China M&A: Investing in China, for China

China outbound M&A has  taken the headlines in recent years, both in terms of government attention and media coverage.

Driven by loosening domestic policy and the generally favorable global economic and financing conditions, China’s outbound M&A deal value grew from circa $50 billion in 2011 to circa $220 billion in 2016.

But in response to large capital outflows and the widening capital account deficit, the Chinese government clamped down on outbound investment in late 2016, through new regulation that restricted outbound investment in certain sectors and strengthened requirements for new outbound investment approval and registration. This has resulted in a significant reduction in outbound M&A activity since 2017.

The new outbound investment regulations coincided with a general crack-down on excess financial leverage in China’s domestic economy, which included reining in the rapid growth of the shadow banking system and a tightening of money supply to reduce systemic risk in the economy. This general tightening of domestic liquidity significantly impacted Chinese companies’ abilities to access onshore financing for outbound investment.

In addition to the progressive restrictions in their home market, Chinese investors have also been facing increasingly restrictive foreign investment screening measures, regulation and political scrutiny abroad. More recently, the rising political tensions between China and the US, the heightened political sensitivity around the world to protect domestic companies following the Covid-19 outbreak and, a growing focus on data protection and consumer privacy regulation, have resulted in the deal value of Chinese outbound M&A declining to the lowest level in over a decade.

But with the media and government spotlight firmly on Chinese outbound M&A, the resilience of the country’s inbound M&A during the past two years has stayed somewhat below the radar. Despite the significant slowdown in global M&A activity as a result of the Covid-19 pandemic, the total deal value for China inbound M&A reached circa $40 billion over the first eight months of 2020, which is already equal to the value for the whole of 2019. This is in sharp contrast to total outbound M&A deal value of only $14 billion in the first eight months of 2020, compared to $60 billion for the whole of 2019. China’s inbound M&A deal value is clearly on track to surpass its outbound deal value for the first time in over a decade.

Inbound investment by Multinational Corporations (“MNCs”) is increasingly aimed at developing their competitive position within the Chinese market, as opposed to obtaining a low-cost manufacturing location for exports. While China’s eroding cost advantage is not new, there are several recent developments that are going to accelerate the trend of MNCs “investing in China, for China”. These include the rise in international trade protectionism; a quicker recovery of the Chinese economy from Covid-19 that is progressively being driven by consumer spending; expansion of Chinese government policy that is aimed at encouraging domestic sourcing; a maturing economy with steadily more competitive domestic companies; and liberalization of China’s foreign direct investment regulation.  

Rising international trade protectionism

Global market and trade integration look set to slow in the coming years, with both international trade and global foreign direct investment expected to decrease significantly in 2020 due to the Covid-19 pandemic.

Trade protectionism is on the rise, driven by rising populist sentiment and a public backlash against economic globalization. Exports are being impacted by the US tariffs placed on more than US$360bn of Chinese goods. Growing international trade tension is forcing MNCs to reconsider their foreign investment decisions and locations. As a result, MNCs are increasingly moving their export manufacturing operations to countries that are not affected by tariff policies, and that also provide low cost manufacturing and global market access.

A recovering economy that is increasingly driven by consumption

After an initial 6.8% fall in Gross Domestic Product (“GDP”) in the first quarter of 2020, China has emerged as one of the first countries to show signs of recovery from the fallout of the Covid-19 pandemic. With Covid-19 lockdown restrictions in China already being eased in April, GDP grew by 3.2% in the second quarter of 2020, compared with the same period in 2019.

Although initially a weak spot in the country’s economic recovery, consumer spending also began to improve in August. Rising consumption is expected to be a key factor in MNC interest in inbound M&A. The Chinese government is encouraging investment in consumer-related industries, as the country tries to shift away from exports, infrastructure investment and heavy industry – towards consumption-based growth. Consumption has increased from circa 34% of GDP in 2010 to circa 40% in 2019. By contrast, Chinese exports have fallen from 35% of GDP in 2007 to just 17% in 2019.

