China cross-border deals: Inside out and outside in

Brice de Morandiere was looking for a new challenge. After a 13-year career with French safety equipment manufacturer Sperian Protection Group, the last five as CEO, he had just seen the company sold to Honeywell and didn't fancy life as the division head of a conglomerate. In September 2011 De La Morandière duly became CEO of Hyva Holdings, a market leader in hydraulic cylinders.

"I was looking for a group that was very industrial and growing. I also wanted to help shape a company culture," he says. "Hyva was one of the best options for me because it's a company of European origin but with 80% of its business outside of Western Europe."

Six months before his appointment, Hyva was acquired by Unitas Capital and a subsidiary of Hong Kong-based New World Holdings for EUR525 million ($695 million).

Asia already accounted for more than two thirds of Hyva's sales but Unitas felt the company wasn't fulfilling its potential. The solution wasn't just overhauling supply chains, marketing, R&D and human resources, but bringing about a fundamental shift in how Hyva engaged with its fastest-growing pool of customers. This involved relocating senior management, including the CEO, to a new corporate office in Hong Kong.

Tasked with coordinating commercial hubs that are nearly 6,000 miles apart - Hyva's other corporate office is in the Netherlands - plus outposts scattered across Europe, Latin America and Asia, De La Morandière had the cultural integration challenge he so desired.

"Not that many companies have dual corporate offices and even fewer set up one of those offices in Asia," he says. "We are a Dutch company with executives from everywhere else. If you want to establish yourself in internationally you need to put in place good processes, but you must also ensure collaboration between different countries. The biggest issue is getting people to talk to one another."

The new world

These challenges are not new to multinationals, particularly in China. WTO accession in 2001, followed by a decade of double-digit economic growth, turned the country into a global priority: a scale market, offering low-cost manufacturing and then nascent consumer classes, was truly open for business. There were teething troubles, but China now accounts for 25% of global automakers' sales and one in four personal luxury goods purchases; Yum Brands, owner of KFC, relies on China for half its operating profit and Starbucks expects the country to become its second-largest market within two years.

But what of those outside the Fortune 500, that have neither the international reach nor the substantial resources of Volkswagen or LVMH?

"A lot of large corporations have been in China for a long time but for most mid-market players it has only become a strategic market in the last 2-3 years," says André Loesekrug-Pietri, chairman and managing partner at A Capital, a Sino-European private equity firm. "What used to be a niche strategy is now a core strategy."

Generally speaking, the smaller the company, the harder it is to build meaningful exposure. For those needing to revitalize their financial statements in the face of difficult developed markets, a successful China strategy could be a make-or-break issue. Private equity firms of all stripes are happy to help out; and when it works, the pay-off is considerable.

In a deal brokered by A Capital, Fosun Group acquired a 7.1% stake in France-based vacation resorts provider Club Med two-and-a-half years ago and has helped provide new direction for a business that was being squeezed in Europe. Club Med has opened two properties in China and seen Chinese customer numbers globally increase by about 40% in both 2010 and 2011.

CITIC Capital has been working on these kinds of deals for more than a decade and so has a few full exits to show for its labors. In 2005, the PE firm acquired Lincoln Industrial, a St Louis-based producer of lubricants used in machinery generating $1 million a year from China. Five years later, the company was racking up China sales of $1 million per month and CITIC Capital sold the business to Sweden's SKF for $1 billion, realizing a 10x money multiple.

"The right buyers tend to be strategic investors," says Brian Doyle, managing partner at the private equity firm. "We have found that, if you can accelerate the China growth, global strategics will pay a premium for China growth, all other revenues being equal."

CITIC Capital concentrates on companies in the US and Japan that have a China angle, and is only interested in control deals. Other investors have their own strategies. Diverso Management, for example, specifically targets European small- and medium-sized enterprises in possession of technologies for which China is potentially the largest global market. Unitas is buyout-focused but with a pan-Asia mandate. John Lewis, the PE firm's CIO, describes the classic target as a leading middle-market industrial company with up to $1 billion in sales and a differentiated product offering, yet lacking the full suite of capabilities to be successful globally and in Asia.

