Project Europe: China targets high-end manufacturing

Weichai Group, a Chinese automotive equipment manufacturer owned by Shandong Heavy Industry, has been busy shopping around Europe. In the past 12 months, the state-owned enterprise (SOE) has acquired Italian luxury-yacht maker Ferretti and made a sizeable investment in Kion Group, the German forklift truckmaker backed by KKR and Goldman Sachs. The latter transaction was valued at EUR738 million ($922 million), making it the largest Chinese direct investment in Germany to date.

The manner in which Weichai approached Kion speaks volumes for its strategic interests. The company took a 25% stake in Kion via a capital increase - with an option to increase its holding to one third in the event of an IPO - and obtained a 70% interest in a Kion subsidiary, Linde Hydraulics. The subsidiary now operates independently of its parent, although Kion retains a financial interest in the asset.

Linde is important to Weichai because China's $4.8 billion hydraulic machinery industry is entirely import-oriented and the lack of domestic expertise is viewed as one of the largest obstacles to the development of the broader manufacturing sector.

"It was important for both parties to enter into a cooperation with a strong underlying strategic and not just a financial rationale," Silke Scheiber, a member of KKR, tells AVCJ. "One interest in the strategic partnership with Kion was to get access to a very high quality hydraulic component business which is important to enhance the product portfolio, and there must be an advantage that they see from Kion's products."

KKR and Goldman, which acquired Kion from German group Linde in 2006, reportedly placing an enterprise valuation on the company of EUR4 billion in a highly leveraged deal, retained their holding after the Weichai's investment.

As Chinese companies seek to climb the technology value chain through outbound M&A, KKR and Goldman are not the only PE players looking to cash in. Earlier this month, Apax Partners agreed to sell International Electronics & Engineering (IEE), a Luxembourg-based developer of specialized sensing systems, to a consortium comprising three Chinese strategic players and an international financial investor. It is Apax first-ever exit to Chinese buyers.

"Money is not necessary the main issue for Chinese companies. It's more about the ability to deal with Western style, time constraint auction processes, as well as how to integrate the overtaken company into their own business," says Bertrand Pivin, a partner at Apax Partners. "Private equity can act as a bridge to facilitate this process and I believe it will be a developing trend going forward."

Policy-driven

While multinationals have for decades been using China as a base for low-cost manufacturing, domestic companies are now starting to take control of the game by acquiring overseas assets. Chinese outbound M&A activity has increased sharply since 2004, with deal volume growing by 24.4% per annum and deal value rising nearly 10-fold. According to Thomson Reuters, China's outbound activity reached $96.7 billion in 2012, surpassing the $91 billion recorded last year.

Technology is at the heart of these M&A initiatives as the country shifts from a volume to a value approach, swapping out labor-intensive production for businesses based on intellectual property and industrial know-how. According to PricewaterhouseCoopers, high-technology was the most popular target for Chinese outbound investment in the first half of 2012 with transactions worth $13.2 billion, compared to only $6.7 billion in the same period a year ago.

The desired transition is writ large in China's 12th Five Year Plan, which outlines government policy targets for 2011-2015, with high-end equipment named as one of seven strategic industries. The country wants to triple sales of high-end machinery to RMB6 trillion ($963 billion) by 2015. By then, advanced equipment will account for 15% of the overall revenue of the equipment industry, compared with 8% in 2010. The figure is expected to reach 25% by 2020.

"The Chinese government doesn't only look to move up the machinery sector from low-end to high-end through the 12th Five-Year Plan, it also provides capital for outbound investments via state-banks. I'd say what we are seeing now is just the very beginning of a much bigger outbound wave," says Stefan Herr, a Germany-based partner at consultancy Simon Kucher, who advises companies in the machinery, construction and electronic and electrical engineering industries.

