Markets & Finance

Behind the Chinese M&A Surge


From Standard & Poor's RatingsDirect

China's M&A activity is in turbo-drive. Outward investment is soaring, as many more Chinese companies need, and are able to pursue, opportunities overseas. Inward investment is accelerating as foreign firms seek a foothold in the potentially lucrative Chinese market. And domestic consolidation is heating up among the country's fragmented industries due to overcapacity.

Now that the Chinese government plans to address policy hurdles affecting M&A and relax foreign currency controls, activity levels should rise across most sectors. But while this may improve market positions and increase synergies for local and foreign investors, credit risks could intensify.

"This should be another record year for Chinese M&A, with bigger and bolder moves by Chinese companies overseas and in the domestic market," says Standard & Poor's Rating Services credit analyst John Bailey. "The country's top companies are looking to diversify their skills by entering more overseas markets, and many are seeking foreign investment at home to help drive growth and consolidate their positions in an increasingly competitive domestic market."

GOVERNMENT SUPPORT. But Bailey notes that if these outfits absorb excessively high debt levels from target assets or overleverage to pay for acquisitions, their credit health could become strained.

The Chinese government's encouragement has been instrumental in the surge in M&A activity overseas. Chinese Premier Wen Jiabao said in March, 2006: "We will support qualified enterprises in going global, making overseas investments, conducting international business in conformity with general international practices, and establishing processing centers, marketing and service networks, and R&D centers in other countries."

While creating conducive conditions for Chinese companies to invest overseas, the government is also laying the groundwork for greater industrial strength by encouraging consolidation. It isn't ready to put "for sale" signs on all its prized assets, however. The Ministry of Commerce warned in July that it plans to keep a close eye on foreign M&A in important sectors to maintain the country's industrial and economic integrity. The ministry has yet to approve the $375 million takeover of Xugong Group Construction Machinery by the Carlyle Group of the U.S. that was signed in October, 2005.

BIG DEALS. The delay has been blamed on concern that the takeover may harm China's machinery industry. It shows that the government still has a role to play in protecting domestic industries by shielding Chinese players from foreign competition until they grow stronger. So while the government largely welcomes M&A activity, both overseas and at home, its support cannot be taken for granted.

China is now the third-largest M&A market in the Asia-Pacific after Japan and Australia. M&A deals in China reached $41 billion in the first half of 2006, up a staggering 71% year-on-year. In 2005, the number of announced deals climbed 14.5% year-on-year to 857. To fund acquisitions, capital-raising activity has hit record highs across all financing categories.

Below, Standard & Poor's looks at China-related M&A activity in the following categories: outward investment (Chinese companies investing overseas), inward investment (foreign companies investing in China), and domestic consolidation (M&A among Chinese companies).

Outward Investment

Likely targets: Oil and gas, mining, high-tech, telecommunications, and some manufacturing

Many of the biggest Chinese companies have built up large cash war chests through equity issuance and free cash flow generation, and they're eager to spend. Some will invest in overseas raw materials; others are looking to grow. Last year, Chinese companies channeled $9.18 billion into overseas acquisitions, up from $3.8 billion the year before. The Chinese Ministry of Commerce forecasts outward investment will rocket by at least 22% annually over the next five years, with the cumulative total projected to top $60 billion by 2010.

Appreciation of the Chinese yuan and increasing forms of liquidity—such as available bank facilities—and greater government support are giving many more companies the flexibility and encouragement to venture overseas. Continuing attempts to curb feverish lending by banks have largely failed, to date. M&A negotiations are taking place across myriad sectors, with some of the biggest deals on the table involving companies in the oil and gas, high-tech, manufacturing, and telecommunication sectors.

For many Chinese companies, overseas expansion is critical as it allows them to avoid being restricted to an intensely competitive domestic market where margins are shrinking, and allows them to secure long-term supplies of raw materials and energy, acquire global distribution networks, and gain greater technological skills and management savvy.

When Chinese companies run into trouble overseas, it's often a result of ill-advised acquisitions. Common problems include a lack of due diligence regarding acquired debt, a failure to adequately research different regulatory or cultural environments, and protectionist policies—especially in politically sensitive sectors. Increasing their focus on strategic alliances and joint ventures, rather than outright takeovers, could help Chinese companies avoid protracted battles over overseas assets.

