Tech M&A: Tactical forays

Toutiao is the poster child of a new generation of social media in China. The five-year-old start-up – the name translates as “headlines” – uses artificial intelligence (AI) to source content from blogs and traditional media outlets and create personalized news feeds. It is tipped as a potential successor to the BAT (Baidu, Alibaba Group, and Tencent Holdings) as a dominant force in China’s technology sector.

Although a relative latecomer to the media scene, Toutiao has expanded beyond news aggregation into segments such as original content, news search, music, video and a Quora-like question-and-answer service. Its daily active users recently surpassed 100 million. Backed by the likes of Sequoia Capital, Source Code Capital and CCB International, the company is reportedly raising a $2 billion round at a valuation of more than $20 billion. General Atlantic is understood to be among the new investors.

Toutiao’s primary challenge is maintaining and growing its audience in a market already populated by Baidu, Sina Weibo and Tencent-owned WeChat. In addition to incubating new businesses internally, the company has made dozens of minority and control investments in start-ups. Its portfolio includes US-based photo and video-sharing app Flipagram, Indonesia’s Babe and India’s Dailyhunt, both of which are news aggregation platforms. Toutiao’s parent has also launched English-language news app TopBuzz in North America and music video platform cum social network Tik Tok across Asia.

“Toutiao will look at anything that can improve its AI technology to make it more precise in distributing content to users. The second priority is market expansion. Ideally, in each market it wants to create a local language Toutiao-like news platform. Whether it’s organic growth, minority investments or M&A, Toutiao will consider it,” says one industry participant familiar with the company’s strategy.

A number of emerging tech giants – including Meituan-Dianping and Didi Chuxng as well as Toutiao – represent a new force in Chinese technology M&A alongside the BAT. The combination of fast growth, intense domestic competition and ever larger funding rounds at ever higher valuations has encouraged them to adopt an inorganic approach in search of new technologies, markets and knowhow.

“Previously many tech giants wouldn’t do M&A even years after listing. When new competition emerged, they would prefer to build similar businesses by themselves rather than make acquisitions. I don’t think it was a healthy approach,” says Wei Zhou, a founding managing partner at China Creation Ventures, which spun out from KPCB China. “Over the last 2-3 years, large internet companies – whether they are listed or still private – have started doing more M&A. It’s an indication that the market is maturing, facilitating more exit options for VC investors.”

M&A imperative

One of the driving forces behind this development is consolidation within different industry verticals. Didi and Meituan-Dianping are both examples of mergers between one-time rivals in the ride-hailing and online-to-offline (O2O) services spaces. They are now said to be worth around $50 billion and $30 billion, respectively. In other verticals, such as online ticketing, travel and co-working spaces, dominant players have emerged by outlasting or buying the competition.

Once these companies have established themselves, they look to diversify product lines beyond their core business areas through investment. Take Didi Chuxing’s $200 million commitment to Renrenche, a used-car trading business. While the company has little relevance to Didi’s ride-hailing operation, it pursued the deal with a view to helping drivers on its platform reduce costs by purchasing second-hand cars or earn money by selling their own vehicles.

“Compared to one or two years ago, today’s M&A market is definitely more dynamic and presents more possibilities. The ‘mergers of equals’ deals were mainly about bringing together the biggest players in different segments. But many segments are now quite concentrated and further merger opportunities may be limited. Hence companies need to be more creative in thinking through how the next deal will make sense in terms of their growth,” says Jeremy Choy, managing director and head of M&A at China Renaissance.

Some companies have formed strategic investment units to search for deals. Meituan-Dianping launched a $440 million fund with a view to expanding its ecosystem in the consumer sector, while online ticketing platform Beijing Weiying Technology set up a corporate VC arm – We Capital – to invest along the media and entertainment value chain. Although each of these affiliates has received backing from third-party investors, industry participants say strategic insight is a higher priority than financial gain.

