Second coming? China’s M&A market rebounds

While debate – and real concern – continues in the US and Europe as to whether the stimulus-induced recovery will prove to be V-shaped, W-shaped or L-shaped, Chinese people on average do not share these worries, according to Anthony Root, long-serving managing partner of international law firm Milbank Tweed Hadley McCloy LLP’s office in Hong Kong.

“The operating assumption out here is that we’re in a V-shaped recovery, period.”

And Glen Maguire, chief economist – Asia with Société Générale, adds:

“Chinese banks tend not to be impaired. So the recovery has become embedded. Meaning we are likely to see household spending start to recover.”

A new domestic dynamic

That’s key, because while various industry players and observers surveyed by AVCJ all refer to a marked strengthening of M&A markets as a whole in China, including the private equity segment, they likewise note a decidedly different dynamic in play this time around; namely that activity is predominantly domestic-led.

Of course, the massive stimulus applied in China, as in the West, is still masking the real market underpinnings of demand. But unlike the West, where demand is palpably weak overall, in China and indeed Asia in general, there is real pent-up demand.

Maguire cites the auto sector as a prime example.

“There has been a real surge in auto market demand. It’s an extremely hefty figure. China’s auto sales are absorbing the capacity not just of the Asian supply chain, but a healthy percentage of the global supply chain as well.”

Many commentators have been saying for some time that it is essential that China drive a demand shift into the domestic market and away, for the time being at least, the slumping export sector. And Maguire sees this as effectively underway.

“The policy response was to hold the yuan steady,” he explains. “And one of our essential scenarios of 2010 was that it move its economy into trade deficit.”

The investment contribution to economic growth in 1Q09 was 95%, whereas consumption’s share had slipped to a pallid 35%. But that is proving temporary as China has ramped up its lending to multi-year infrastructure projects.

“We believe that China will be successful in adjusting this balance and, as a result, the economy will move into trade deficit.”

His colleague, Stephen Gallagher, chief economist-US at Société Générale, agrees:

“The infrastructure spending going on now in China is huge, and very significant in fostering domestic consumption.”

On the deal front

Obviously this has knock-on ramifications for the Chinese deal market, though based strictly on AVCJ data as of the end of 2009, one couldn’t characterize it as dramatic. Still the tips of some new and interesting icebergs are evident in it.

In basic terms, the number of M&A transactions executed in China in 2009 (1,141) was roughly the same as 2006 (1,440), which was itself a 56% rise over 2005 (819). But there is a real difference in terms of comparative value. In 2009, aggregate deal value was pegged at $98 billion, which was admittedly a nearly 20% drop from 2009 when the all-time high of $119.4 billion via 1,853 deals was recorded. But in 2006, the same number of deals churned only $56.4 billion of value.

David Brown, China transactions partner at PricewaterhouseCoopers, largely reflects our numbers, but with a twist on the outbound side looking immediately ahead:

“On the domestic and inbound front, deal activity has returned to 2007-08 levels. But what we saw in this global recession was a sudden, sharp downturn. After this, however, it came back very quickly."

Outbound: the sky’s the limit

“On the outbound side, moreover, we’ve seen more than 50% growth, particularly in the second half of the year (2009)."

Milbank Tweed’s Anthony Root agrees, noting a sharp uptick in the last half of 2009 – but also the paucity of inbound strategic transactions.

He too is very bullish on the outbound segment, adding some detail:

“Outbound is massive. And the state-owned enterprises (SOEs) are gearing up multiple billions of dollars of investment around the world for a variety of purposes,” he contends. “To secure natural resources [has been a main motive for years]; but also as an instrument of state policy, to enhance relations with other emerging market countries, to acquire branding – very important to a prestige-conscious middle class – and to enhance returns.”

The latter grows particularly out of the fact that SOEs are capped as a political matter as to the kinds of returns they can get in China, because their original raison d’etre was to provide a variety of social services. And in the minds of many Chinese people, that’s still important. So the government is sensitive about any indication that they are profiteering on the backs of the people.

If they go offshore, however, they can achieve returns more in line with international norms.

David Brown adds that, in the domestic and inbound grouping, 80% of the transactions have been China-China domestic deals. And while domestic being the biggest segment of an M&A market is quite normal, it’s domination in China is extraordinary.

This is reflected, for example, in the top 20 PRC M&A deals of 2009, in which only three foreign companies figured as acquirers.

Big foreign buy-ins rare

Leading the way was Canada-based Eldorado Gold Corp’s completion in December of a 100% purchase of Sino Gold Mining Ltd for some $1.8 billion. This was shortly preceded by Banca Bilbao Vizcaya Argentaria (BBVA) of Spain expanding its shareholding in China CITIC Bank Corp by 4.93% for a total of 15% at a cost of $1.49 billion; and world number three heavy duty truck manufacturer MAN SE of Germany shelled out $827 million for a 25% stake in Hong Kong-listed Sinotruk (China’s largest heavy duty truck group); the motive, in terms of global markets, is obvious.

According to AVCJ data, however, Chinese companies invested $30.4 billion offshore in 2009 (via 150 deals), compared to $64.9 billion (via 135 deals) in 2008.

