How China will open a sea of M&A opportunities for private equity
UPDATED-The imminent trade war between the U.S. and China has highlighted just how important the Chinese economy is on a global scale. With tariffs being levied in both directions, the whole world has been watching the dynamic between the two nations and evaluating the impact that is likely to be felt across other countries and affect multiple sectors. What is clear is that China has already emerged as an economic power to be reckoned with, and its rise has opened up what has previously been seen as a closed and unexplored market for many.
Doing business in China still represents huge opportunities for M&A. But with these opportunities comes an environment which continues to change rapidly, often encouraging investment while necessitating that proper controls are in place for good corporate practice. For those working on the sell side, understanding how to navigate some of these choppy waters can make the difference between plain sailing, and a deal running aground.
Harness the opportunities of a maturing market
China has much that is unique, but in terms of broad M&A trends, it seems to be taking a development track consistent with other major markets. This means more private equity buyout deals to come.
Following a long record of growth capital / pre-IPO investments, funds today are more open to taking control. They also have considerable firepower, with the likes of Blackstone, Carlyle and KKR, all raising multi-billion sums for Asian acquisitions, much of which will be deployed in China. The buyout surge is likely to spur future exits, while secondary deals – with sponsors on both sides - are already becoming more common, just as in the US and Europe. CITIC Capital’s sale of King Koil China to Advent International is a prime example of a deal type that was rare just a few years ago.
If these trends continue, now is the time to take advantage of the potential for more sponsor-led buyout deals in 2018 and beyond, including secondary transactions.
Avoid stalling in the doldrums
Before any secondary deal, there is an initial transaction, i.e. where the original business owner sells control. For sellside advisors, this can be a very challenging scenario.
Supply is not the issue. More primary buyout opportunities are arising from succession situations as company founders reach retirement age, without suitable heirs apparent for handovers. Instead, increased scrutiny of IPO candidates is becoming a more pressing factor. Following last year’s introduction of the new stock exchange oversight committee, with officials personally liable for post-listing performance of successful corporates, rejections duly spiked - leaving trade sale plans to be drawn up as a “plan B”.
However, most of all, unrealistic valuation expectations still present a major hurdle. Target prices are referenced from elevated trading multiples in domestic public markets, thereby frustrating M&A outcomes. Other barriers then include long-standing pre-IPO investors unwilling to acknowledge that their shares were acquired on overly-optimistic terms, with local governments incentivised to see companies in their district trade on a national stock exchange.
In order to avoid these headaches, it is crucial to manage seller valuation expectations early in the process, thereby maximizing the chance of getting a founder deal done.
Keep watch for potential regulatory restrictions
Rule changes in China are at a startling pace, as authorities look to maintain order in a rapidly evolving and increasingly complex economy.
One area that merits particular attention is flow of funds from buyer to seller. The currency not - yet – being fully convertible, means exchange controls remain governed by the State Administration of Foreign Exchange. Over the years, focus has flipped between preventing inbound money flows over-inflating the value of the yuan or, as today, guarding against capital flight and depreciation. Adoption of exchange quotas has impacted a onshore company’s ability to close on a timely basis, even for optically onshore deals involving local businesses where held by offshore holding vehicles.
This means understanding a prospective buyer’s ability to get consideration offshore is critical, right from first contact. Where an extended period between signing and closing is unavoidable, then seller-protective measures, such as deposits, should be required to prevent problems later down the line.
Knowing the game means knowing the players
Dealmaking in China takes place in what some label as a “low-trust environment”. In other words, counterparties are conscious that seeking legal recourse is often simply more impractical than elsewhere, and behavior can duly reflect this reality. As long as this is recognized upfront, practical steps can be taken to ensure seller-buyer dialogue is as effective as possible.
Vendor due diligence (“VDD”) is not as widespread in China as other markets, but its application signals that nasty surprises are less likely to be lurking, and that, therefore, the deal opportunity should be taken seriously. It also shortens and minimizes disruption to the business itself, which can be a critical concern. The more that financial and legal VDD is encouraged and becomes best practice in China M&A, the more that both buyers and sellers know that there is nothing behind the scenes that could derail a deal at the eleventh hour.
Plot the course to all the way to your final destination
Some aspects of executing deals in China require relatively more attention from advisors than elsewhere - this is especially true as closing approaches.
Escrow accounts can take a long time to establish, particularly when they have to be local to a target, where banking options can be limited. Early inquiries and consistent monitoring of progress as closing nears, will avoid delays to transfer of consideration. Sellers should also be aware of the administrative quirk that the buyer’s name may appear on the business license of their Chinese company, well before receipt of funds. Given effective control is executed through physical possession of corporate chops and actions of key individuals, such as the designated legal representative, risk here is certainly mitigated.
Upfront, clear communications about how closing will play out will avoid missteps and delays at the back-end of the transaction, but also has the added advantage of showing that each party is serious about seeing the deal through to its successful conclusion.