Opportunities in M&A Transactions in China's Emerging Private Sector

In certain sectors and regions, these companies have become substantial market players. Some firms have multi-year track records of successfully perceiving and satisfying market needs, especially by building, financing and managing production and sales organizations, and taking market share from state-owned (and often FIE) competitors. Given their competitiveness in the marketplace, Chinese private enterprises are likely to continue to grow faster than the overall market.

The New Chinese Entrepreneurs

Often, as in other Asian markets, private Chinese companies are owned and operated by individual entrepreneurs or families, whom we've termed new Chinese entrepreneurs (NCEs). Frequently we find that these NCEs have "bureaucratic capitalist" backgrounds. They began careers as government officials in charge of state-owned enterprises (SOEs), and at some point "jumped into the sea" (xia hai) to run the enterprises, subsidiaries or new ventures back by SOE funds. In the course of official and unofficial privatization actions at the local level during the past decade, the SOE enterprises or assets within them were transferred-often at low prices or gratis-to the entrepreneurs.

Huawei Technologies Co. in Shenzhen represents another type of NCE enterprise. This company's management and ownership, while private, are hard to associate with any particular family. Rather they are a coalition of individuals and interests with bureaucratic capitalist backgrounds.

Given their backgrounds, NCEs are usually closely tied in business relationships and obligations to officials in a particular place. They are careful to nurture continuing good relationships with local and provincial officials, who can be a continuing source of support and new business opportunities.

In recent years, the most successful entrepreneurs have been able to move beyond government patronage and have built increasingly independent successful businesses by relying on their own skills. Over the past decade these entrepreneurs have quickly seized opportunities, countered threats and satisfied marketplace needs, all at a substantial profit. Huawei Technologies, for example, has 30% market share in China's telecoms market and is finding increasing success selling abroad.

The New Strategic Option for Foreign Firms: Acquisitions of and Alliances with Chinese Private Enterprises

Over the past decade, achieving quantum leaps in market growth through acquisitions, if considered at all by foreign companies in China, has often been dismissed as unworkable, and the obstacles have been judged to be prohibitive.

Unlike a decade ago, it is now possible for many foreign firms to consider a growth-by-acquisition strategy by targeting private companies owned and run by new Chinese entrepreneurs. For example, Emerson Electric will reportedly purchase the power systems business of Huawei Technologies for between US$700 million and $800 million. In general, the viability of the strategy will depend most upon the business and product sector and its degree of "openness" to foreign investment, as well as the marketplace structure. Among the high potential sectors would be intermediate industrial products, and light industrial products, including consumer non-durables, where competitiveness is often determined by the strength of distribution systems at the local level.

Danone's Formula for Success

An example of a successful growth-by-acquisition strategy-focused on private Chinese companies-is Danone, the French food group. Danone products in China include beverages, biscuits, fresh dairy products and sauces. Danone operates nine companies. In four cases, Danone has acquired majority positions in local companies founded by Chinese entrepreneurs. In 1996 Danone acquired 41% of Wahaha, a Hangzhou-based bottled water producer. In 1998, it acquired 54% of Shenzhen Health Drinks. Danone has also acquired majority stakes in bottled water companies Robust in Guangzhou and Aquarius in Shanghai. These companies have achieved the top two or three positions in their local marketplaces along the coast and have strong local brands.

Danone's formula has been to "partner" with the entrepreneur, and to leave the partner in charge of managing the business. While they prefer to keep the matter private, Danone's senior managers are extremely pleased with the results of these ventures. Performance actually has been consistently better than in the two ventures-Shanghai Danone Biscuits and Wuhan East West Lake Beer-where Danone has installed foreign management.

Executing an M&A Strategy in China: Issues, Problems and Solutions

When might an NCE be receptive to interest from a foreign company? The most common case is when the NCE is encountering difficulties typical of growth businesses: shortage of capital for expansion; the need to move up the product quality and value chain; the need to acquire new products and manufacturing technology; the need to upgrade internal management systems; and the need to expand coverage across China rather than be confined to one city. In other cases, the NCEs could be looking to "cash out" of part of their business, and to reduce entrepreneurial risk going forward.

What should be the objectives of a foreign firm? These could be acquisition of a substantial and growing position in a market segment that the company had been unable to develop on its own or from which it is effectively barred by its own cost structure. Also, the foreign firm may wish to gain China-specific market knowledge and market development techniques that it would find difficult to acquire on its own.

Investigating the Target

The due diligence process in the case of a private Chinese enterprise largely follows the normal process for any acquisition or joint venture in China, though particular attention is required in certain areas. Common issues include having competent legal counsel review asset ownership documents, land registration and transfer contracts, business registrations, licenses, certifications of paid-in-capital, articles of association, and the like.

One key area of attention is the need to obtain an enhanced understanding of the NCE and the immediate family members of the NCE. In many respects the NCE is the business, and his personal style, business practices, and relationships (familial and otherwise) can be expected to inform all parts of the company. Though this may be interpreted as advocating hiring an investigation company, one cannot overemphasize the value of ample time being spent getting to know the NCE personally, observing working styles and understanding relationships.

