Insights | February 28, 2018

Investing with China – Risk and Reward in China Related M&A, part II

Given the popularity of the recent Chinese investment track and the mosaic of options on the investment market in China, there is no doubt that the Chinese economy will be one to look out for the upcoming years. China’s urbanization is the main contributing factor to the Chinese success over the past two decades. China is home to almost 20% of the world’s population, and if that population continues to urbanize another 20 years or more as expected, a lot needs to happen, inter alia, growth in services, commerce, know-how and infrastructure. The investment opportunities are extensive and the amount of ongoing projects plentiful.

The new “Silk Road”

In connection with China’s increasing foreign investments, China is working on different projects to further increase its economic might. The “One Belt, One Road” initiative chiefly along the ancient trade route was first proposed by Chinese President Xi Jinping in 2013. The plan is to integrate 65 countries from East Asia to Western Europe through an approximately USD 900 billion investment in railways, roads and harbors to further increase trade with China and facilitate global investments by strengthening the link between the country and the rest of the world. The modernized “silk road” is intended to connect all the way to Finland through Russia, which several Finnish companies are predicted to benefit from.

There are also smaller projects linked to the extensive Belt and Road project such as the planned underground train connection from Helsinki-Vantaa Airport to Tallinn, which could be financed by Chinese investors. Among the most important factors behind the Chinese interest are the good airway connections from China and the rest of Asia to Helsinki-Vantaa Airport, which would perhaps also be connected to Baltia and Poland through the Rail Baltica railway project if the Tallinn tunnel project gets completed. Today Finland mostly exports via shipping (approximately 80%), however, this number will presumably change as the Belt and Road initiative and thereto linked connections develop.

Ghost towns and zombie companies

Other Chinese projects creating investment opportunities attribute to the creation of new cities, in essentially greenfield sites marked for industrial projects and commercial development, often however in the periphery of a more established area. The Xiong’an New Area, Zhengzhou and Kangbashi are examples to name a few. In some cases, these new cities are built to the point of near completion before introducing the inhabitants, and consequently get called “ghost towns” during the empty interim period between finalization of the constructions and the introduction of people. Naturally, the rapid establishment of new cities, which are predominantly medium-sized cities but in some cases intended for even more than 10 million inhabitants, sets ground for favorable circumstances for investments considering the unsaturated need for both services and products in the areas.

However, there are also certain risks to consider when investing in such projects and in Chinese targets in general. The possible consequences arising from the unstable regulatory environment and the unpredictable decision making process in China is one – plans may turn around unexpectedly as Chinese leaders or governmental policies change. Further, the needs of the newly developed areas may not end up corresponding to those estimated when placing the investments as it impossible to know in advance how the new city will turn out, if at all.

Additionally, when evaluating potential investment targets in China from an M&A perspective, it is wise to notice so called “zombie companies”, meaning enterprises that incur recurring losses but in fact rely on the support of state banks and the government. Chinese authorities are likely to favor mergers between weak companies with economically stronger ones as an alternative to bankruptcy. Since the tightened credit conditions and rising policy attention in the late 2016, Chinese authorities have become more willing to abandon unprofitable state-owned companies to improve the insolvency framework, and to allow the market forces to determine bankruptcies to a greater extent. The number of bankruptcies are likely to continue increasing in China over the next few years, however, in particular within sectors in need of restructuring, China is reluctant as regards insolvency of large enterprises compared to other large economies.

Advising clients in China related deals

Clients often have a number of concerns when transacting with business partners from a jurisdiction with divergent regulatory and administrative environment, generally stemming from their limited experience from such transactions. A detailed analysis of all aspects to consider is beyond the scope of this article, however, when advising Chinese and Finnish clients in M&A deals relating to China, there are some key considerations to assess, which are likely to increase the success rate of the transactions:

Investors to be prepared to pay “China premium”. The regulatory environment in China results in increased uncertainty as to whether cross-border transactions with Chinese buyers will be executed as planned. Consequently, investors are often required to provide comfort in the form of higher consideration or other more creative options to secure their bidding position (such as escrow arrangements and reverse break-up fees).
Sources of funds readily available outside mainland China. Generally, overseas-listed companies and companies with other funds than RMB and/or overseas financing will have an advantage as M&A buyers. Many Chinese companies have, for example, used their foreign subsidiaries to buy or borrow RMB in Hong Kong, New York, London, and elsewhere outside the authority of the Chinese banks.
Consider local co-investors (such as pension institutions) in order to increase trustworthiness and acceptance of the investment.
Acceptance of limited protection in the transaction documentation and awareness of warranty and indemnity insurance and other singularities from the other juristiction. For example, there are certain differences between the types of securities available in China and in the Nordics (warrants, options and other convertible instruments) and Nordic banks are strict with their “know your customer” (KYC) requirements. Notwithstanding the accelerated M&A tempo among Chinese investors, in most cases Chinese companies have a shorter track record of M&A execution than the Finnish counterpart. Parties with experience and knowledge are more likely to increase the success rate of closing M&A deals.
Proposal for management incentive package available. Typically, Chinese buyers prefer to retain the management team of the target as they appreciate that they will be more accustomed with the European market. Further, consistent with Chinese culture, relationship building with the management during and/or already before the transaction is of high importance.
Clear plan for deal and tax structure, division of equity and debt and an exit plan to be agreed on with the management and co-investors at an early stage of the transaction. Generally, Chinese buyers require a longer time, up to six months, to prepare for auctions than Western ones which usually need one to two months.

Article sources can be found here.

To read part I click here.