Selected Research > Overseas, uninformed
from China Economic Review on 9 July 2010 http://www.chinaeconomicreview.com
Chinese outbound investors are wary of paying investment consultancies, but cultural misunderstandings still stand in the way of successful deals.
In July of last year, US newspaper The Onion was acquired by the Yu Wan Mei corporation. The acquisition was first venture abroad for the Sichuanese fish product conglomerate. Its lack of experience showed: The first issue produced by the new editorial team exhibited an obnoxious mixture of nationalist propaganda, patronising lectures on social responsibility and blatant product placement.
"According to all sources, the People's Republic of China is strong," began one report. "The nation is united, the military unmatched, the economy vibrant, and the people ever joyful." The opinion section featured articles with titles like "How Can We Be More Productive To Society?" and "American Children Like Me Are Lazy And Insolent And Must Try Harder." And nearly every article included an awkward pitch for a Yu Wan Mei product: "The American masses seem unable to deny the assertion that any time is excellent for ingesting fine fish-based foodstuffs from Yu Wan Mei."
The issue was hilarious because it was intended to be: The Onion is a satirical newspaper that only publishes spoof articles, and Yu Wan Mei does not exist. But in depicting Chinese outbound investors as simultaneously threatening and buffoonish, the satire touched a nerve. Several weeks before the issue went to print, the Chinese government had arrested negotiators for Australian miner Rio Tinto in what some considered retaliation for the rejection of Chinalco's acquisition bid by Rio shareholders. A month prior, General Motors announced it had signed a memorandum of understanding to sell its Hummer brand Sichuan Tengzhong, a company with no experience making passenger automobiles. In context, the Onion acquisition spoof was over the top, but realistic enough to sting.
The depiction of a Chinese firm clumsily acquiring a foreign company in a market it barely understood rings true for many foreign investment consultants who have been waiting for Chinese outbound investors to call on them for help. In the Onion spoof, Yu Wan Mei quickly regretted its decision: "Why Did No One Inform Us Of The Imminent Death Of The American Newspaper Industry?" read the headline announcing the company's intention to offload its new subsidiary. "Great shame must now consume those who did not open their lips before our dealings were done, and allowed the industrious and cherished Yu Wan Mei Group to sink itself like a granite stone." But were Yu Wan Mei a genuine Chinese corporation, in all likelihood it would not have sought advice in the first place.
Free beer tomorrow: when Premier Jiang Zemin formally promulgated the "Going Outward" policy at the 16th Party Plenum in 2002, some predicted a wave of Chinese investment similar to that unleashed by Japanese firms in the 80s would pour into foreign markets.
Advisory firms were excited by the potential of earning huge fees on a surge in outbound acquisitions. At present, China only invests a small portion of its GDP abroad. According to a 2009 report by the United Nations Committee on Trade and Development (UNCTAD), Chinese outward direct investment (ODI) comprised only 3.4 percent of its GDP in 2008. By comparison the average developing nation put 14 percent of its GDP into overseas direct investments that year. Had China invested outward at the developing economy standard, it would have ploughed EUR174 billion into foreign assets in 2008, instead of the EUR41.3 billion it actually spent. Assuming a fee-to-deal value ratio of 10 percent, that would have been EUR17 billion worth of contracts for experienced cross-border investment consultancies.
Service providers assumed - with reason - that Chinese firms would need more advice than most. Ge Dingkun, assistant professor of strategy and entrepreneurship at China Europe International Business School (CEIBS), points out that most of these firms remain inexperienced with foreign markets. "Less than 10 percent of the Chinese companies that have the wherewithal to go global actually have the capability to effectively integrate their acquisitions," he says.
Small fish: The biggest consultancies and investment banks did manage to cash in. Over the last four years, nearly every high-value Chinese outbound M&A deal was associated with high-profile advisors like KPMG, Morgan Stanley, and Deloitte Touche.
Unfortunately, it hasn't done much for the small niche consultancies here, who hoped to profit from a high volume of smaller, less complex deals. According to a survey by the China Council for the Promotion of International Trade (CCPIT), over two-thirds of respondent firms who invested abroad spent less than EUR4.1 million, and 61 percent of respondents say that the size of their overseas investments in the next five years will remain under EUR811,000. Most small- and medium-sized Chinese firms still prefer simpler ventures like overseas representative offices. Unfortunately for the consultants, small-scale simple transactions require less assistance. Another reason is that the role of the consultant is not widely understood here. A senior adviser at a China-based consultancy specialising in outbound investment says that your average Chinese firm still doesn't distinguish between reputable consultants and the parasitic guanxi peddlers who infest domestic deal-making. "The inherent problem is the service sector here is so underdeveloped, they don't see our value. We're seen as glorified middlemen."
Some say that even in the case that a Chinese firm decides to seek advice, they are rarely prepared to pay much, or anything, for it. Ghislain de Mareuil, partner at outbound M&A and investment advisory Shanghaivest, says payment is a recurring problem for consultancies. "It's really hard to negotiate international-style fees when you advise a Chinese company. Retainers are very low; you will get maybe a few thousand US dollars, maximum." And in the case a deal closes, getting paid commission remains difficult. "Legally they have to pay, but many of these companies are well-connected, so enforcement is sometimes difficult."