Foreign company investments into the PRC were off by a little less than a third, to $25.9 billion in 2009 vs $35.4 billion in 2008. But PRC company investments in China were likewise off to $71.4 billion in 2009 versus $84 billion (over 1,168 deals) in 2008.

Of particular interest was the sell down of stakes in Chinese banks by their western counterparts suddenly beset with pressing problems at home: Bank of America, Royal Bank of Scotland, Allianz AG, American Express and Goldman Sachs all divested stakes in China Construction Bank (CCB), Bank of China (BoC) and Industrial & Commercial Bank of China, to undisclosed buyers.

On the other hand, a bright spot for the foreign segment – though as all point out, this is a very small percentage of the overall PRC market – was buyout firm TPG Capital’s June announcement that it would sell the 17% control stake in then-basket case Shenzhen Development Bank that it managed to get around the restrictive regulations and acquire for $155 million back in 2004. Chinese insurance giant Ping An will pay a reported $1.68 billion.

The private equity perspective

This leads us to the private equity situation within the broader M&A market. Here too there have been significant changes, in market makeup and the growing focus on onshore deals to name just two.

According to PwC’s David Brown, prospects for international private equity players have become somewhat limited although bright pockets remain:

“Among financial buyers generally, the deal numbers have stayed fairly level,” he told AVCJ. “But again, the segment has been dominated by domestic buyers.”

One reason is that foreign-linked private equity activity has dropped sharply. Partly that’s due to a stubborn pricing gap:

“They just haven’t been able to snap up the sellers,” he explains. “The latter haven’t been prepared to reduce their expectations as dramatically as was expected. In many cases they were able to hold on and ride this out.”

As a result, the international private equity houses are re-focusing their China strategies. And as a consequence there is growing interest in RMB funds. But despite this difficulty in sourcing deals – which some, like Kohlberg Kravis Roberts and perhaps Warburg Pincus are overcoming – there are some interesting possibilities in various pipelines, Brown contends.

Drilling down into resurgent PRC domestics

Among domestic private equity firms, he anticipates strong growth throughout 2010 in virtually all major sectors, and in particular in outbound activity. But the growth story evident in Chinese consumer area and green technology look especially attractive. Real estate too. “And there are always deals in financial services,” he notes wryly.

Private equity work is very much a sweet spot for law firm Milbank Tweed, and Anthony Root offers a psychological insight into the vigor Brown has noted:

“I think it’s a self-evident proposition that the Chinese are all about acquiring wealth for the Chinese,” he explains. “They’ve long seen and envied the private equity wealth that has been generated in the western world, and they have every intention of replicating it in China. So I think in time that the RMB funds will become incredibly competitive with the international funds.”

Thus, a primary way forward for the latter, he believes, is either to team up with their domestic counterparts or to co-invest with them.

The art of the deal

Which brings up the end point for this overview; that ultimately an ‘us’ and ‘them’ mindset is counterproductive because the best deals can have compelling symmetry for both Chinese and international interests. This will be a factor in driving private equity activity to higher heights in China in 2010 Root and Brown both believe.

First, there is early anecdotal evidence that the price expectation log jam is becoming unstuck. But more importantly…

“There is always going to be a variety of reasons for people to want to do deals.”

Thus, while new money (from the internationals) may be mostly lacking at the moment, there is a great deal of preparatory work going into the harvesting of exits from earlier investments:

“The second half of last year and evident at present in 2010 is the emphasis on portfolio management in a variety of ways, such as restructuring, re-financing, perhaps making additional acquisitions, fixing up stock option arrangements and so on: housekeeping in a word, the aim being to better position for an IPO,” Root explains.

“Another part is selling down to other private equity firms trying to get in, ie monetizing a position in expectation of an IPO to protect gains.”

As an example, if the investor got in three to four years ago, they’re probably up about 200% on their investment outlay. They might make 400% on an IPO, but current thinking – laced now with plenty of caution – can be more like deciding to sell a third of the positions and take the 200% profit, meaning getting the original investment out. This eliminates any losses if for any reason the IPO fails to materialize.

From the Chinese perspective, money issues aside, deal motivators can include Chinese entrepreneurs with global ambitions seeing the advantages of partnering with a global private equity house, or positioning themselves for international listings.

As for long-standing concerns re: capital repatriation, Root points out that if invested side-by-side with an RMB fund in a PRC company that wants a blend of domestic and foreign investment, there’s no restriction on repatriation of invested capital. And said foreign investor can also repatriate capital gains and dividends, though subject to a withholding tax.

That said, Root doesn’t expect a rush of LPs suddenly investing in RMB funds at present, partly because PRC stock markets remain closed for all practical purposes to foreign investors.

What has disappeared, however, are the structured pre-IPO private finance deals, PIPEs and “…all that other structured paper that people thought was debt, but was in fact more like ‘subordinated equity’: that was all the hedge funds and prop desks of the investment banks, and it’s just gone.”

For at least six months, he adds.

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Greater China
• Buyouts
• Restructuring
• KKR
• Warburg Pincus Asia