“It has become a norm for these ‘mini-giants’ to set up corporate investment departments. It’s because they not only face competition from their peers, but also from the BAT. Each one of the BAT has its own investment department and ample cash for acquisitions, so the mini-giants – which have raised a lot of private market funding – have to do the same. That’s the reality,” explains Zhen Zhang, a founding partner at Banyan Capital. The firm exited payments provider Qiandaibao last year when Meituan-Dianping bought the business.

For growth-stage companies that have yet to become the sole leader in their verticals – in certain areas there are still two major protagonists fighting for market share – M&A is increasingly seen as the best route to strategic expansion. This is most obvious in platform-based businesses. For example, Toutiao has invested in multiple video-sharing start-ups and expects this vertical to become a critical component of its business in the future.

“As a company continues to grow, it will expand into new territories. We always tell founders to think ahead – some businesses they haven’t started to develop but will do so in the future. If there are valuable assets available in the areas they want to expand into, it makes sense for them to make investments or acquisitions right now,” says Creation’s Zhou. “However, some companies still have an immature mindset towards M&A, over-emphasizing their core products. This is partly because they haven’t realized they are already big players in their own verticals and it’s time for them to move on.”

This indicates a shift of attitude towards M&A as many VC investors previously preferred entrepreneurs  concentrate on building their core businesses rather than acting like would-be conglomerates and grabbing different assets that are of interest. Smart phone maker Xiaomi is a case in point. Founded in 2000, the company has cultivated an investment portfolio with a view to building a technology ecosystem around its core products. It has invested in at least 20 hardware start-ups, ranging from wearables to air purifier manufacturers, and helps them sell products through the Xiaomi platform.

Most of these have been minority investments, but not all of Xiaomi’s backers appreciated this approach – they wanted the company to spend time and money on making better smart phones. But Xiaomi persevered and subsequently launched Mi Homes, a network of brick-and-mortar retail outlets. These previous investments and alliances means the company can sell a much wider range of products online and offline, says one VC investor who supports Xiaomi’s corporate investment strategy.

“Online traffic is the most attractive selling point to target companies. Players like Xiaomi, Meituan-Dianping, Didi and Toutiao can offer large customer bases to start-ups at an early stage. As the Chinese internet industry has become more competitive, new entrants are willing to sell equity in return for accelerated growth by leveraging these large players’ existing resources,” Banyan’s Zhang says. 

Terms of sale

At present, M&A transactions tend to be relatively small in size. It is worth noting that in many situations, target companies – and their existing VC backers – and acquirers prefer equity to cash, so most deals are structured as share-swaps. The bottom line is incentivizing people: the acquirer wants the target company’s management to continue to work hard and offering them upside by owning equity in the acquirer achieves this.

Some deals also come with call options. For example, when a strategic player offers to buy a controlling stake in a high-growth start-up, VC investors in the target company might suggest the founder sell a minority stake with a call option. This means the strategic player moves to a majority position after two or three years at a higher valuation when the target company’s potential is fully realized.

“The ways of doing M&A have become more diversified, with greater flexibility in deal structures,” says James Mi, co-founder and managing director at Lightspeed China Partners. “Even when the strategic player finally owns 51% stake or more in the target company, it still wants to see the business grow and then go for an independent IPO.”

While acquirers tend to respect the autonomy of target companies, questions are sometimes raised about the effectiveness of post-deal integration. Harsha Basnayake, a managing partner in EY’s Asia transaction advisory services practice, observes that technology players tend to approach investments with a less clear and cohesive development plans than their counterparts in other sectors. As such, it remains to be seen whether the likes of Toutiao can seamlessly bring together dozens of investments under a single platform.

“I expect post-investment integration will become an important task for Chinese tech companies when they get more mature,” Basnayake says. “They will execute more pre-deal exercises such reviewing business synergies between the acquirer and target, rather than just buying them and figuring things out later.”  

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• Topics
• Greater China
• Technology
• Buyouts
• Performance
• China
• TMT
• M&A
• Outbound investment
• Banyan Capital
• China Renaissance
• Lightspeed Venture Partners