Friend or foe? Chinese M&A in the US

One way or another, the largest-ever acquisition in the US by a Chinese company was going to be a political lightning rod. Last week the head of the Senate Agricultural Committee duly announced a hearing on foreign ownership of US food manufacturers in response to the proposed $7 billion purchase of Smithfield Foods by China's Shuanghui International.

The July 10 hearing will feature testimony by the CEO of Smithfield and examine government oversight of such takeovers given concerns about US food safety and the protection of indigenous technologies and intellectual property.

Smithfield, for its part, welcomed the review, noting that the Shuanghui-Smithfield combination doesn't present any national security concerns and it might benefit the US agriculture industry. The two companies have already made a filing with the Committee on Foreign Investment in the United States (CFIUS), the agency that has the power to veto the deal.

Every legal expert AVCJ spoke to agreed there are limited grounds on which the committee could exercise this veto. But they appreciate that political sentiment is a far more fickle creature and wait to see how the transaction stands up in the face of stringent opposition, if indeed any emerges at all.

Should the acquisition go through it will set the seal on a string of significant investments completed in the last year or so, instilling confidence not only in other acquisitive Chinese companies, but also in US sellers who still harbor doubts about these companies' ability to get deals done. Should it fail, progress on these fronts would be curtailed.

There is also an interesting subplot for private equity - investors including CDH Investments and Goldman Sachs own more than 45% of Shuanghui - and the role it plays as facilitator, and beneficiary, of cross-border M&A.

"This is a huge political acquisition, and much depends on how long the deal takes and how much noise comes out during the one-month cooling-off period," says Bob Partridge, managing partner for China transaction advisory services at Ernst & Young. "It's the perfect example of how approval restrictions might intimidate Chinese companies."

Deals by numbers

The numbers suggest that these companies are becoming more bullish on overseas acquisitions. Between 2005 and 2011, annual Chinese outbound M&A jumped more than fivefold to $63 billion. Last year, total deal value topped $64 billion and it will likely continue to increase, supported by government policies to secure natural resources, technologies and expertise required to sustain long-term economic growth.

According to Thomson Reuters, announced M&A in the US by Chinese companies reached $11.5 billion in 2012, the highest level on record, but 2013 could surpass this with $11.1 billion in the first six months alone.

Smithfield accounts for a sizeable portion of the 2013 total and Dalian Wanda Group's acquisition of movie theater chain AMC Entertainment from a PE consortium contributed $2.6 billion to the previous year's tally. There is also China National Offshore Oil Corp's (CNOOC) $15.1 billion purchase of Nexen, a Canadian oil and gas company but one with US subsidiaries.

These deals might offset what appears to be an unhealthy preoccupation with China's past M&A failures. CNOOC's first foray into the US - an $18.5 billion bid for Unocal in 2005 - remains the case study for political and trade tensions conspiring to scuttle a deal. The travails of Huawei Technologies and ZTE Corporation, which last year were effectively placed on a blacklist by the US House of Representatives Intelligence Committee over concerns that Chinese government influence poses a security threat, are well documented.

Participants in an outbound investment panel at AVCJ's China Forum in May expressed a preference for Europe over the US because of the perception that regulatory approval is more easily obtained.

"The US regulatory environment post acquisition is quite fair compared to other places, but CFIUS has, rightly or wrongly, become somewhat of a bogeyman," says Daniel Dusek, a partner at Skadden. "The US could do better in terms of transparency, although it is a national security-based review so there are limits."

The clauses in the Smithfield-Shuanghui agreement show how far US sellers will go to protect themselves against a Chinese buyer bailing on a deal. Should either party fail to secure one of a number of consents and approvals, Shuanghui is liable for a break fee of $275 million, which equates to more than three-quarters of Smithfield's 2012 net income.

The sum was placed in escrow at Bank of China's New York branch by the time the merger was announced. Industry participants cite this as an example of "jurisdictional comfort" - the seller has to be satisfied that if agreements crumble and litigation ensues it actually has something to go after; if a local lender is providing financing and it doesn't have assets in the US that creates an issue in terms of enforceability.

Similarly, for the AMC acquisition, Wanda was on the hook for a break fee if the transaction was halted due to a financing failure and the sum in question was held in escrow in Hong Kong.

CFIUS approval isn't the only concern, though. For the US sellers, there is far less visibility as to whether a prospective Chinese buyer has received the relevant consent from its home regulators - such as the Ministry of Commerce (MofCom), the National Development and Reform Commission (NDRC) and the State Administration of Foreign Exchange (SAFE) - to proceed with a deal.

The most infamous case of a US acquisition being tripped up by MofCom was heavy machinery manufacturer Sichuan Tengzhong failing to get the green light to buy General Motors' Hummer business in 2010, but virtually every industry participant can tell a similar story. It feeds into the perception that Chinese strategic investors are unable to move fast on deals, which can be a problem in auction situations.

