MERGERS & ACQUISITIONS
Viewpoint: China Deal Trends and Best Practices
September 27, 2006
Michael Thorneman and Tao Ke, Bain & Company, Shanghai

Financial professionals contemplating mergers in China may wonder how new government regulations may affect their plans. Bain & Company told us about best practices and what to expect in the future. Here Michael Thorneman, a Shanghai-based partner and Tao Ke, a manager with significant mergers experience, explain.

What has been your experience advising companies with mergers in China?

Bain & Company is a business consulting firm with 33 offices in 21 countries worldwide. Approximately 20% of our work involves M&A. We have supported over 1,000 corporate M&A deals and over 2,000 private equity evaluations and transactions.

Like our global M&A practice, we have an experienced and localized China team providing full services along the M&A value chain, which includes M&A strategy, sourcing & screening, commercial review & valuation, merger integration and divestiture.

Are there any industries that are seeing significant merger activity?

We see an increasing number of M&A deals in the past two years, mainly from financial services, TMT, industrial goods, utilities & energy sectors driven by industry deregulation, overseas listing and entry of international strategic and financial investors. Bain advises both corporate and private equity clients on M&A deals across a wide range of industries including TMT (technology, media and telecommunications), industrial products, financial services and consumer products.

When might a company wish to employ a joint venture structure vs. a wholly-owned foreign enterprise?

As defined by their names, a wholly-owned foreign enterprise (WOFE) is 100% owned by a foreign entity while a joint venture (JV) is owned jointly by a foreign company and Chinese counterpart(s). The choice between JV and WOFE varies case by case, depending on industry and company strategic preference. In certain industries such as insurance, foreign players are still not permitted to establish WOFE in China. However, we have already seen an increasing trend of foreign investors such as P&G and Avon buying out their Chinese partners to take control over the existing joint ventures.

How have you seen deals typically structured recently?

Deal structures in different industries vary significantly, depending on regulatory requirements, desired degree of control and acquirer's strategy. Most foreign investors in China increasingly prefer a deal structure that ensures they retain a high degree of control. However, in some sectors such as automotive manufacturing and financial services, foreign investors still face equity restrictions preventing them being majority shareholders.

For private equity deals in China, most of them are still minority deals with very few leveraged buyouts. The Carlyle Group's recent bid for Xugong Group is a good example of the emerging buyout market in China and the challenges such deals face in terms of regulatory approval. However, in the long term, we expect to see more buyout deals with the improvement in regulatory environment and further deregulation.

Are you noticing any type of deal trend?

There are several major trends in M&A activities:

• Significant growth in M&A activities, both globally and in China - Global M&A total volume increased by 38% to approximately US$2.9 trillion in 2005 and overall M&A activity in China (including Hong Kong and Macau) grew 34% in 2005 to reach US$46.4 billion.

• Increasing competition between corporate buyers and financial buyers (PE funds) - We expect this trend to continue driven by improving regulatory environment and strong inflow of private equity funds in China.

• Increasing number of outbound M&A deals by Chinese companies - This trend is demonstrated by some high-profile acquisitions such as Lenovo's recent acquisition of IBM's personal computer division in the US and China National Petroleum Corp (CNPC)'s acquisition of Canadian-owned PetroKazakhstan.

• Changing regulatory landscape with mix of both positive and negative impacts

We understand that some new regulations have been put in place related to mergers of foreign and Chinese companies. Briefly explain. What is the impact likely to be?

The recent "M&A rules", which took effect on September 8, 2006, requires certain Chinese companies to get approval from the China Securities Regulatory Commission (CSRC) before going IPOs.

In the short term, this new rule on red chip companies getting foreign listings will have some negative impact in the PE community given the multiple approvals required from the Ministry of Commerce (MOFCOM) and CSRC, resulting delays of IPOs and affecting some firms' investment exits.

In the long term, it will likely only have limited impact. Deals will continue to happen in China regardless given the strong fundamentals and the general push for more transparency and open investment climate. After all, the government is more likely aiming to regulate the PE and M&A environment instead of putting a full stop because of the negative consequence for the country as well as everyone else.

In terms of the timing for CFOs to start worrying about post-merger integration, our take is that timing might not be a critical issue - the sooner you put it in your plan, the better. We think what does matter are the roles that a CFO plays throughout the deal process and particularly in integration.

It varies case by case, but successful CFOs usually play a critical role in M&A process through activities such as leading a small due diligence team and institutionalizing the learning from M&A activities. Most successful acquirers have a clear acquisition strategy and follow four key principles.

• Pick the right targets. Successful acquirers have a concrete "investment thesis" (how this deal will add value) and conduct rigorous due diligence
• Know when to walk away. They value synergies realistically and take a critical outsider's view of a company
• Integrate where it matters. They plan for integration early and focus on getting the few most important facets of integration absolutely right
• Be ready for the unexpected. They set up early warning system and act swiftly when something goes "off-track"
• In addition, successful CFOs typically work closely with line managers during M&A process in order to identify synergy and facilitate the integration.

What are some of the merger-related risks that might be encountered in China and how can treasurers/CFOs seek to mitigate these risks?

The most common risks related to M&A in China:

• Unreliable information and statistics
• Poor transparency of financials and governance
• Long and complex negotiation
• Delayed regulatory approval
• Overestimated synergies
• Difficulties in getting management talent
• Clashes in company culture

To effectively mitigate those risks, acquirers should:

• Have a clear strategic objective of acquisition that is well shared within the organization and with partners
• Overinvest in conducting a thorough and well-structured due-diligence
• Develop a contingency plan to deal with delays and unexpected events such as regulatory approval
• Develop a thorough post-acquisition plan, dealing with both hard and soft issues
• Invest extra efforts in integration
  

What type of advisory services can multinationals seek to assist them in this process?

Generally speaking, investment banks, accounting firms, law firms and consulting companies all provide professional advisory services to multinationals on M&A transactions with different focuses.

Consulting companies such as Bain & Company focus on providing full services along the M&A value chain, which includes M&A strategy, sourcing & screening, commercial review & valuation, merger integration and divestiture.

Any other advice for companies contemplating acquisitions in China?

China provides significant opportunities and challenges for multinationals, especially regarding M&A. Your acquisition strategy needs to be closely linked to the company's growth strategy and you should carefully assess whether you should acquire or grow organically. Once you are determined to pursue M&A, you need to have a thoughtful and systematic process given the complexity of doing M&A in China.

About the Authors:
Michael Thorneman is a Shanghai-based partner with Bain & Company and the head of Private Equity, Mergers & Acquisitions and Industrial Practice for Bain Greater China. He has 15 years of consulting experience, including five in China with corporate and private equity clients covering strategy development, due-diligence for private equity deals, mergers & acquisitions, joint ventures, portfolio management, etc.

Tao Ke is a Shanghai-based manager with Bain & Company and a key member of Technology & Telecom, PE/M&A and Industrial Practice for Bain Greater China. He has over seven years of consulting experience covering strategy development and implementation, due diligence for private equity deals, mergers & acquisitions, etc.

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