Despite headlines about capital controls and restrictions on overseas investment, don't expect Chinese companies to give up international acquisitions any time soon. Even now, the dealmaking is continuing apace.
Many potential acquirers have extensive reserves of capital outside China that they can deploy. In priority sectors, such as those identified in the government's "Made in China 2025" plan, companies will still be able to move funds out. In fact, we are already seeing the government rolling back some of its restrictions on taking capital out of China.
What we should expect to see is smarter acquisitions: a focus on strategic and control transactions with the opportunity to add real value and critically, much more active post-deal integration to capture this value. Chinese acquirers are learning from the mistakes they made in outbound mergers and acquisitions over the past decade and are aggressively building internal teams with the international experience to run large overseas businesses under the rubric of China-headquartered enterprises.
The new era of Chinese acquisitions will be led by these freshly formed, internationally hardened teams who seek to be both active investors and active acquirers. Their due diligence will be more rigorous, there will be a plan for value creation from day one that both the acquired company and its new Chinese parent understand and there will be Chinese managers ready and committed to take the operational lead.
There will also be a growing emphasis this year on international acquisitions of companies at a much earlier stage of development. This will follow the lead of major internet companies Baidu, Alibaba Group Holding and Tencent Holdings, each of which has built a strong portfolio of tech investments in the U.S. and elsewhere.
Start-up valuations in the mainland today are so high that Chinese acquirers, whether strategic investors or venture funds, can invest in start-ups in Europe, Israel and many other tech hubs much more cheaply while also getting a stake in more advanced technologies. These start-ups know they need access to the U.S. or China to reach their full potential scale and that Chinese companies are writing the larger checks today.
Learning from experience
Reviewing the results of over 500 Chinese outbound transactions worth $100 million or more undertaken between 2005 and 2016 makes for depressing reading if you invested in these deals. More than half, with a total value of more than $300 billion, destroyed value.
Two particular types of deals performed extremely poorly. Fewer than one in six investments in basic resources were successful and the average annual return in this area was minus 10%. Minority investments in listed companies that continued to trade after the investment generated annual returns on average of minus 7%. Nearly half of these investments were in the financial sector, many before the global financial crisis.
The worst performing investments were in services, namely retail and professional services. Virtually none of the acquisitions during the period were turnarounds; most involved stable companies which were performing reasonably.
Transactions in which the Chinese acquirer took a controlling stake had a much greater chance of success. The failure rate for control deals worth between $500 million and $2 billion was "only" about 30%. Deals in this range were likely large enough to draw management's attention but not so large as to swamp their ability to digest the acquisition.
Summarizing my research, done in conjunction with sovereign wealth fund China Investment Corp., the recently concluded era was one of active acquisitions, but passive ownership. Few acquirers followed the early example of Lenovo's acquisition and instant integration of IBM's PC business. Most buyers would not or could not integrate what they acquired and left value creation to the management of the acquired company or the rising tide of external markets. Even today, acquirers such as China National Chemical, Ctrip and Midea Group are willing to commit to almost no integration for several years as part of closing arrangements.
Chinese acquirers have prioritized stability and have seen integration as a destabilizing process. Often they have not even developed a specific post-acquisition operational plan and have had no one on their leadership team with experience managing international talent, let alone running a cross-border integration process. Consequences that I have observed include: a buyer taking six months post-closing to get a copy of the acquired company's monthly accounts in Chinese; a year passing after closing without a single operating-level meeting between international and Chinese management; and a buyer tolerating missed monthly plan targets for its new acquisition for a year and a half.
Chinese acquirers have frequently been too slow to call out underperformance in acquired management, let alone replace the teams. The fear that alternative leadership -- whether unknown new Western executives or Chinese managers sent in -- could be worse has led acquirers to tolerate poor and even willful underperformance for too long.
But Chinese acquirers, especially from the private sector, are quick learners from their own experience and from that of others. Chinese entrepreneurs often meet privately to exchange lessons learned. Failures of the past are not likely to be repeated into the future.
The $43 billion takeover of Swiss chemical producer Syngenta by China National Chemical, or ChemChina, may prove to be a high watermark in the scale of Chinese outbound M&A for many years, but the volume of future transactions will very likely grow.
Even in the last couple years, the scale of outbound M&A as a share of GDP was only 0.8%, well below that of the U.S. or major European nations. At 25-30%, the acquisition premiums Chinese buyers have been paying are actually not radically different from those absorbed by Western acquirers. The tendency of analysts to focus on the outliers has taken attention away from the more sensible prices paid in most deals, especially in light of the very low cost of equity in China today.
This will be just as true in larger acquisitions. Many Chinese acquirers have looked to the successful post-acquisition example of WH Group's purchase of U.S. meat processor Smithfield. Smithfield had been a very loosely organized company with three distinct operating centers and a large number of independent subsidiaries. This had resulted in considerable duplication and redundancy across its operations. Top management were long-term veterans of the company, with high salaries and limited incentives to shake the company up.
WH saw synergies in bringing some of Smithfield's processes to China. However it also wanted to strengthen Smithfield's operational performance. It first consolidated the operating centers, then streamlined shared services, introduced more performance-driven compensation and reorganized the company into business units with primary responsibility for their own profits and losses. It introduced WH's more detailed and frequent system of business reporting too.
Over the course of two to three years, WH retired Smithfield's previous top management and installed a new team, mostly promoted from within. WH placed only one full-time senior manager from China at Smithfield, though it put three representatives on its board.
This model of changing management, imposing a tougher performance management system, simplifying the acquired organization, and strengthening financial incentives is what private equity investors do to portfolio companies, though such funds use more financial leverage and allow management of the acquired company to make more personal profit if they deliver. It is a model that many more Chinese acquirers will deploy in the years ahead. Competitors and possible target companies should be prepared.
Gordon Orr is a senior advisor to McKinsey & Co. on China-related topics and a board director of Lenovo.