Mixed bag

Taking these approaches into account, the range of deals targeted is huge and it means that broad data streams offer few pointers. AVCJ Research has records of $6.3 billion in European buyouts completed in 2012 by Asia-focused private equity firms; for the US, the total is $11.5 billion. It is very difficult to break down transactions into sub-categories because they come in all shapes and sizes; and the numbers don't even reflect acquisitions made by European and US private equity firms that are also wholly or partly driven by a need for a China strategy.

However, virtually every potential investee already has a degree of exposure to China, or the private equity pitch would mean little. In many cases, companies have grown frustrated at trying to manage operations from overseas in a commercial environment they don't fully understand.

"They have already skinned their knees in China - and the more challenges they encounter the more they realize it would be better to have an owner based in China who can help solve many of their problems," says Doyle. "The previous owner might be 10,000 miles away and have limited resources to help in China, but we are based in Shanghai.
At this point there aren't a lot of issues we haven't seen so we aren't going to be shocked if the management team comes to us and are open about the challenges they are facing in China, whereas a US-based PE fund might not be as understanding."

On-the-ground experience also offers an awareness of the problems these companies might be facing. Sit down with an electronics business that has a joint venture manufacturing operation in China and a natural conversation point is the impact of rising labor costs and what this means for factory locations. Has the company considered shifting its production inland, moving from the Pearl River Delta to the outskirts of Chongqing municipality? And, if so, what is it doing about the accompanying headaches, such as employee retention and relations with local customs departments?

Another consideration is whether a joint venture is appropriate for the business in the first place. As part of one of CITIC Capital's investments, it worked with company management to rip up the joint venture agreement because the business was underperforming and established a wholly-owned subsidiary in its place.

"People are struggling to find the right strategy to address China. Going alone is tough, but going with a partner through a traditional joint venture model sometimes doesn't work either," adds A Capital's Loesekrug-Pietri.

While the majority of Sino-foreign joint ventures operate smoothly, horror stories inevitably capture headlines, and they can usually be traced back to a misalignment of interest. The apocryphal tale of the foreign executive who takes a wrong turn on the way to the factory one day and finds a facility in the neighboring valley at which his JV partner is manufacturing copycat products is closer to the truth than some would care to admit.

By bringing in a Chinese partner at the corporate level - as an investee in the Western company alongside a Sino-Western investor - it is more likely that all parties will move in the same direction. Much the same applies when the foreign player is selling into China, and requires local assistance with distribution and marketing. One option is to use a licensee but if they perform well and establish a market for the brand, the owner might opt against renewing the agreement and sell directly.

Loesekrug-Pietri argues that becoming the co-owner of a brand is the natural outcome for a significant local distributor. This underpinned A Capital's approach to deals involving Club Med and Danish electronics brand Bang &Olufson (B&O). Fosun was invited to partner Club Med because it could offer expertise in constructing new resorts and expanding the domestic customer base.

With B&O, the priority was finding a distributor with a strong grounding in luxury goods. Sparkle Roll, a China licensee for brands including Bentley and Rolls-Royce, teamed up with A Capital last year to buy a 7.71% stake in the company for $30 million. It is estimated that the partnership with an established player like Sparkle Roll has saved B&O 2-3 years of challenging work building its own core group of customers in China.

Clearly, approaches must be tailored to the needs of the companies involved, and private equity investors with an ear to the ground are well positioned to facilitate the creation or termination of local partnerships as they see fit.

Cinven found itself in an unhappy licensing arrangement with its portfolio company Phadia, an in vitro allergy diagnostics specialist based in Sweden that relied on intermediaries to manage its Asia distribution. Supported by the private equity firm's Hong Kong office, opened in 2009 to help portfolio companies expand their presence in the region, Phadia took back distributorships in Taiwan and Korea, and bought out a distributor in China. The company was sold to Thermo Fisher for EUR2.47 billion in 2011, securing Cinven a EUR1 billion profit.

"This would never have happened if it wasn't for the office in Hong Kong," says Joseph Wan, the operating partner who opened the office. He adds that the same applies to Avio, an Italian aircraft components manufacturer with no presence in China whatsoever until Cinven helped set up sourcing agreements and identify a local joint venture partner.