Given the background of NCEs and their organic relationships with local political and bureaucratic interests, appropriate actions should be taken to understand the NCEÕs political and governmental relationships. Such due diligence can be conducted by asking the NCE to arrange meetings with their key political and governmental relationships in the cities or provinces concerned. Obviously, to obtain a credible assessment the foreign company will need to assign a local language-speaking, experienced and trustworthy individual to this due diligence task.

Unraveling NCE Business Interests

The target NCE company is likely to be young, fast growing and one of several entities that the NCE has used to conduct business and to comply with (or artfully circumvent) Chinese taxes and regulations. A first step is to distinguish the various NCE enterprises or group entities from legal and beneficial ownership, legal status, operational and financial perspectives. For an NCE, it may be convenient-or a requirement of Chinese regulations-to place certain activities into separate legal vehicles or to combine them in one, with the result being considerable operational and legal risk. Foreign-owned firms in China are held by local supervisory and enforcement agencies to far higher standards of compliance than are local firms. Indeed, there are numerous regulations and compliance requirements in China directed exclusively at foreign-owned firms. As a result it can be assumed that as soon as it is known that the enterprise has acquired some elements of foreign ownership, the firm is subject to more rigorous scrutiny. This puts a premium on enhanced transparency and integrity of ownership structures.

Straightening Out the Books, Before and After the Acquisition

Notwithstanding that company accounts may have been audited and bear the official chop of a Chinese CPA, it is likely that the accounts do not fully represent the actual operations and financial condition of the business. Either before or shortly after the acquisition, the foreign acquirer should ask that their auditors examine the NCE's business according to US GAAP or IAS. This audit will produce a "Statement of Financial Condition" which should form the agreed basis for valuing assets and liabilities. If in the purchase agreement a price has been agreed prior to the audit based upon another set of figures, and significant variances (plus or minus 10%) are discovered as a result of the audit, this should be justification for an adjustment in the purchase price.

Dealing with "Off the Books" Transactions

China has a thriving, unreported "cash only" economy, which is not limited to private companies. It will not be unusual to find that on average 20-30 percent of the NCE's businesses is conducted "off the books". These off-the-book transactions are typically raw material purchases in which the seller does not issue a VAT tax invoice, and the corresponding sales are also done without a tax invoice. Often such transactions will not have been reflected in the NCE's locally audited financial statements. Whether this business can be placed back "on the books"--by requiring proper invoicing-or must be discontinued, is something that a foreign acquirer must consider and deal with in the course of acquisition discussions.

Keeping the NCE Partner "On Side" and with the Business

The greatest fear of any acquirer of a business is that the seller will within a short time re-enter the business in competition with the business just sold and quickly spawn copycat businesses that rapidly undermine the value of the acquisition. The physical size of China and its markets, and the well-known frailties of its legal system, greatly increase this concern. Hence, in addition to the details of non-competition clauses, consideration should be given to:

• substantially deferring payment, in exchange for adding an enhanced bonus or profit element;
• providing service agreements with terminal payments that are forfeited in any instance of competition; and
• providing a genuine and significant role for the former NCE in the new structure.

Venture or Development Capital Opportunities

Venture Capital (VC, for start-ups) and Development Capital (DC, for early-stage established companies) funds are increasingly active in the Chinese marketplace, though foreign VC or DC activities are much less significant than domestic funds. These funds target both SOEs and NCE-run enterprises. In most cases, the exit is expected to be an IPO and listing in China's domestic A share market.

IPOs and listings have recently been freed from rules requiring government vetting. In principle, any qualified company will be permitted to make an IPO and list shares. However, it is expected that being an FIEÐby definition, with over 25 percent of equity in the hands of foreign interestsÐwill complicate the listing process. This continues to give pause to potential foreign venture or development capital funds.

Exploiting Offshore Structures

The NCE is likely to want an offshore structure for ownership of the project. This is a reflection of the limitations placed on PRC-based vehicles such as the Joint Stock Limited Company or the officially blessed model of the Chinese-foreign joint venture corporation. In the case of the Joint Stock Limited Company numerous bureaucratic approvals are required, and by law five shareholders are required, three of whom must be Chinese.

In the case of the "official" Chinese-foreign joint venture, the chief difficulty is that private Chinese citizens may not be direct shareholders of such entities. As a result, the most attractive method for an NCE is to become an owner or shareholder in an offshore entity that invests in the Chinese "onshore" business, so that the domestic entity becomes a wholly foreign-owned enterprise (WFOE). Typically the NCE will receive shares in the offshore holding company in exchange for transferring the business assets in China to the WFOE. Although this requires approvals, when obtained it results in the business in China being operated as a foreign-owned business, while further transactions (such as changes in equity) are executed offshore.

Until some of these wrinkles are ironed out, perhaps after China's accession to the WTO, the NCE has the consolation that they only have to reach Hong Kong to be offshore. The offshore investment often is a company organized in Hong Kong, though other destinations, such as the British Virgin Islands, are also popular.

In the near future one can anticipate that Chinese law will allow creation of on-shore joint ventures between Chinese individuals and foreign entities to reduce the instances when such projects are driven offshore by deficiencies in the regulatory and investment structure in China.

We are optimistic that the current environment in China offers opportunities for growth through acquisition to foreign firms that take the time to understand the characteristics and goals of China's dynamic NCEs, and that are willing to structure acquisition arrangements that take these factors into account.