ARE CHINESE ACQUISITIONS OVERPRICED FOR FOREIGN INVESTORS?
An insider view on Chinese M&A
Despite dialed-down growth, on-going anti-corruption campaign as well as bloated and inefficient state- owned enterprises, China remains one of the top destinations for foreign investors to pursue M&A deals. Nevertheless, China is also deemed to be amongst the most challenging environments for deal-making despite having huge investment potential. With regard to various “deal breakers”, one of the greatest challenges foreign investors are facing these days is the valuation expectation gap between buyer and Chinese entrepreneurs. This causes investors to either prematurely sentence “death penalty” on the envisaged transaction or to psychologically deny adapting to these facts without attempting to comprehend the deep-rooted factors causing such gap. Foreign investors should listen closely to what their Chinese business counterparties have to say, and most importantly formulate pragmatic, sometimes even creative, not-by-the-book workarounds. It is China, after all.
The contrasting views and approaches on valuating companies contribute to the gap of valuation expectations. Foreign buyers routinely offer purchase prices based on widely-accepted valuation methods (discounted cash flow, comparable companies, precedent transactions etc.) without taking into account the “Chinese Factors”: DCF has its major constraints: forecasting a Chinese business beyond 3-5 years is mere conjecture, taking into account the dynamic Chinese market and how quickly businesses may evolve. Furthermore, the lack of internal planning and -budgeting processes as well as the capability of Chinese enterprises, especially in traditional industries, is so prevalent that it makes forward-looking projection even more challenging. As a cash flow driven valuation method, DCF also inherently tends to undervalue typical Chinese enterprises with oversized fixed assets as compared to their western counterparts. Sometimes, the buyers are inclined to include various risk premiums that may or may not be justifiable, into the discount factor making deals appear unattractive on paper in general. Market Approach may not accurately reflect the intrinsic value. Major reasons: 1) Lack of transparent valuation information of precedent transactions in China and, 2) the complicated deal structure which largely affects the purchase price and 3) overly strong dependences on the trading multiples of comparable companies.
Be flexible and pragmatic to adjust valuation post a robust due diligence
It is undoubtedly important to carry out a comprehensive due diligence in China. And the investors should always be ready to uncover risks and liabilities exposure such as multiple sets of financial books, tax evasion, social benefit issues etc. when dealing with typical Chinese acquisition targets. But the question that the foreign buyers should ask themselves is, if it’s necessary to factor all these typical-
Chinese risks into the valuation model, leading to economically unattractive valuation and making Chinese seller walk away from the negotiation table. After all, there are many ways in “deal structure” and “legal terms” to mitigate risks:
- put options
- forms of payment (f.e. escrow account)
- Assets purchase vs. share purchase transaction
Valuation is not only about figures but also mindgames
It is critical to understand why Chinese entrepreneurs are willing to consider a sale and also crucial to build up relationships with those Chinese entrepreneurs in order to understand their mindsets and understand the motives of sale behind the scenes. It is also not uncommon in China that the valuation expectation of the seller is purely a “gut feeling”
that comes unsupported with clear logic, facts as well as sound realistic assumptions. Many times, it is even more important to deploy the right negotiation tactics, build a strong cooperation case, and formulate intelligent strategies to psychologically manage the valuation expectation of the seller when it comes to deal-making in China.