Who's secret sauce?

Cinven isn't the only European private equity firm seeking to launch or re-launch portfolio companies in Asia. Terra Firma opened an office in Beijing in 2011 and admits that its Asia capabilities now form part of the pitch made to prospective targets. Part of the investment thesis for acquiring UK-based elderly and specialist care provider Four Seasons Health Care last year was that the Beijing team could help the company establish a China sales network and identify a suitable local partner.

With European players joining pan-Asian and China-focused private equity investors in the hunt for assets that can be revitalized by boosting China exposure, this begs the question of who is able to execute the strategy most effectively.

The general consensus is that successful investors must have one foot in each camp, China and overseas. A pure US or European PE firm will have the domestic resources to unearth suitable investee companies, but is it able to deliver on pre-acquisition promises? Without experienced professionals in China, finding optimal locations, hiring staff and managing supply chains might prove difficult. Even financing a deal could be problematic.

There is also the risk that existing local management teams will lose faith in their new owners. It is not uncommon for executives who want to stay with the company post-transaction to lobby on behalf of a particular buyer. CITIC Capital prevailed in one deal despite submitting the fourth-highest bid because the owner took into account the management team's view.

As A Capital's Loesekrug-Pietri puts it, "There are some great private equity firms in Europe but most of them have no idea about China and how to engage with investors in China."

The flip side of the argument is a China- or Asia-focused PE firm with minimal operating experience overseas. It may struggle to identify targets properly and end up paying over the odds for poor assets or fail to appreciate the regulatory or practical nuances of individual markets, leading to problems after a deal closes.

When CVC Capital Partners and Standard Chartered Private Equity acquired what became fastener manufacturer Infastech in 2010, they actually took on two separate divisions of a larger company, Acument Global Technologies. One division supplied nuts, bolts and screws to the Asia electronics sector; the other was a London-based rivets producer for the European auto industry. Not only did the PE firms consolidate operations into a single distribution platform, they also had to address pension issues within the UK division. This would have been difficult without competencies in Europe as well as Asia.
If Cinven's call sheets are anything to go by, plenty of Asian and Chinese private equity firms are trying to address these shortcomings by forging partnerships with European and North American peers.

Tony Wang, a partner with Weil in Shanghai, expects Chinese managers to become more sophisticated, but in the meantime these players are likely to spend more of their time looking at deals closer to home. "While they may still look at deals coming from the West, there is an opportunity cost tied to doing this, so naturally, they will spend more time looking at deals within Asia," he says.

This certainly appears to be true of Hony Capital's initial forays into the cross-border space. Speaking to AVCJ last year, CEO John Zhao said the firm had completed 5-6 of these deals involving overseas companies that required assistance in China and had more in the pipeline. One of the first was a $134 million investment in Biosensors International, a medical devices manufacturer based in Singapore.

Transition time

As China becomes a more integral part of the global economy, there will be no shortage of Western mid-cap companies willing to sacrifice equity ownership in return for a viable market entry strategy. Around half of Unitas' deal flow now is companies that are not based in Asia but have aspirations to grow in Asia, either coming directly or through intermediaries. More than one third of A Capital's deal flow across the industrial, consumer and services sectors originates from CEOs or controlling shareholders reaching out to the private equity firm.

It remains to be seen whether a larger number of PE firms - Chinese or Western - will manage to bridge the gap between these worlds and challenge the incumbents. The transition they must make from a homogenous culture to one that is more diversified and geographically dispersed is not unlike that facing the portfolio companies themselves.

"The company's leadership needs to be able to relate to different cultures," says Unitas' Lewis. "We have a number of people that have run businesses and have gone through the same experience, and they can offer some insights and practical advice."

Hyva CEO De La Morandière offers similar sentiments, viewed through an operational lens. "Unitas recruited me because we are of the same breed. I know a lot of PE firms and even the bigger ones are often regional in nature. Unitas is also regional but they have global people. In that respect it's easier for me because they understand what I am implementing and who I am recruiting."

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• Topics
• Greater China
• China
• CITIC Capital
• A Capital Asia
• CVC Capital Partners
• Outbound investment
• Hony Capital