"If a US company is put on sale, the seller expects a 4-6 month process and often Chinese strategics can't move that quickly," says Victor Yuan, head of Citi's financial entrepreneurs group for Asia Pacific and COO for global banking. "If you are a US seller, even you want to go with a Chinese buyer, do you take that risk of extending your process and hope the buyer comes in, or do you sell to another credible buyer, maybe at a lower price, because there is greater certainty? It is one of the biggest deal blockers."

There are numerous steps arrangers can stake to smooth the path for Chinese strategic investors such as informing potential buyers of the impending sale well in advance of the auction process and then tailoring the process itself to create a longer lead time for diligence and internal approvals.

Private equity participation in the process is also helpful. This may be in the form of an activist shareholder, driving the company towards a sale by agitating for the board to explore strategic options, or as the selling party. The certainty of private equity exits in particular appeal to Chinese buyers. With AMC Entertainment, for example, the PE backers were looking for a way out, having held the asset for eight years and seen two attempts at IPOs flounder.

"A key question for Chinese and other Asian acquirers is whether a deal is actionable and the asset is truly ‘for sale' - they generally do not want to make an approach if it is likely to be rebuffed," says Peter Chang, COO for Asia Pacific investment banking at Morgan Stanley. "Sponsor-owned assets are attractive options as they are clearly identified as eventual sellers, which is why many of the deals which have happened have involved sponsor portfolio companies."

Other industry participants highlight the role of private equity firms as potential partners for Chinese strategic investors on deals - and not only for their cross-border transaction expertise.

A 100% acquisition by a Chinese company inevitably attracts a lot of political attention; this risk could be lowered by the Chinese company initially taking 49% to the private equity partner's 51% and then assuming a control position over time, once it has proved its commitment to the development of the business.

There is also the possibility that global or US-based PE firms could leverage their own political clout in support of a deal. "A lot of large funds have good government relations and business networks so they can add credibility to the deal and support the company on execution," says Olivia Lee, a partner at Troutman Sanders. "For example, they can line up independent directors to sit in the board of the target company."

Practice makes perfect

It is worth noting that in addition to proactively engaging CFIUS, Shuanghui also took measures to ensure it received pre-approvals from Chinese regulators. Indeed, MofCom went so far as to issue a rebuttal to political concerns expressed in the US about food safety.

Industry participants say that, in general, Chinese companies are learning from their experiences and becoming more sophisticated M&A practitioners. For several years, the state-owned enterprises (SOEs) have run international acquisitions divisions out of Hong Kong and the resources they have plowed into building up expertise are now paying off.

"They have training sessions and - I've done this a load of times - you have 200 people in a lecture theater and you talk about cross-border M&A," says Michael Weiss, a former China M&A banker who is now a partner with Sailing Capital, an outbound-focused PE fund. "There is an appetite and eagerness to learn. And as they do more of it they learn more about it."

There is also a greater willingness, among SOEs and their privately-run counterparts, to pay the fees charged by external advisors for assistance in getting deals done.

This sophistication isn't just reflected in the large or potentially controversial deals that go through - Wanda, Nexen and, more recently, China Wanxiang's acquisition of battery maker A123 Systems, the latter two with measures to mitigate regulatory concerns - but also in those that don't. Ernst & Young's Partridge says Chinese companies are increasingly aware of the political costs that come with certain deals, and they are prepared to walk away if the valuation isn't right.

But there is a caveat. Are these companies laying the proper groundwork when they decide to stay in? For all the resources being put towards successfully closing a transaction, post-deal integration is still regarded as a weakness.

According to research conducted by consultancy Towers Watson, poor human resources due diligence plus shortcomings in communication and change management contribute to 47% of senior management leaving within a year of the acquisition, rising to 75% within three years. Trouble spots include a failure to appreciate the burden of staff pension and medical liabilities and a failure to address cultural conflicts that arise when merging entities.

The majority of these issues can be preemptively handled if companies consider what they want from a transaction before diving into it. Some industry participants attest that integration has become a higher priority for Chinese management teams, but it remains to be seen if they are really acting on it.

"A common mistake that Chinese companies make when going overseas is not formulating clear investment plans," says Vaughn Barber, head of China outbound at KPMG China. "Decisions about where to invest, in what company, through what means and where the synergies might come from should be made based on an overseas investment strategy, which is consistent with the company's overall strategy."

SIDEBAR: Sectors - Capital flows explained

The story of Chinese outbound direct investment (ODI) is one of natural resources, with roughly two thirds of the capital deployed over the last seven years finding its way into mining and oil and gas assets required to fuel the country's ongoing industrialization and urbanization efforts.