The quickest way MNCs can strengthen their market position to benefit from the growth in consumer spending, is often through the acquisition of a local competitor. A recent example of inbound M&A in the consumer sector, is Pepsi’s $700 million acquisition of local snack brand Be & Cheery.

Government policy aimed at increasing domestic sourcing

The “Made in China 2025” strategic plan was introduced by the Chinese government in 2015 and is aimed at upgrading the domestic manufacturing industry. A key goal of the plan is to expand the Chinese-domestic content of core components and materials to 40% by 2020 and 70% by 2025. The plan focuses on high-tech sectors, such as semiconductors, robotics, medical equipment, automotive and aerospace. More recently, the Chinese government has been hinting at plans to reduce its dependence on international markets and technology through a so-called “dual circulation” policy.

To meet the advancing localization requirements, MNCs are pursuing acquisitions and partnerships in China to gain access to regulatory and commercial advantages that would otherwise be reserved for domestic companies. An example of this is the medical equipment market. Public hospitals in China now have to source a certain percentage of their medical equipment domestically, which makes it difficult for MNCs that export to China to participate in hospital supply tenders.

In a recent example, US medical equipment company Accuray formed a joint venture with China Isotope & Radiation Corporation to manufacture and sell radiation oncology systems in China. Vermilion Partners advised Accuray on this transaction.  

A maturing economy with increasingly competitive domestic companies

Historically, MNCs have had advantages over domestic Chinese companies in relation to product marketing and technology, providing MNCs with advantages in terms of “perceived quality” over domestic Chinese brands. This enabled MNCs to grow their market share and charge higher prices.

But over the past decade, Chinese companies have become more and more competitive. They have developed their experience to advertise their products effectively and they have an advantage in understanding Chinese customer preferences. Chinese companies have been successful at leading the “good-enough” segment of market, while simultaneously developing their activities in the premium segment of the market. Innovative Chinese companies are also developing competitive technologies that meet the demands of the Chinese market. As a result, MNCs no longer benefit from the “perceived premium” advantage.

MNCs need to take this into account in the development of their China M&A strategy and they may need to consider options to diversify into other segments of the market. MNCs may also consider M&A and partnership options that are focused on developing their position in China’s internet and e-commerce ecosystem.

With the growing pool of mature domestic companies whose technologies, product quality and business performance are becoming similar to Western standards, there are more options for MNCs to invest in Chinese companies for their technology, brands and market position. Take, for example, Volkswagen’s recent acquisition of a 26% stake in Guoxuan High-Tech, China’s third largest electric vehicle battery producer, for $1.2 billion.

Liberalization of China’s foreign direct investment regulation

Since 2017, China has used a so-called “Negative List” to regulate foreign direct investment. Under this approach, foreign direct investment in China is generally permitted, except for industries that are categorized as prohibited or restricted. In a new version of the Negative List that was issued in June 2020, the number of industries was further reduced from 37 to 30.

Notable examples of industries for which foreign ownership restrictions have been removed, include the financial services sector and the automobile manufacturing sector.

Following recent regulatory changes, many leading global financial institutions have acquired majority ownership in their China joint ventures.

In the automobile sector, Volkswagen recently acquired a 50% stake in Jianghuai Automobile Group, which is the holding company of Volkswagen’s joint venture partner JAC Motors. This investment has lifted Volkswagen’s stake in its JAC-Volkswagen electric vehicle joint venture to 75%.

China’s M&A environment is more complex than most. The rapidly developing market limits the visibility of suitable target companies. In addition, many Chinese companies have easy access to domestic capital. Having said that, opportunities may come from the many companies owned by fist-generation entrepreneurs that are facing succession issues.

A successful M&A approach requires an experienced team on the ground in China who can build trust with Chinese business owners and other counterparties, and who have a deep and broad experience of transacting and operating in China. Vermilion are well positioned to assist MNCs in navigating the complexities of the China M&A market.