While SOEs are among the prime outbound movers, cut-throat competition across the domestic manufacturing sectors - as well as efforts to supplement dwindling exports with local business - is pushing private enterprises sector to do the same. According to A Capital, a cross border-focused PE firm, private companies accounted for 28% of China's outbound deals in 2011, compared to 17% a year earlier.

The most high-profile private sector outbound acquisition in the manufacturing space was Sany Heavy Industry's EUR360 million acquisition of Germany's Putzmeister last January. CITIC Private Equity took a 10% stake in the pump manufacturer as part of the transaction. The deal came three years after Sany's state-owned rival Zoomlion bought CompagniaItalianaFormeAcciaio (CIFA) in 2008, backed by Hony Capital, Goldman Sachs and Mandarin Capital Partners.

"Looking forward, we see co-investment opportunities with both SOEs and private companies for overseas assets. The merit of private companies is that they usually require less time to reach a close, compared to at least six months for SOE-initiated deals," says André Loesekrug-Pietri, chairman of A Capital.

Betting on Germany

Loesekrug-Pietri adds that close to 60% of his firm's deal flow will focus on the European manufacturing and technology, with another 21% in consumer and 20% in services. Automotives, aerospace, logistics, telecom, chemicals, oil and gas, and shipbuilding are among the key sectors. The firm is in the process of finalizing a transaction involving a high-end environmental equipment industrial firm.

"Europe, which remains the Western world's manufacturing hub in particular in areas like heavy industry, automotives and chemicals, is definitely poised to see more Chinese outbound direct investments in the months and years to come," he says. "When the process is well managed and the benefit for both the European target and our Chinese co-investor are clear, it can be very profitable."

Among different geographies, Germany has emerged as a popular hunting ground, largely thanks to its stable and sizable manufacturing sector, which has performed solidly despite the global financial crisis. According to the World Bank, manufacturing currently accounts for more than 20% of Germany's GDP, compared to 17% in Italy, and 11% in both France and the UK.

That explains why Sino-European private equity firm Mandarin Capital Partners decided to devote the entire corpus of its second cross-border fund to investments in advanced manufacturing and services companies across China and German-speaking parts of Europe. The vehicle is nearing a EUR500 million first close and is expected to reach a final close of EUR1 billion in the second half of 2013. Alberto Forchielli, the firm's founding partner, has also temporarily moved to Munich to get the German operations started. The new office will eventually grow to a team of 12 in the next five years.

"Since the Sany-Putzmeister deal, acquisitions have been everywhere over Germany," Forchielli says. "For our fund, we will invest in 12-15 companies across the advanced technology space. The average ticket size will be around EUR200 million for buyouts, and $40-50 million for minority deals."

Japan and the US are also potential targets for Chinese outbound investors, but both markets present obstacles of a cultural and political making. In Japan, entrepreneurs are traditionally reluctant to sell their companies unless a clear alignment of interest is in evidence. The US, meanwhile, is political minefield with companies wary of falling afoul of the Committee on Foreign Investment in the US (CFIUS).

Huawei Technologies and Bain Capital backed out of a bid for computer networking company 3Com in 2008 after security concerns were raised, and the Chinese company was subsequently forced to withdraw plans to acquire serve technology assets from 3Leaf. Huawei's founder, RenZhengfei, was previously an officer in the People's Liberation Army. Last October, the US House of Representatives Intelligence Committee recommended that US telecom operators avoid doing business with Huawei and counterpart ZTE Corp. because potential Chinese government influence poses a security threat.

"Many SOEs are concerned that the US market as it is not a friendly environment to invest whenever the central government is involved. We do find the investment trend slowing a bit in the US especially in the energy and heavy industries," says Allen Shyu, managing partner of Troutman Sanders' Beijing office. "Europe, compared to the US, may therefore be a more preferred destination for certain Chinese investors."

The PE approach

An inevitable consequence of European manufacturing assets becoming attractive to Chinese strategic buyers is escalating valuations - to the extent that investors potentially end up paying far more than a company is worth. According to a person with knowledge of the Putzmeister transaction, Sany Heavy agreed to fork out as much as 16x the price-to-earnings (P/E) ratio. Questions are being asked as to whether CITIC PE will earn a reasonable profit on the transaction.

