Beijing’s Big Backyard

InTheBlack, September 2011

As China grows, its institutions inevitably look further afield, and its remarkable domestic story starts to shape the rest of the world too. The headline deals are those that venture into the west or to Africa: Lenovo buying IBM’s PC division, Petrochina and CNOOC buying up chunks of Nigerian or Sudanese resource fields, China Investment Corporation taking stakes in Morgan Stanley and Blackrock. But what of its near neighbours? How is China Inc affecting Asia Inc?

When China buys overseas, it has gone local less frequently than it has ventured further afield. According to data from the Heritage Foundation, Chinese outbound investment into East Asia totalled $31.6 billion between 2005 and 2010, with Indonesia accounting for the biggest slice at $9.8 billion, followed by Singapore and Vietnam. But that’s actually one of the smallest blocs worldwide: it put $61.7 billion into the Americas minus the USA (a further $28.1 billion), $43.7 billion into Sub-Saharan Africa, $37.1 billion into the Arab world and $45.2 billion into what Heritage calls West Asia (chiefly Iran, Kazakhstan and the Russian Federation) over the same period. Australia on its own, with $34 billion, accounted for more than East Asia.

Why should this be? Chiefly, it’s a reflection of what Chinese companies have opted to buy. “The majority of M&A activity in China has been outbound and in the natural resources sector. That’s been the first wave,” says Mayooran Elalingam, who heads M&A execution for southeast Asia for Deutsche Bank. But with the exception of Indonesia, southeast Asia is not a huge market for resources compared to, say, Australia, Canada or Africa.

Consequently, outbound M&A into Asia has so far focused on the handful of places where the resources are found or processed. In 2009, for example, China Investment Corporation – China’s sovereign wealth fund – invested US$1.9 billion in the Indonesian mining group Bumi Resources through a debt instrument. Other key examples have included several deals in Singapore, most notably China Huaneng Power (and its Hong Kong-listed subsidiary Huaneng Power International) buying Tuas Power, and Petrochina buying Singapore Petroleum. And CIC is a big investor in Mongolia, notably with a $500 million investment in SouthGobi Energy Resources, which mines coal in Mongolia, in 2009.

While most southeast Asian nations do not offer big mining or oil operations, they do come with some other advantages. In the west foreign sensitivities have often nixed resources deals, most famously in the USA, with CNOOC’s attempt to buy Unocal. It’s particularly acute when state-owned companies involved – which includes most major Chinese resource companies. But politics have been less of an issue in Asia. National interest hardly came up in the Bumi Resources deal; Bumi’s President Director and CEO called CIC “the leading sovereign fund in the world,” and declared himself “honoured by this historic and transformational investment.”

In Singapore, too, the deals have attracted little dissent – partly because Singapore simply doesn’t do dissent, and partly because, in a nation built on free markets and with a chiefly Chinese population, big deals from China are considered welcome. “If assets are deemed to be sensitive nationally there is a suspicion in the west that wouldn’t exist so much in Asia,” says Malcolm Macdonald, partner at PricewaterhouseCoopers in Beijing.

Consequently more deals are likely to be struck in future. “There’s a lot of interest in Indonesia, not just in coal put plantations, both rubber and palm oil,” says Ronald Chao, national leader for China for corporate finance advisory at Deloitte in Beijing. “There’s a lot of people scouting for things, but there are just not that many major transactions being struck yet.”

And if resources are the first wave of Chinese overseas expansion, then what comes next? “The question is, will there by Chinese outbound M&A activity in sectors outside of natural resources?” asks Elalingam. “We think this is possible, but only if there is a strong strategic rationale and connection to the China growth story.” A Chinese company acquiring overseas for acquisition’s sake makes little sense: no acquisition is likely to offer a higher growth rate than is already available in China. There needs to be something else to be gained. “For example, can the consumer product or brand from the target be sold into the Chinese consumers?” says Elalingam. “If not, the target would be less attractive. Similarly, can the technology of the target be utilised to improve the technology of the Chinese operations?” Acquiring technology has tended to underpin industrial M&A from China – and it has tended to take place in places like Germany rather than in Asia. “With China outbound M&A, the question to ask is: ‘is there a connection back to the home market’?”

