Adapt or Dispose? Multinationals Face Tough Decisions in China

Multinational Corporation (“MNC”) disposals and restructurings of China businesses have for some time been a common topic of conversation amongst those involved with China-related M&A, even before the burgeoning US-China trade war and the onset of the Coronavirus pandemic. In part, this is a natural consequence of the rapid build-up of foreign capital over the past two decades, which, as the below chart shows, is now approaching USD1.8 trillion. China accounts for around 5% of world total FDI stock, behind only the United States (USD9.5 trillion), and the UK (USD2.1 trillion). Inevitably, with so much foreign investment there will always be a certain level of divestment activity.

The chart also shows, however, that growth in FDI has slowed and that, as a percentage of global FDI, China’s share has begun to fall. While this does not present a full picture as to what is happening (i.e. is this attributed just to lower inbound investment, or also heightened divestment?), it is notable given that China remains one of the fastest growing major economies, which in normal circumstances might be expected to drive an increased share of global FDI.

Some of the drivers of this have been clear for some time:

• Costs have been rising, eroding the advantage that has drawn so much manufacturing to China;
• Growth is slowing, especially in top tier cities, with foreign capital less adept at accessing lower tier areas where growth remains stronger;
• There is no shortage of domestic capital to tap opportunities.

But there have also been other dynamics at play that have made life more difficult for MNCs:

• Local competitors are catching up and at times surpassing MNCs in terms of quality and service levels;
• The phenomenal speed at which the Chinese market is evolving has meant that MNCs with a long chain of command back to HQ are unable to react quickly enough.

This being said, many MNCs continue to do well in China, and for a substantial number, China represents the no.1 or no.2 market, which leads to other considerations:

• Does the existing corporate structure (e.g. top management concentrated in home markets) reflect the reality of the company’s geographical footprint?
• China-related risks, which top MNC management do not feel they fully grasp, are more front-of-mind.

It is too early to estimate the extent of the impact of the US-China trade war, Covid-19, and the attendant geopolitical upheaval. Many companies remain in ‘watch and see’ mode. For some, focus on China will increase, being as it is amongst the quickest to bounce back from the pandemic (China’s stock market has just hit a 5-year high at time of writing). For other MNCs, however, there is almost certain to be some reassessment of China businesses:

• Some may not recover from the recent crisis and need to either sell or shut down;
• For some exporters, there will be direct pressure to move supply chains out of China or face a loss of business;
• Some, like those mentioned above, may look to reduce their China exposure, as they reassess the geopolitical risk and look to shore up group finances;
• For other MNCs with subsidiaries which wash their face but do not provide strong returns, the recent crisis may be the impetus to make a strategic change that otherwise may have been put off to another day.

Whatever the key drivers, as they seek the answer to their China questions, MNCs face the same basic options – change strategy (which may include doubling down and further investment), and/or dispose of some or all of the business. Most will probably choose the first option, but a significant number will explore the second, and it is worth reflecting on some of the forms this may take and some of the considerations at play:

Complete disposal

Can the business be carved out from the rest of the global business? What ongoing relationships (IP licensing, supply, etc.) will need to be retained, and what will be the economics of that?

• How to conduct a sale process – howto position the business and put on a positive spin? How to manage the expectations of differentiated prospective buyer groups including other MNCs, private equity and local corporates?
• Managing stakeholders – e.g.retaining key employees who enjoy the kudos and way of working of MNCs; relationship with the local government, especially where there may be issues related to past incentives, tax and land;
• How to receive and repatriate payment – if selling the China entity directly (i.e., not an offshore holding co) then understanding risks around repatriation will be a consideration;companies may all consider options to reutilize cash onshore in China in other ways;
• Valuation – some things may work in the MNC’s favour, for instance losing expensive global overheads, and local buyers may see other opportunities to reduce often ‘gold plated’ costs bases;
• Other considerations: for some types of businesses there may be hidden value not related to the underlying business, for instance there may be significant value in the land, licences,or relationships with local government.

Spin-off/listing

• For some larger listed businesses there may be interest in spinning out the China operations (a la YumChina);
• Potential to achieve a better valuation overall if some of the China value is not fully appreciated by the market;
• May help to recruit and incentivize high quality local management and allow them to manage the business more effectively without global reporting lines.

Partial sale / Joint venture

• Keep a foot in market – many MNCs will be reluctant to lose all exposure to China;
• Helps to de-risk, with a partner sharing the financial burden and, often, helping to manage the relationship with government and other key stakeholders
• Combine the IP, global strengths and customer base of international players with local mindset and positioning of strong local players

Vermilion Partners and Natixis Partners recently advised on the sale of PSA’s 50% interest in CAPSA, its auto-manufacturing joint-venture with ChangAn Auto, to Baoneng, which also acquired ChangAn’s 50% interest in CAPSA. The transaction completed in June 2020.

Natixis and Vermilion are well positioned to assist clients with the challenges and opportunities that these unprecedented times have created. Now more than ever, successful M&A in China requires a team on the ground who can navigate the local environment and build trust with local counterparts, whilst effectively communicating and managing the relationship with clients in Europe and across the world.