Survival of the fittest: China's internet giants go toe to toe

Alibaba Group's M&A binge of 2012 offers a distorted picture of acquisitions by Chinese internet companies. The e-commerce behemoth first completed a $2.5 billion take-private of B2B trading platform Alibaba.com in June, then bought back a 20% stake in itself from Yahoo for a further $7.6 billion in September. Public debt and private equity providers basked in a summer of plenty that is unlikely to be repeated.

Exclude these transactions and M&A activity by China's BATS - internet giants Baidu, Alibaba, Tencent Holdings and Sina - amounted to a more modest $631 million across 20 deals, according to AVCJ Research. It was down on the previous year's total of $1.5 billion but this isn't enough to shake an overriding trend: the BATS are spending more than ever before.

"It's good and bad," says J.P. Gan, managing partner at Qiming Venture Partners. "The good thing is that we have another channel for exits, in addition to overseas listings. The bad thing is that some of our companies might not become multi-billion-dollar operations because someone comes in early and a few of the VCs or the entrepreneurs want to sell out."
Last week Qiming exited PPS when Baidu bought the company's online video business for $370 million. Ceyuan Ventures led the Series A round and Qiming came in for Series B, investing $8 million in total. It is looking at a10x return. 

Gaining momentum

Between 2001 and 2009, the BATS completed less than 30 deals worth $775 million. Since 2010, the deal count has soared to nearly 80, with $4.5 billion deployed, although the values for some of these transactions haven't been disclosed. Tencent is the most active investor with 38 deals during the period. This week Alibaba became the biggest spender, paying $294 million for a 28% stake in digital mapping company AutoNavi, taking its total commitments past $1.9 billion.

The driving force behind acquisitions is a combination of financial and strategic. "They are cash rich and under a lot of shareholder pressure to deploy capital," says Bob Partridge, managing partner for transaction advisory services at Ernst & Young. "They also want to diversify their portfolios and in certain cases leverage their existing customer bases."

By year-end 2012, Baidu had RMB34.7 billion ($5.6 billion) in current assets, of which RMB32.5 billion was in cash and short-form investments. Tencent's overall figure was a bit higher, although it had slightly less in easily accessible assets. Sina, meanwhile, had $885.3 million, with $713.6 million in cash and short-term investments.

"You just have to look at how their businesses have grown in scale in the last five years," adds Jon Parker, transaction services partner with KPMG China. "The motivation for them to do inorganic growth is because they have other revenue streams that help cover the costs. This allows them to focus on areas they think will be growth areas in the future."

The investments completed in the past week suggest as much. Baidu CEO Robin Li's comments in the first quarter earnings report offer a neat snapshot of where the company wants to go, and the acquisition of PPS' online video business ticks a few boxes. Li highlighted investment in mobile platforms - Baidu's search engine success has been built on PCs, but it is now responding to rising smart phone usage - and the need to integrate search with verticals such as e-commerce and location-based services.

The company already has an advertising-supported online television and movie portal - iQiyi - but incorporating PPS' business into this will create China's largest online video platform by number of mobile users and video viewing time. PPS has a much larger customer base than iQiyi, with 30 million active users each day. It also operates under a person-to-person client software model, which means the bandwidth costs are much lower than for web-based video streamed from server to user.

"PPS is the largest market participant in terms of user base and mobile devices," says Qiming's Gan. "Everyone is shifting from PC to mobile devices and Baidu has been criticized for not having a big enough presence in the mobile space. So has Alibaba."

The investment in AutoNavi, meanwhile, includes a partnership agreement with Alibaba subsidiaries Taobao and Tmall to develop location-based e-commerce opportunities. These enable advertisers to target customers individually, based on location and preferences.

Another recent Alibaba investment, the purchase of an 18% stake in Sina-owned Chinese Twitter clone Weibo for $586 million, offers a foothold in mobile-enabled social media, treading on territory dominated by Tencent. At the same time, Tencent's recent M&A activity suggests intent to breach

Alibaba's e-commerce hegemony. Of the last 10 Tencent deals for which AVCJ Research has records, five have involved mobile software and systems and four were focused on e-commerce.

Darwinian theory

What this alludes to is that the BATS aren't just in acquisitive mode to develop broader platforms for themselves; they want to do it at the expense of one another. "There is an inherent level of competition amongst the largest players to expand the depth and breadth of their platforms," says Thomas Chou, partner and co-head of Morrison & Foerster's Asia private equity practice. "In some respects, it appears that an internet arms' race is underway.

This offers some context for the competitive tensions that exit between these companies. Qihoo 360, which shot to prominence by offering free-to-download antivirus software, has added itself to the mix in recent years and wants to move into search and social media. A dispute between Qihoo and Tencent ended up in an antitrust lawsuit while the government stepped in last year to mediate a search engine spat emanating from Baidu and Qihoo.
As long as these firms have firepower, they will pursue M&A opportunities, and there should be no shortage of targets. "When you look at the stagnant IPO markets there are a lot of different companies for whom a listing opportunity isn't coming as quickly as expected," says KPMG's Parker. "A number of these on the TMT side will be of interest to the big guys, particularly as the PE backers are looking to cash out."

If the relatively brief history of China's internet history has taught us anything, it is that the superpowers of today won't necessarily dominate tomorrow. But the incumbents are trying their best to build broader and more sustainable businesses. Transactions involving Sohu search engine Sogou (with interest from Qihoo, Tencent and Baidu) and mobile browser UCWeb (supposed to be a lock-up for Alibaba) are rumored to be next out of the pipeline.

In this hyper-competitive environment, check sizes are set to carry on rising. "We are already seeing companies valued in the hundreds of millions," says Qiming's Gan. "We will see more deals done closer to the $1 billion mark. And that's cash, which is very important for us VCs."

SIDEBAR: Potential obstacles

Alibaba Group is set to become the single largest shareholder in AutoNavi Holdings, a NASDAQ-listed Chinese digital mapping company, after agreeing to buy a 28% stake. But what are the chances of the deal triggering a review under the Anti-Monopoly Law (AML), perhaps even at the instigation of one of its rivals?

An AML filing is required if the two parties involved in the transaction have aggregate global sales revenues in excess of RMB10 billion ($1.4 billion) during the previous fiscal year, or aggregate China sales of at least RMB2 billion. Alibaba and AutoNavi appear to cross this threshold. It could be argued that this is a minority deal with no change of control but the Ministry of Commerce (MofCom) doesn't necessarily wave through such transactions.

At issue is the variable interest entity (VIE) structure used by many Chinese internet companies to work around the fact that offshore investors aren't allowed to have direct ownership of certain operating licenses in the sector. MofCom is generally unwilling to conduct AML reviews of deals that involve VIEs.
"This is an issue transaction parties are acutely aware of," says Miranda So, a partner at Davis Polk. "Each situation needs to be evaluated on its own facts to determine if AML review will be triggered and if there are alternative ways to structure a deal to achieve the parties' commercial objectives."

So advised on Baidu's recent acquisition of VC-backed PPS' online video business and is restricted from commenting on the specifics of the transaction. However, other industry participants suggest that Baidu only took the online video assets - and not the online gaming business through which PPS monetizes its video user base - due to concerns about a potential AML review.

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• Topics
• Greater China
• Technology
• Venture
• China
• TMT
• M&A
• Venture
• buyout
• Qiming Venture Partners