China cross-border industrial buyouts: Strategic rationale

When CITIC Capital invested in Stackpole International and Henniges Automotive Holdings, it was not expecting exits to Chinese strategic players. The PE firm's typical approach for international deals has been to identify an asset with an underexploited China angle and then team up with a US-based GP to make the acquisition. If everything went according to plan, the asset would be sold to a multinational keen to boost its China exposure.

Then last August, Canadian auto parts supplier Stackpole - acquired two years earlier in conjunction with Crestview Partners - was acquired by Hong Kong-listed Johnson Electric. The following month majority shareholder Littlejohn & Co. and CITIC sold Henniges to a joint venture between Aviation Industry Corporation of China (AVIC) and BHR Partners, a Chinese PE firm that targets cross-border transactions.

"We did these deals in 2011 and 2012 and we didn't really start seeing Chinese strategics going overseas until 2014 and 2015, so that kind of exit was not something we underwrote on going in," says Boon Chew, a senior managing director at CITIC Capital. "But if you look at the cross-border deals we've done, we self-select ourselves into businesses that have the technology, knowhow and footprint to be relevant to the Chinese market. Chinese strategic investors are looking for the same things."

If you buy a company and half the engineers, floor managers and manufacturing leaders leave, that’s a problem – you just have blueprints and you have to figure out how it is done – Waikay Eik

Given the surge in Chinese M&A globally, the changing identity of the likely buyers for CITIC-backed businesses comes as little surprise. At the same time, these transactions say much about how private equity can tap into this trend as a partner for companies going overseas - two of the bidders for Henniges were Chinese strategics with PE co-investors - and as a seller to them.

A rising tide

Outbound M&A by Chinese companies reached $99.2 billion last year, with 313 deals announced, close to twice the volume seen in 2013 on both counts, according to Mergermarket. Already this year, 49 transactions have been agreed worth a combined $69.6 billion, higher than the full-year figure for 2014 with 10 months still to go.

The industrials sector is playing an increasingly significant role in this deal flow. A total of 71 transactions were announced in 2015, up from 51 the previous year, and the capital committed more than doubled year-on-year to $14.9 billion. In the first two months of 2016 alone, investment stands at $49.1 billion, although one of the 15 deals announced accounts for more than 90% of the total: the proposed acquisition of Switzerland's Syngenta by China National Chemical Corporation (ChemChina), corporate China's largest-ever outbound deal.

"Clearly the government is encouraging the transformation of Chinese manufacturing from labor intensive to more high-value-added through the acquisition of overseas advanced technology companies. And because of this support, companies have access to financing, with a lot of outbound transactions supported by Chinese banks," says John Gu, a partner at KPMG. "A third factor is currency. The consensus view is that the renminbi may devalue over time and so it might make sense to buy a company while the currency is still strong."

The Syngenta deal says everything about these cross-border ambitions. A global leader in agribusiness with $15.1 billion in revenues in 2014, half of which came from emerging markets, it is the stuff of dreams to Chinese corporates: rich in technology and knowhow that can be used to offset the impact of slowing domestic economic growth by carving out a defensible and sustainable market position. However, the transaction also underlines the gulf in ability between best in class and rest of the class in outbound M&A.

Shortly before the Syngenta deal, ChemChina teamed up with Guoxin International Investment Corp. and AGIC Capital to acquire KraussMaffei Group, a Germany-based machinery manufacturer, for EUR925 million ($1.01 billion). It was at the time the largest direct Chinese investment in Europe, topping the EUR738 million Weichai Group paid for a stake in forklift truck maker Kion in 2012.

For those seeking technology, the Mittelstand - small and mid-size companies in Germany, Switzerland and Austria - is a rich hunting ground. But ChemChina and Weichai are the exceptions to the rule in corporate China: strategic investors with the talent to close cross-border deals. Others are not as far along the evolutionary curve.

In Germany particularly, Chinese appetite for Mittelstand exposure is not as enthusiastically reciprocated by the companies themselves. Alberto Forchielli, managing partner at Mandarin Capital Partners, which has participated in numerous Europe-based deals with a China angle, observes that the German M&A market is expensive and highly competitive. This is largely because family owners are not willing sellers.

It is a view echoed by several industry participants, with the addendum that when assets do become available prospective Chinese buyers rarely prevail in competitive situations. Longstanding obstacles such as a reluctance to participate in auction processes - due to fears that deals will become too expensive - and an inability to make quick decisions if they do participate have yet to be overcome. Many Chinese companies also fail to communicate effectively with their targets.

"There is a gap between what they are looking for and what the owners of the European companies are looking for," says one transaction advisor with experience in China and Germany. "A Chinese group might be more interested in capital arrangements where they can arbitrage the difference in P/E (price-to-earnings) ratios between the target and the Chinese stock market. It is difficult to make these approaches work because there is a misalignment of interest."

Value-add opportunity

Successful investments in mid-market family-owned Mittelstand businesses tend to emphasize the strategic angle - starting as minority interests, with a view to building trust and creating a longer-term alignment between investor and investee. While Chinese groups increasingly appreciate these nuances, it has yet to manifest in substantial deal flow.