Inward Investment

Likely targets: Banks, cement, autos, retail, and chemicals

The biggest investment in M&A comes from foreign firms investing in Chinese companies, spurred by the country's strong economic growth and tantalizing market potential. Inward investment hit $12.8 billion in the first half of 2006, an historical high.

Financial businesses are squarely on the radar of foreign buyers. The sector attracted an estimated $9.7 billion in completed acquisitions in 2005, boosted by the government's attempts to strengthen the financial system and to deregulate the banking industry. In particular, foreign investors poured into three of China's "Big Four" state-owned banks—Bank of China (S&P credit rating, BBB+), China Construction Bank (BBB+), and Industrial and Commercial Bank of China (BBB+). They also have their sights set on weaker or smaller banks in major cities.

Other key targets include state-owned enterprises that have been forced to sell off noncore assets due to sustained losses, or that are selling off concessions in infrastructure facilities. For example, several foreign steel companies are holding talks with Chinese counterparts with the intention of moving some of their production capacity to China to be closer to their end markets.

At the moment, foreign players can take only a minority stake in Chinese steel companies. Netherlands-based Mittal Steel (BBB+) has secured a 36.7% stake in Hunan Valin Iron & Steel, and Luxembourg-based steel maker Arcelor (BBB) now has a 38.4% interest in Laiwu Steel.

In the past, foreign investment in China has centered on joint ventures with local partners, mainly as a means to benefit from cheap labor while focusing on export markets. As the country relaxes M&A restrictions even further and affordability levels rise, foreign firms will increasingly target Chinese consumers for their products.

Among the promises luring foreign investors are a huge potential market for their goods and services, cheap and abundant supplies, and attractive rates of return on investments.

But foreign firms salivating over Chinese investments must do their homework. Commonly cited problems include lack of transparency at target companies, less-transparent regulatory environment and evolving policies, inability to adequately protect intellectual property, and strong competition.

Foreign investors require a long-term perspective and must be prepared to accept significant risks. As an emerging market, China can be a difficult operating environment. State-owned enterprises can be wary about selling key assets to foreigners, while the country's laws and regulations are constantly evolving, making it difficult to fully comprehend the operating environment.

Protecting brands and intellectual property can also be challenging, given the loose enforcement of regulations. This is one of the biggest obstacles for global pharmaceutical companies, for example.

Domestic Consolidation

Likely targets: Banks, steel, aluminum, cement, real estate, pharmaceuticals, and retail

Chinese firms invested $18.8 billion buying up other Chinese companies in the 12 months ending in June, 2006. That's a jump of 50% over the year before. The total number of transactions rose to 517 from 406 over the same period. Chinese industries can be highly fragmented, with many small, largely state-owned firms competing for the same customers and lacking economies of scale. Austerity measures have meant that some of the smallest companies are being squeezed to such an extent that they are ripe for takeover, with overcapacity and declining margins providing attractive opportunities.

To meet commitments made as a condition for gaining admittance to the WTO, China is gradually opening up its home markets to foreign companies. If China is to defend itself against increasing competitive threats, consolidation among small players is essential. M&A among domestic companies allow an industry to keep a few top players that have the pricing power and ability to maintain a reasonable profit margin and keep growing.

This enables them to negotiate from a position of strength with suppliers and limit the risk of overcapacity. And, of course, the better the financial health of newly merged entities, the less risk there is that they will get into financial trouble.

Consolidation can also have far-reaching social implications. Unemployment in China's rustbelt towns is high, and closing state-owned factories can trigger civil unrest. Weak target companies, mostly state-owned, often have social responsibilities that may bring potential acquirers into conflict with local governments.

For example, acquirers may be required to demonstrate their commitment to reallocating or retraining surplus staff, or provide redundancy payments before a deal is approved. And if companies are consolidating across different regions in China, they can be caught between the conflicting interests of provincial governments. Common interprovincial disputes center on ownership of the consolidated entity, or tax benefits. The consolidation process is therefore likely to be long and painful.

Recent Major M&A Transactions Involving Chinese Companies


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