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While there has been some recent optimism about China’s economic prospects, according to the National Bureau of Statistics, the country’s year-over-year GDP growth fell to 7.8% in the first half of 2012, down from 9.6% just one year ago. Compared with negative GDP growth in Europe and 2% GDP growth in the U.S., China’s 7.5% annual GDP growth target for 2012 is still impressive. The figure, however, is in sharp contrast to the country’s three-decade average of 10% a year. Up or down - what does the shifting landscape mean for M&A activity?

China’s Economic Landscape - What Does It Mean for M&A?

Contrary to popular theory, China’s long-standing economic boom has not necessarily translated into M&A activity. In a study by Harris Williams & Co. that tracked the geographic location of all buyers that acquired U.S. middle market companies over the last 10 years (excluding real estate and financial services transactions), Chinese buyers accounted for less than 0.5% of all transactions. In fact, only 3% of U.S. middle market companies sold over the last 10 years went to buyers from the Asia-Pacific region, and of these, China represented a mere 7% of buyers (Australia, Japan, and India were in the lead with 30%, 25%, and 12% of U.S.-based acquisitions by Asia-Pacific buyers, respectively).

The low volume of activity associated with Chinese buyers is largely based on a few key themes. First, China’s long-standing growth trends have resulted in plenty of investment opportunities for buyers within their home country. Second, Western transaction processes can prove to be a hurdle for Chinese buyers to clear before successfully crossing the finish line. Third, the role of the Chinese government and its interconnection with businesses can create significant obstacles for potential acquirers.

With China’s GDP historically growing at a much faster rate than those of the U.S. and Europe, investors need not look further than their own backyard to find ripe places for their capital. Furthermore, keeping their

investments in China helps perpetuate the country’s economic growth. Within their home country, investors can also take advantage of their knowledge of the local business environment without the risks associated with investing in highly competitive Western markets.

The speed and momentum of sale processes in the U.S. and Europe and their emphasis on financial records and documentation is in sharp contrast to Chinese customs. Chinese acquirers often move at a much slower pace and as a result are unable to be competitive. They also place more weight on relationships, versus data rooms and cross-continental email exchanges. While it is common practice for potential acquirers in the U.S. and Europe to put in an indicative offer prior to meeting a management team, Chinese investors want to meet the team prior to revealing any interest. Written contracts and agreements are less trusted in China, and relationships take time to develop.

Additionally, valuations are derived differently in China than in the U.S. and Europe. The Chinese tend to ascribe more value to net assets than to cash flow. As a result, virtual companies or those with fewer net assets are generally not attractive to the Chinese.

On top of transactional challenges, the link between businesses and the Chinese government has interfered with certain cross-border acquisitions. For example, late last year, China’s Huawei was set to acquire the assets of

• United States and Canada

• Europe

• Asia-Pacific

• Latin America and Caribbean

• Middle East

Source: CapitalIQ. Includes all transactions valued between $50 million and $1 billion between June 2002 and June 2012; excludes real estate and financial services transactions.

Geographic Composition of Buyers for All U.S.-Based Middle Market Acquisitions Over the Last 10 Years

Composition of Asia-Pacific Buyers for All U.S.-Based Middle Market Acquisitions Over the Last 10 Years

• Australia • Japan

• India • Mainland China

• Singapore • Korea

• Hong Kong • Other Asia

Source: CapitalIQ. Includes all transactions valued between $50 million and $1 billion between June 2002 and June 2012; excludes real estate and financial services transactions.

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The growth of the Chinese middle class has led to acquisition interest within the transportation industry. For example, in August 2010, China’s Geely bought Volvo from Ford. Just months later, GM sold Nexteer Automotive, a Michigan-based auto-parts supplier, to Pacific Century Motors, an affiliate of the Beijing municipal government. And in April 2011, AVIC International completed a $186 million purchase of Continental Motors, a U.S. aviation manufacturing firm.

According to Reuters, the Chinese tourism market is estimated to be growing at about 10% annually. This trend has fueled investment within the hospitality sector. In May 2010, Jin Jiang Hotels bought a 50% stake in Interstate Hotels & Resorts in a transaction with total enterprise value of approximately $300 million. And in June 2010, Chinese investment firm Fosun International acquired a 7.1% stake in Club Med and plans to open five villages in China by 2015, attracting 200,000 Chinese customers.

The country’s historical focus on manufacturing has changed to a focus on creating more value in the supply chain, and Chinese companies

U.S. server technology company 3Leaf Systems, but U.S. regulatory concerns about Huawei’s relationship with the Chinese government impeded the sale. Additionally, all outbound investment from China requires government approval. There is a well-defined process that Chinese investors have to go through to buy a company outside of the country, and it usually takes three to four months to complete unless the company has an offshore account or credit outside of the country. Although the approval process is becoming more efficient, it is still

are interested in acquisitions that improve their domestic competitiveness and leverage their existing customer bases. In addition, Chinese acquirers are interested in buying companies that provide much-needed natural resources, such as iron ore, so that they are less reliant on importing these supplies from other parts of the world.