Cross-border co-investments with Chinese corporates are also complicated by the time-consuming approval process. Companies typically require the go-ahead from at least three agencies: the National Development and Reform Commission, the Ministry of Commerce and the State Administration of Foreign Exchange. SOEs might also need approval from the State-owned Assets Supervision and Administration Commission, while listed companies must go to the China Securities Regulatory Commission.

"From a PE perspective, the best way for outbound investments is to do stand-alone deals and sell them to Chinese buyers," says Mandarin's Forchielli. "One cannot gain much from aligning oneself with the Chinese companies, which often pay a premium of 30-40% and lose a lot of speed in terms of deal execution."

Stand-alone deals, however, are easier said than done. Chinese corporates, with their longer investment horizons and post-acquisition synergies, make for fierce competition in an auction process, even if they require more time to close a deal. In addition to paying more than private equity rivals, these strategic investors are able to provide direct distribution channels to an overtaking company as part of the transaction, making their bids even more attractive.

PE firms seeking stand-alone deals with to exiting assets to Chinese investors are therefore best advised to create proprietary opportunities. Apax'sPivin argues that the key to success is taking advantage of the market knowledge and identifying innovative technologies during the early stages of the value chain.

"I don't think Chinese companies can acquire the business as how we do it because of the inherent difficulties of carve-outs and the numerous experiences that are required to deal with it," says Pivin. "Our role as a PE firm is to prepare and transform an asset into an appealing and independent company to be acquired by industrial corporates in Asia, especially China."

Apax's recent exit in IEE is a case in point. When the PE firm identified IEE, its sensing systems were a technology niche lost in the vast corporate structure of ArcelorMittal. As the technology had little in common with global giant's core steel and mining businesses, Apax completed a full carve-out in 2004 alongside the management team and two Luxembourg-based investment companies, Luxempart and BGL Investment Partners.

Over the last eight years, IEE's revenues have nearly doubled and its EBITDA has more than tripled. When Apax launched the auction in late spring last year, it received 15 preliminary offers from parties across Asia, Europe and the US.

"The final acquirers operate in China-based automotive and high-tech industrial businesses that are very much linked to IEE," Pivin says, declining to disclose the buyers. "It is a combination of IEE's worldwide connections to car manufacturer R&D and design centers as well as its innovation capability that have attracted the buyers."

Apax is now looking for more investments with a few to fashioning exits to Chinese corporate buyers. As part of these efforts, it will partner with Chinese private equity co-investors on European mid-market deals valued at around EUR100-500 million. The expectation is that local partners will be able to offer insights into what Chinese companies are looking for.

A combination of Chinese and European competencies is clearly important in terms of taking such companies to their next stage of development. In these sense, globally integrated investment firms that bestride both regions will be uniquely positioned to target the anticipated wave of Chinese outbound deals.

However, front-end execution is just one part of the process. The demerger process, which includes integrating the key talents and culture of the investor and investee in order to realize the synergies, can be even trickier. Weichai and the Linde Hydraulics management team, for example, put together detailed post carve-out plans. KKR's Scheiber recalls that securing 100% approval from the employees who were to remain with the business was one of the most difficult parts of the deal.

"Most M&A is unsuccessful whatever the industry, and that's nothing to do with China, Germany, or the US," adds Stefan Herr of Simon Kucher. "The question is how good are you in the demerger process: If you don't allow the overtaking company to retain a little bit of its culture, integration may fail and you end up overtaking a nice name with all the nice things gone."

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• Topics
• Greater China
• Europe
• Buyouts
• Industrials
• China
• Europe
• buyout
• M&A
• Outbound investment
• Apax Partners Hong Kong
• KKR
• Citic Private Equity
• Mandarin Capital Partners
• A Capital Asia