Non-payment is a common complaint. The senior adviser also says that his firm has been stiffed multiple times. Ge Dingkun of CEIBS says that he gave up consulting entirely because of payment problems: "Once you transfer the information, they don't need to pay you. Even if you save them millions of renminbi, they don't realise it and still won't pay."
In response, many consultancies have begun to either bill the foreign seller for their fees, or only do business with Chinese firms that have assets exposed abroad, preferably in a convenient location like Hong Kong.
Lee Edwards is managing partner at Shearman & Sterling in China, the firm which advised Sichuan Tengzhong on the Hummer acquisition. He believes that another problem is the high rate of deal failure. "By almost anyone's standards, the outbound market for advisory services has been disappointing over the last three or four years. I would say that it's not true that you can't make money on these deals. But the main reason people aren't making money is the high deal failure rate. If you do an unsuccessful deal in the US, you get 75 cents on the dollar. In China, you get nothing."
Edwards says that deals fail for a wide variety of reasons. Lack of government approval is one (although Edwards says it is not as common as some think). Foreign regulatory barriers, IP concerns and translation problems also stymie deals. But as serious a problem are the reservations of Chinese managers.
Paradise lost: The economic downturn offered an unprecedented opportunity to snap up foreign assets. Fu Ziying, then vice-minister of the Ministry of Commerce (MofCom), argued as much in a public statement: "These [distressed] firms possess well-known brands, formidable international sales networks, and relatively strong research capabilities. If our firms can successfully acquire them, we can use these resources to greatly enhance Chinese firms' international competitiveness."
But while China did indeed increase its outbound investments by 6.5 percent in 2009, most of the capital was concentrated in a few high-value acquisitions of natural resources, not sales networks, brands or research. Such acquisitions did little to increase export profit margins or develop outlets for manufacturing overcapacity.
With a few high-profile exceptions like carmaker Geely, most Chinese firms stayed home. Indeed, after watching sovereign portfolio investments in Blackstone and Lehman Brothers spectacularly deflate, Beijing encouraged them to. Vice-Premier Wang Qishan, responding to a request for better support for outbound investment from Hunan-based machine manufacturer Sany, threw frozen slush on the idea:
"Do you have a handle on your own management capabilities? Have you analysed the cultural differences of the two sides? Do you understand the relationship between unionised labour and management in that place? If the other side's engineers resign, are you really going to send people from Changsha overseas, and make the whole company speak Hunanese? If you don't know yourself and your opponent, then this kind of confidence scares me."
Wang's admonishments might not have been necessary. Most Chinese firms are well aware of their lack of experience in overseas markets and the challenges of operations there, which is why the number and size of deals remains relatively low. A consultant familiar with Chinese outbound investment says that many acquisition deals, both domestic and international, fall through at the very last minute. "One time the CEO of a Chinese company was at the signing ceremony, and cameras were rolling. He choked at the last minute and didn't sign."
Opportunity cost: Lack of experience in management, due diligence and legal matters are the very problems that consultancies are supposed to help firms alleviate, and some Chinese firms have already paid the price for doing it themselves. For example, the unwillingness of Chinese firms to pay service fees helps explain their reputation for overpaying for assets. "If you look at many of the transactions that were made, you'll see in many cases they were for Western brands or assets that had no value in the West," says De Mareuil of Shanghaivest. "Look at Hummer. In the West, nobody wanted those cars. The only one that was interested was a poor Chinese company that had nothing to do with the car industry." But the Chinese side did not emerge with an increased appreciation for how good advice can save costs, but rather a general distrust of sellers and advisers alike. Not all this distrust is paranoia; some naive Chinese firms were indeed conned by foreigners.
This distrust is mutual, and has begun to cost Chinese bidders at the negotiation table. An investment professional who has worked on multiple foreign acquisitions by Chinese firms says that thanks to a combination of late-breaking bureaucratic blocks by Beijing and Chinese managers' reluctance to follow through, many foreign sellers now demand punishing break fees in escrow immediately after definitivetransaction documents are signed.
In the short run, it does not seem like much will change. Big SOEs will continue to buy firms who own strategic resources and technologies, and big consulting firms will continue to help them do it. Most Chinese SMEs will remain cautious and parochial in their strategies, and the smaller consultancies will still face an uphill battle marketing their services.
Optimism, pessimism: But this is only a problem if it's imperative for Chinese firms to globalise. That's not necessarily the case, says Ge of CEIBS. Outbound investment should not be a macroeconomic strategy, but a way to for an individual firm to profit, he says. "M&A is only a mode, a tool, a means, not an end. If you don't have an end, there's no use in having the means. Anything that does not generate profit is not a good business practice."
Ge points out that the best acquisition opportunities for Chinese firms remain in China, a market they understand well and which continues to grow rapidly. In the short run, increasing Chinese domestic M&A is unlikely to do much for the foreign consultancies. But in the long run, he believes the development of internal M&A teams within Chinese companies will translate into renewed interest in outward investment.
Not all foreign consultancies have the patience and the money to wait. But Edwards of Shearman & Sterling believes the opportunity is still attractive enough to maintain a pool of available advisors who will be ready when the tide of Chinese direct investment really starts going out. "Every year, two or three [advisory firms] say 'We've had enough, we're done.' For every one of those, there's someone who comes in and says, 'Let's take a shot at China. We gotta be in China. For the next ten years all we need is market share.'"