Partnerships with Western investors have become a popular strategy with Chinese acquirers. Brian Doyle, managing partner at CITIC Capital Partners, a China-based private equity group, indicates that his firm has been quite active in buying U.S. companies, although it has done this in collaboration with U.S. private equity groups, including Audax Group, Littlejohn & Co., Vector Capital, and Sentinel Capital Partners. Although CITIC has a New York office, it typically works with a U.S. or European partner because the company believes that local market expertise is essential to effectively managing investments in highly competitive developed markets.

CITIC invests in only companies that have a significant presence or opportunity to expand in China; this can represent as much as 30%-50%

difficult when potential acquirers without this limitation are interested in purchasing an asset.

Although Chinese buyers have historically accounted for a relatively low volume of M&A in the Western world, there are indeed pockets of opportunities that should be explored by sellers. Furthermore, the Chinese government has recently shown greater support for cross-border M&A, which should bolster Chinese investors’ interest in acquiring foreign companies. In February 2012, the Chinese government launched an $8 billion fund in

of revenue growth and 50%-100% of their manufacturing footprint. CITIC has dedicated post-investment professionals who help with management recruiting, manufacturing site selection and construction, bank financing, customer acquisition, and M&A.

Doyle explains, “We only purchase companies in partnership with U.S. and European private equity firms who are looking for a complementary partner from China with whom they can share the ownership of the company and who can help them turn the ‘China risk’ into ‘China opportunity.’ ”

CITIC is not alone in its interest in utilizing cross-border partnerships for acquisitions. Fosun recently announced a partnership with Danish private equity investment firm Axcel to identify business opportunities in China and Europe.

Shanghai to aid overseas acquisitions by Chinese companies. Other paradigms are shifting, which bodes well for future M&A activity by Chinese acquirers as well. For example, Chinese private equity firm China Science & Merchants (CSM) recently announced the launch of a new $1 billion fund that will be its first one open to non-Chinese investors, aimed at raising the firm’s profile overseas. This suggests the adoption of a more open-minded approach to investments.

Rising labor and transportation costs have shifted the country’s attention from production of goods to selling products directly to Chinese consumers with growing disposable income. The most sought-after companies in the Western part of the world have been those that tap into the buying power of China’s burgeoning middle class. Chinese buyers tend to seek out unique technologies that can be used to enhance Chinese-based businesses, as well as strong international brands that can be brought into China and sold to Chinese consumers.

China’s Economic Slowdown (continued from page 1)

What Attracts Chinese Buyers?

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Even with its deflated GDP, economic growth and the size of the market keep China as an area of interest for acquisitions. U.S. and European companies that initially sought access to a cheap Chinese labor market are now contemplating how they can gain access to Chinese consumers. Because building from scratch is usually too costly and time-consuming (it typically takes three to five years just to gain regulatory approval to start a new operation in China, longer than many private equity hold periods), most investors that seek to tap into China’s market do so through acquisitions. Language barriers, cultural differences, government control and restrictions, and dissimilarity in business practices, however, create significant hurdles for would-be investors. Careful planning and being plugged in at the local level are prerequisites. Investors that have committed manpower and capital to the country or have hired someone on the ground to oversee their investments have been able to tap into the market most successfully.

There are a number of Western private equity groups that have opened offices in China to facilitate investment in the country. This strategy provides a high level of control in terms of acquiring talent and managing their portfolios. However, it is an expensive proposition, and it can be difficult for many firms to justify the expense of having a China office when only a small percentage of their portfolio companies may have a strong China angle. Competing against home-grown private equity firms is also difficult because local nationals have less stringent regulations and greater access to funding in renminbi (yuan).

According to Martin Sabine, chairman of Somerley Limited, a leading M&A advisory firm in the region that is part of Harris Williams & Co.’s network in Asia, “The risks associated with M&A in China are considerable and need very careful management.”

Sun Capital is an example of a private equity group that has had success making Chinese acquisitions. In 2012, Sun completed the acquisition of TEX China, a manufacturer of premium plastic beauty products packaging, through its affiliate Albéa. Based in France, Albéa is one of the world’s largest packaging companies and a key supplier in China, with five production sites throughout the country and a sales office in Shanghai. The acquisition enhances Albéa’s presence in China and its opportunities in the export market. According to Benjamin Buerstedde, a vice president at Sun Capital involved in the TEX acquisition, some of the biggest challenges were getting a representative set of historic financial information for the target entities and providing comfort around Albea’s credentials to a first-generation seller. The size of the Albéa transaction did not trigger regulatory approval.

