M&A continues to make headlines, as in last month's news that Air China was looking at taking over Hong Kong's Cathay Pacific. The sector is hopping on the Mainland too, such that last year an estimated 15- 20% of all inbound foreign direct investment (US$60.6bn) went to buying up Chinese companies – if not buying them out, at least buying into them.
Increasingly, foreign investors are taking stakes in state-owned enterprises, like Nissan's September buy-up of 50% of Dongfeng Motor operations. According to Kim Woodart, chairman and CEO of advisory firm Javelin Investments, China's State Council is engaged in "a systematic restructuring and privatization of all but China's biggest SOEs."
It got the ball rolling in early 2003, set- ting up the State Assets Supervision and Administration Commission (SASAC), handing over ownership of 185 national SOEs and literally thousands of provincial and municipal SOEs, to the commission to dispose of. "SASAC and its provincial branches will undertake a large-scale equity restructuring and divestment of underperforming SOEs at every level," Woodart says.
So are Chinese regulators making it easier on foreigners? No. With February 2004's introduction of what insiders derisively call SASAC's auction system, the process of closing deals slowed considerably – even on tiny deals. Ernst & Young tells of one sub-US$10m deal that was supposed to close in February last year dragging on to November, raising transaction costs and leaving the acquirer nearly a year behind schedule.
And that is the irony: because deals take so long to close, more investors are jumping in earlier to get started on their acquisition projects: bad enough that they might take a year or a more to pull off – but far worse if the process has to start again a year later because the deal derailed.
"We're starting to see people pull the trigger a lot earlier – and taking a lot more risk – across all sectors," says Bob Partridge, head of Ernst & Young's transaction advisory practice. Partridge, who went to Hong Kong five years ago to oversee E&Y's due diligence and deal structuring operations across Asia, says he now spends up to 80% of his time in China. (Among other transactions E&Y worked on was Nissan's buy into Dongfeng Motor.)
US-based law firm Morrison & Foerster works the legal side of deals, a recent one involving UPS buying Sinotrans out of their agency joint venture. But Hong Kong-based partner Bob Wohl can't point to any regulatory improvements of late. "I don't think much has changed," he says.
Scott Jalowayski, a senior associate with the firm, echoes the view: "The regulatory environment is not getting any easier – but certainly the mindset of the regulators is completely different. Instead of a mindset that says, 'We can do anything we want regardless of how much sense it makes', there's a much more rational view of transactions: if it makes sense and there's room for it in the regulatory framework, they're inclined to approve it."
Jalowayski says today's regulators are pretty sharp. "They're seeing a lot more sophisticated transactions than 10 years ago. They're not baffled or surprised when you try to explain what's going on." Although inevitably, political logic can intrude on business logic if, for example, a deal would cost a lot of jobs.
So if the regulators are so smart, does it not follow that the rules will get smart, too? Jalowayski knows the answer to that, but he hesitates for a second before repeating the maxim: "It's not that the PRC government wants to prevent things from happening, they just want to be in control."
And, by his lights, they achieve that by keeping the rules loose and subject to considerable interpretation. "One of the challenges in trying to execute a transaction is China's incremental legislation that is vague and open to interpretation," he says.
On one level, it looks like the regulators would easily approve a deal. "On the other, they are not offering a really definitive view," Jalowayski continues. "And that gets back to my point about control – if you want to do something, you really have to talk to the regulatory body and get their point of view."
Which leads Jalowayski to this piece of advice: acquirer and target companies must be on the same page in their interpretation of the rules. "Each side can have different views on what approvals are needed and they have to converge to get the right approvals," he says.
Javelin's Woodart patrols China's manufacturing sector of US multinationals and he says there aren't many who aren't seeking or thinking about China acquisitions. "Multinationals are buying in because there's a lot of capacity in place already – so it makes sense to buy in and get market access by buying a local player."
The problem is there are not a lot of companies of sufficient scale to buy. "What starts out as a huge field of potential targets quickly boils down to just a handful of options," Woodart says.
Apart from assessing which companies should be shortlisted, which can be expensive, there is the problem is figuring out the carve-out – which parts are worth buying – and price. Deals that on paper might look like 20 cents on the dollar but can end up costing US$1.20 by the time equipment and plant are capable of producing export quality goods like auto components.
Then there is management: it tends to be weak in target companies, Woodart says, which means the acquirer has to be big enough to part with its own top people to get the company up to speed.
But he agrees the rules of the game are a patchwork of interim measures always, or nearly always, subject to amendment. That can trip up foreign investors, Woodart agrees, but he reckons even vague rules are better than no rules at all, which used to be the rule, so to speak, in a host of different areas.
SASAC's auction system is something else, designed primarily at trapping domestic wheeler-dealers involved in bogus management buy-outs (MBOs). Its system requires acquirer and target companies to post details of prospective transactions on their web site. Something had to be done: SOE managers, Woodart says, were setting up MBOs and giving themselves shares in state companies at discounts that even undercut their net asset values.
Foreigners understand the reason for it, but it starts a bidding war on the eve of what should be deal completion. After all the investment of time and money in due diligence and negotiation, a third party, having invested nothing, can come and bid.
E&Y's Partridge says the auction system has to go, or at least be restricted to domestic-todomestic deals where the frauds occur.