China’s companies are expanding the focus of their outbound M&A, but so far they have struggled to create value.

Author: Thomas Luedi

June 2008

Chinese companies have been slower to expand abroad than many in the global business community had expected, but some evidence suggests that the long-awaited expansion is now under way: in the first quarter of 2008, they announced foreign direct investments of almost $26 billion (182 billion renminbi)—nearly twice as much as during the same period last year.

These companies are in a good position to make an impact in the global M&A market. At the very moment when the valuations of their foreign counterparts are falling as a result of turmoil in the world economy and global capital markets, many of them are sitting on large cash balances built up over the past few years of quick and profitable growth. Others are responding to the convergence of high domestic liquidity levels (including the money that Chinese banks have to lend and the state’s foreign reserves), global exchange-rate adjustments, political support for overseas expansion, and the need for access to raw materials and new markets.

That raises eyebrows in many Western countries, where uncertainty over the source of the capital and fears of political interference in strategically important industries are generating significant opposition to otherwise solid business ventures. There is also concern about whether some of these overseas deals will create value for investors.

To develop a clearer understanding of the globalization strategies of Chinese companies, we assessed all of their cross-border deals from 1995 to 2007 and examined some of their more recent large-scale M&A ventures in greater detail. We found that these companies have diverse motives for acquiring foreign ones and that not all of the acquisitions are aimed primarily at creating value for shareholders. Indeed, few have actually done so, at least in the short term.

An explosion of M&A

The acquisition of foreign assets by Chinese companies is a relatively new phenomenon. As recently as 2003, their foreign direct investments, in both organic growth and M&A, came to only $2.9 billion (20.3 billion renminbi). Since then, the level has risen tenfold, to 0.8 percent of GDP in 2007—still far below the levels of France, Germany, and the United Kingdom, for example. Some megadeals (with a combined capital market value of more than $1 billion, or 7 billion renminbi) have certainly caught the world’s attention.

Where the deals are
In the past, Chinese outbound M&A deals were concentrated in Asia, except for natural resources such as metals, oil, and gas, which Chinese companies have sought all over the world. This dual focus is understandable given the facts of geography and China’s need to obtain access to minerals and energy resources because of its own limited supply.

More recently, leading Chinese companies have pursued growth and a global presence more actively, announcing deals across all geographies and in many industry sectors. Most of these deals are the first of their kind for the companies involved, and many of them are small and focused—for example, aimed at gaining access to a specific market—rather than large and transformative. Many companies, lacking the ability to conduct cross-border transactions and the experience to maximize the value from large ones, seem risk averse. Not coincidentally, China’s domestic M&A and industry consolidation activity are still often mandated by the government and executed on a net-asset-valuation basis rather than on market value (in particular, when assets of state-owned enterprises are involved). These deals tend not to be very complex.

Still, we expect the number and size of cross-border deals to increase as Chinese companies build the capabilities they need to identify, capture, and conserve value.

The strategy behind the deals

Chinese companies have many strategic rationales for cross-border deals—and the rationales vary among industries. The first transactions aimed primarily to gain secure access to supplies of critical raw materials. That strategy remains an important driver for metals and energy companies to make acquisitions in resource-rich locations such as Central Asia and Africa. It does, however, raise some questions for investors in these companies. Finance theory suggests that it may be good for the country of the acquirer to obtain natural resources, but not, perhaps, for its shareholders. At this point, the size of the sample is too small to draw anything but the most general conclusions. Clearly, some of the resource deals create value for shareholders; others clearly do not.

Recent cross-border deals outside the natural-resource sector have been increasingly strategic in nature. Some, such as Lenovo’s acquisition of IBM’s personal-computer business, aim to help Chinese companies globalize. Other companies do cross-border deals to enhance their operating capabilities; Chinese auto companies, for example, have successfully acquired brands and technology from ailing UK companies and used them to launch brands in China—for instance, Shanghai Automotive Industry Corporation’s (SAIC) Roewe brand, based on technology from Rover. Many manufacturing companies have acquired foreign businesses to gain access to new growth markets, to lower the cost base by globalizing supply chains, and to consolidate manufacturing in large-scale facilities in China, thus benefiting from its lower capital and operating costs. Chinese banks and insurance companies have used their investments in foreign financial institutions to diversify their product portfolios and gain access to risk-management, credit-rating, and other critical skills.

Mixed performance

At best, the outcome of outbound Chinese M&A deals has been mixed. They have underwhelmed the market by the standard of value creation measured through share price movements around the time of announcement, namely, deal value added (DVA) and proportion overpaid (POP). Although drawn from a relatively small sample, our analysis suggests that Chinese acquirers tend to overpay in a little more than half of all deals and that the capital markets on average discount the value of the combined entities. Although the low number of deals—very few of which include two public companies—makes comparisons with global POP and DVA levels problematic, evidence suggests that the deals of Chinese companies from 1995 to 2007 performed less favorably than those of Western ones did.

There is some indication that Chinese companies do much better, in terms of both POP and DVA, in transformational deals than in nontransformational ones. The reason could be a more careful selection of targets, a significant enhancement in the overall operating and management capabilities of the combined companies, or the availability of transformational synergies that improve overall operating efficiencies rather than merely capturing cost synergies.

Where the capital comes from

China has enjoyed strong economic growth since the start of economic reforms and the transformation of state-owned enterprises into listed corporations. Unlisted state-owned enterprises, listed ones, and privately held companies all enjoy large cash balances that allow them to acquire assets overseas. For now, a majority of the companies pursuing cross-border deals are publicly traded state-owned enterprises that used to be wholly state owned. While at this point the state is still a major shareholder in many of these companies—often with as much as 70 to 80 percent of their total equity—managers must operate them as corporate entities and follow the disclosure rules of the exchange on which they are listed. Because they rank among China’s largest companies, it’s understandable that they have so far been in the forefront of the country’s corporate globalization effort.

Furthermore, the government’s stake in these enterprises continues to fall; McKinsey estimates that it will be almost entirely sold off by 2012. Meanwhile, their shareholders will increasingly hold them accountable for the value created (or destroyed) by their overseas acquisitions. That will further reduce fears that they might act on behalf of the government. It will also make them obtain access to funds through conventional channels, such as market-rate equity issuance or debt.

The China Investment Corporation (CIC), a sovereign-wealth fund, has funds of some $200 billion (1.4 trillion renminbi), and it too is expected to make selected cross-border forays. It is more likely to do so, however, as a minority investor aiming for capital gains consistent with its mandate and stated intentions than as an active shareholder. Separately, China’s wide range of nascent private-equity funds tend to focus on domestic investments, in view of the large number of opportunities and the greater ease of executing these deals and managing the portfolios they create.