From an execution standpoint, an investment in China requires a different mind-set. Most transactions are conducted at a much slower pace, and interpersonal interaction and communication are more heavily weighted than written documents and record keeping. Financial documents and reporting systems in China are generally less reliable than in the U.S. and Europe, and cash without a clear paper trail may be used to pay for goods. In some cases, the best way to acquire a company in China is to set up a new company and then put the assets of the existing business into the new entity to create a clean capital structure. This can help diminish liabilities from the previous business, depending on circumstances.

The Chinese government’s role and level of control in business can also be off-putting to Western investors. For example, the government can dictate which suppliers are used and the price of services offered. Having a strong local presence can help ease government-imposed restrictions and bolster government officials’ support of a foreign company.

Purchase prices for Chinese companies may need to be negotiated down to account for the loss the new owner will incur upon bringing the business up to Western standards. What’s more, the use of debt to complete an acquisition is not widely accepted, particularly if the deal is in a sector the government deems sensitive. This has prohibited many private equity groups from making Chinese acquisitions and contributes to the popularity of the public market listings.

Fund constraints also often prohibit U.S. and European private equity groups from making platform acquisitions abroad unless the funds are specifically designated for overseas investment, but Chinese add-on acquisitions can be highly effective and there are a number of benefits. Chinese businesses typically have considerable room for operational improvements, and a Chinese add-on can enhance the competitive advantage of a Western private equity group’s domestic portfolio company. Additionally, add-ons tend to be smaller deals and therefore can reduce some of the risk associated with making investments in Chinese companies, which is of particular concern with companies located in lesser-invested Chinese cities.

Any acquisition also requires a well-thought-out exit strategy in order to be able to get investment dollars back out of the country and limit taxes paid in China. A Western investor should avoid sending money into China as registered capital, because it is tracked as foreign money, and once registered it is difficult to get out of the country. Furthermore, to mitigate tax consequences, investors should consider establishing a Hong Kong holding company that can then be used to make an investment into a mainland China-based company. It is also easier from a regulatory perspective to sell the holding company than the underlying China-based asset. Lead time can be challenging, however, as creating a Hong Kong holding company often takes up to six months.

On the Flip Side: Is Now a Good Time to Buy in China?

ConclusionBusinesses have been flocking to China for more than a decade, and although there has been recent weakness in the Chinese economy, the country remains a vibrant place to do business. Although executional considerations will continue to be a roadblock for many Chinese acquirers, greater support by the government for Chinese business to make foreign investments may help propel M&A. Further, with a population of approximately 1.3 billion and GDP growth nearly four times that of the U.S., there’s no question that opportunities for Western investors to do business in China will continue to increase.

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For more information about Harris Williams & Co. and our international expertise, visit www.harriswilliams.com/global-reach. Harris Williams & Co. is a preeminent middle market advisor serving clients worldwide. The firm’s geographic footprint and

experience span every active M&A market, including the Americas, Europe, India, and the Asia-Pacific.

©2012. Investment banking services are provided by Harris Williams LLC, a registered broker-dealer and member of FINRA and SIPC, and Harris Williams & Co. Ltd, which is authorized and regulated by the Financial Services Authority. Harris Williams & Co. is a trade name under which Harris Williams LLC and Harris Williams & Co. Ltd conduct business.

SourcesCapitalIQ

www.albea-group.com/news/albea-announces-acquisition-of-chinese-factories-of-tex-r-l-group.html

www.avcj.com/avcj/news/2153473/china-rolls-usd8b-fund-outbound-investments

www.businessweek.com/news/2012-07-03/rexam-agrees-to-sell-unit-for-709-million-to-sun-silgan

http://english.peopledaily.com.cn/90778/7915990.html

www.nexteer.com/news-releases/pcm-completes-acquisition-of-nexteer-automotive-opens-new-channels-for-growth-in-china/

www.nytimes.com/2010/08/03/business/global/03volvo.html

www.prnewswire.com/news-releases-test/jin-jiang-hotels-joint-venture-with-us-based-thayer-lodging-to-acquire-interstate-hotels--resorts-79772132.html?utm_expid=43414375-18

www.reuters.com/article/2010/06/13/us-clubmed-china-idUSTRE65C1EU20100613

www.teledyne.com/news/tdy_12142010.asp

www.themiddlemarket.com/maj/2011_39/cross_border_ma_china_enthusiasm_for_us_deals_wane-225948-1.html

http://usa.chinadaily.com.cn/us/2011-04/21/content_12368667.htm

http://worldbank.org

Chris WilliamsCo-Founder and Managing Director

Harris Williams & Co.phone: +1 804-648-0072

cwilliams@harriswilliams.com

Derek LewisManaging DirectorHarris Williams & Co.phone: +1 804-648-0072dlewis@harriswilliams.com

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