook. New York: Mergermarket. Rosen, D., & Hanenmann, T. (2009). China's Changing Outbound Foreign Investment Profile: Drivers and Implications. Peterson Institute for Financial Economics (PB09-­‐14), 1-­‐21. Spooner, J., & Kanellos, M. (2004, 12 08). IBM sells PC group to Lenovo. (CNET News) Retrieved 10 30, 2014, from CNET News: http://news.cnet.com/IBM-­‐sells-­‐PC-­‐group-­‐ to-­‐Lenovo/2100-­‐1042_3-­‐5482284.html The Economist. (2012, Aug). Huawei: The company that spooked the world. The Economist , 20-­‐25. Zhang, J., & Ebbers, H. (2010). Why half of China's Overseas Acquisitions Could Not Be Completed. Journal of Current Chinese Affairs , 39 (2), 101 -­‐ 131.

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