For AGIC, which stands for Asia-Germany Industrial Promotion Capital, helping Chinese companies get transactions over the line represents a large enough opportunity to justify a dedicated fund. The GP is targeting $1 billion and reached a first close of $550 million last October with China International Capital Corporation (CIC) as an anchor investor.

"A lot of Chinese companies are interested in going to Germany but it's not easy," Henry Cai, chairman of AGIC, told AVCJ after the KraussMaffei deal closed. "First, there is a different culture and investment philosophy. Then you have to deal with German companies' concerns about patent protection and whether the Chinese investor is going to shut all the plants in Germany. We know how to get access in Germany, this is unique knowhow and IP."

The fund will focus on companies specializing in intelligent production and automation, medical equipment and healthcare technologies, and high-end systems and components. Check sizes, for minority and control positions, will be in the $20-100 million range, which suggests AGIC will spend most of its time working with smaller groups than ChemChina on smaller deals than KraussMaffei.

BHR sees itself playing a similar role, as do numerous other middle-market private equity firms in China. However, their value-add is not necessarily limited to sourcing and execution. Post-deal integration is the area in which previous acquisitions have often gone awry. "It is tempting to think that moving up the value chain simply means acquiring technology, but so many things need to happen within a company's manufacturing ecosystem for technology to be adopted effectively," says CITIC's Chew.

When switching in an automated process for one guided by the human hand, the margin for error is very small. Successful integration is contingent on having engineers and line workers who can operate the machinery, as well as upstream suppliers and downstream customers who operate at an equally high level so the costs saved or value created through automation is not lost elsewhere in the chain. A process that works in Germany might not be as effective in China because there is a different mindset.

In certain industries, integration patterns are well established. Waikay Eik, partner and head of the delivering deal value and M&A integration practice for Greater China at PwC, describes a process that begins with careful analysis of where the Chinese company's existing technology trails that of the recently acquired European counterpart. There is a particular emphasis on studying different functions in terms of productivity and cost.

Higher value components continue to be manufactured in Europe, or manufacturing is transferred from China to Europe, where greater productivity offsets a heavier wage burden. Meanwhile, all the lower value manufacturing is relocated to China, taking advantage of economies of scale and relatively lower costs. Throughout this process, people are moving back and forth: Chinese managers will spend at least six months in Europe learning the processes and then European engineers will come to China to ensure the substance of the lessons is being applied. People are the key to exploiting these synergies.

"The value is often deeply embedded in the systems but behind that it is all about people. If you buy a company and half the engineers, floor managers and manufacturing leaders leave, that's a problem - you just have blueprints and you have to figure out how it is done," says Eik. "Quality is all about that intangible element, how you select suppliers, decide how much refinement you want, and how much testing should be done. It is in the culture and the knowhow."

Private equity firms can help instill the required discipline. As financial investors sitting in between strategic players they are well positioned to identify clear paths through bureaucratic and political chaos. This may involve maintaining a stable workforce by convincing each party of the other's merits.

The other side

Equally, they may see integration opportunities that cannot be realized within the typical private equity holding period. "It's nice to think that new technology will bring about a paradigm shift in how these companies operate, but it is probably not going to happen so quickly," says CITIC's Chew. "You are waiting for an ecosystem to catch up and there is nothing a private equity firm can do about that. All you can do is identify which sectors are at an inflection point and which are not."

As such, prior to working with a Chinese corporate on an outbound deal, a private equity firm might carry out as much due diligence on its partner as on the potential target. For some, these arrangements remain a challenge despite the progress made in recent years. CITIC has yet to do this and Chew says it would be considered on two conditions: the partner must be well known and trusted by the GP; and the asset should offer strong strategic value, with clear synergies.

Mandarin Capital has worked with Zoomlion Heavy Industry Science & Technology on a couple of deals but Forchielli says partnerships are rare. "It slows us down," he explains. "Co-investment with Chinese groups is a burdensome process. They say, ‘We can come in,' but then the torture starts. You have to deal with people at the top and further down explaining everything 10 times. In 2008 it would take five meetings and five conference calls. Now it is down to four meetings and four conference calls; it is not one and one."

Although pursuing deals independently and exiting to a Chinese strategic can be just as painful, several GPs have done so successfully with industrial businesses. Stackpole and Henniges are not isolated incidents - if an asset has achieved significant enough scale, it might fall within the scope of the country's more sophisticated outbound investors. Germany is once again a reference point.

Weichai bought its stake in Kion from KKR and Goldman Sachs, while the ChemChina consortium bought KrassMaffei from Onex Corp, the investment group that prevailed over an unnamed Chinese player when purchasing the asset - from another PE owner - nearly four years earlier. And when, a few weeks later, the mantle of China's largest direct investment in Germany changed hands again, as Beijing Enterprises Holding agreed to buy EEW Energy from Waste, the seller was EQT Partners.

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• Topics
• Greater China
• Technology
• Industrials
• Buyouts
• Trade sale
• buyout
• Exit
• manufacturing
• CITIC Capital
• Mandarin Capital Partners
• BHR Partners