In the first half of 2013 alone, five of the 10 largest announced Chinese deals in the US involve natural resources, accounting for $3.7 billion between them. If Shuanghui's $7 billion acquisition of pork producer Smithfield Foods goes through, it would be a landmark transaction. Not just in terms of size, but also as a significant operating business as opposed to an asset-based business. Is this a hint of the new normal?

"While there has certainly been consistent interest in outbound acquisitions across sectors - particularly towards US targets - most deals have focused on natural resources," says Peter Chang, COO for Asia Pacific investment banking at Morgan Stanley.

"If you strip these out and acquisitions by non-Chinese Asian acquirers, there are very few in the US$500 million-plus range, and these are still focused on companies with embedded technology or know-how rather than services or human capital-based businesses."

He does, however, expect to see more activity in these as yet underpenetrated areas. It is a view shared by numerous industry participants who are tracking an evolution in China that has already been seen in other emerging economies: ODI starts with resources and then moves on to manufacturing and finally services. There has already been a significant pickup in industrial M&A, although it is more apparent in Europe than the US.

In 1995, Chinese ODI spanned just four industries globally; nine years later it had grown to 20 and reached 26 in 2012. Unless an infrequent, massive acquisition skews the numbers, average deal size has also fallen over the years, which reflects growing M&A activity among private sector players.

If the goals set out in China's 12th Five-Year Plan - a broad policy document covering 2011-2015 - are anything to go by, capital will continue to flow overseas, although it may increasingly stray from the traditional areas such as overseas contracting, resources and financial services. Rather the focus is on accumulating intellectual property and expertise to give local players a head start in agriculture and food, high-end manufacturing and renewable energy.

"China's economic development is entering a transition period and there are requirements for industrial transformation," says Vaughn Barber, head of China outbound at KPMG China. "ODI is a key route towards achieving that objective and for that reason we will continue to see increasing globalization of Chinese companies and we will possibly see another boom in ODI."

 

SIDEBAR: CFIUS - Taming the beast

Seven months after closing its acquisition of Canada-based Lincoln Mining, Procon Mining & Tunnelling - which is controlled by China National Machinery Industry Corporation - will unwind the entire transaction. It appears the US Navy's TOPGUN flight school is to blame.

Although Canadian by incorporation, Lincoln's principal mining operations are in the US. The Procon deal meant a change in ultimate ownership to a Chinese party and so approval was required from the Committee on Foreign Investment in the United States (CFIUS). It was not forthcoming.

The committee doesn't explain its decisions but it is understood that the proximity of Lincoln's mining operations in California and Nevada to US military bases was a factor.

There have been two previous cases in which the Fallon Naval Air Station in Nevada - TOPGUN's home - was linked to thwarted Chinese M&A transactions. Given this past history why did Lincoln and Procon not approach CFIUS before the deal closed?

"There have been transactions where there were obviously CFIUS issues but the Chinese buyer didn't get an experienced CFIUS counsel," says one lawyer who has been involved a number of CFIUS deals. "It's very different from other regulatory areas because it is a proactive process."

Lincoln-Procon is not the only deal to run into difficulty with CFIUS in recent months. Last September, Chinese energy company Ralls went so far as to take legal action against the committee after its acquisition of an Oregon wind farm was blocked on national security grounds.

Stephen Heifetz, a partner with law firm Steptoe who served on CFIUS between 2006 and 2010, argues that the committee isn't striking a balance between security risks and the importance of the US-China trade relationship. "In some of these cases, it appears as though scuttling the deal results in 2,002 points of vulnerability being reduced to 2,001 points," he says.

However, Heifetz notes that the majority of China deals get through. Earlier this year, Chinese auto parts maker Wanxiang Group won CFIUS approval for its acquisition of battery manufacturer A123 Systems after agreeing to divest the target's government-related business. China National Offshore Oil Corp. (CNOOC) completed the $15.1 billion purchase of Canada's Nexen after putting together a mitigation package that reportedly barred it from controlling Gulf of Mexico oilfields.

"Clearly, US national security was a disabling issue for CNOOC ‘s bid for Unocal [which failed in 2005], so it was encouraging to see the company get through the CFIUS review successfully in its Nexen acquisition, even though it is also an oil and gas asset," says Philip Mills, a partner with DavisPolk. "It has generated a lot of interest in China as to what might be doable in the US."

Should interest translate into activity, there is now a cottage industry of top-tier law firms willing to help manage the CFIUS process. While it is important to understand how the committee defines a control transaction - the purchase of a minority stake could be reviewed if it includes veto rights or influence over board composition and voting - communication is key.

The Chinese buyer to establish early on whether there are going to be CFIUS concerns and then reach out to the relevant agencies and establish how any problems might be addressed.

In addition to divestments, the company could appease regulators by appointing US citizens in key positions or agreeing to a security plan implemented by trusted US parties. At the very least, by introducing itself to CFIUS, a company becomes a known quantity.

"The perception is that CFIUS is a huge obstacle, but it can be overcome," says Heifetz.

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