Nevertheless, there have been some interesting transactions that have hinted at further expansion into near neighbours. In financial services, Bank of China’s purchase of an aircraft leasing business in Singapore called SALE in 2006 was an interesting one-off deal, and more recently Industrial & Commercial Bank of China (ICBC)’s purchase of almost all of Thailand’s ACL Bank increased discussion that China’s vast banks might be looking to become more regional. “It is known quite publicly that ICBC has looked elsewhere in southeast Asia as well,” says Chao. “In Indonesia in particular, the overseas Chinese population there makes it attractive to Chinese banks.”

Macdonald adds: “Having a recognised financial services brand within Asia gives these [Chinese] banks an advantage. We might well see some transactions in financial services in future.” There’s certainly no shortage of capital: despite almost entirely domestic models, China’s banks are the largest in the world by market capitalization. But again, there has to be an obvious rationale for further expansion.

An interesting parallel here is the way that Japanese banks have expanded in the world: they have done so based on a model of serving Japanese corporates wherever they go, and then other businesses develop off that initial anchor. China is likely to behave in the same way. That said, Chinese banks are largely able to do that through establishing offices, rather than feeling the need to acquire in every country they do business in. ICBC, for example, has over 100 overseas subsidiaries, many of them in Asia. Bank of China said in May, when it set up a new Chinese desk in Dubai, that it had 711 overseas business branches and offices covering Hong Kong, Macau, Taiwan and a further 31 countries and regions; in Asia they include seven branches in Singapore alone, plus Malaysia, Japan, Kazakhstan, Korea, Thailand, Vietnam, Indonesia and the Philippines. ICBC’s ACL deal is discussed in the box but looks like something of a test case. “They don’t need to buy a DBS, they just need a presence here,” says one banker. “FIG is a highly regulated sector: it’s not easy to buy banks unless the relationship at a government level is very strong, and even then, buying 100% – which is always the preference for Chinese buyers – is very difficult.”

Political sensitivities aside, the other central challenge in Chinese M&A is talent: finding companies with good management teams that can help them to build. In this respect, Chinese companies tend to behave in perhaps unexpected ways after acquisitions: rather than imposing their own methods, they are very willing to learn. “The Chinese are fairly hands-off in terms of real integration,” says Macdonald. “They tend to trust the foreign management team and want them to stay in place to run the non-China business.” It is almost a reverse integration. “We’ve seen a number of clients want to learn the manufacturing processes, technology or internal systems” of the companies they acquire, Macdonald says. “They seek to learn a lot from the target they are acquiring, rather than assuming they know what to do and taking over. It’s a sensible approach, as they don’t have a surfeit of globally experienced managers.”

As one banker puts it: “It’s not the McDonald’s mentality of: my model should work here, so I will overlay it onto what I just bought.” At Singapore Petroleum, for example, the name has not been changed and the management is largely what it was before the acquisition.

One thing that isn’t a challenge for Chinese state-backed companies is funding. State-backed companies, whether in listed form or through unlisted parents, have deep pockets; if they need more, bank liquidity has long been plentiful; and in recent years the domestic debt capital markets have opened up still another source. Instead, Chinese companies are much more concerned about deal certainty. “One of the clear distinguishing factors on a lot of these deals is that they want absolute certainty,” says one banker. “Announcing a deal and then failing to complete it is not an option.” In both the Singapore Petroleum and ACL deals, the buyers are understood to have required complete certainty that the deal would go through, without any danger of competing bids being considered, before going ahead.

Indeed, far from funding being a challenge, if anything the imperative is for deals to go ahead in the national good. “A lot of China’s huge foreign exchange reserves are locked up in fixed income investments, notably in the US, and with the RMB continuing to strengthen those assets are depreciating just through the exchange rates,” says Chao. “Rather than seeing it gradually deplete, finding more opportunities or assets with a higher long-run return is economical.” One trend that may have an impact is the increasingly international nature of the RMB itself, and another is the emergence of private equity businesses within China.

Beyond M&A, there is also potential for Chinese direct investment in neighbouring countries – setting up factories, for example, or outsourcing manufacturing. This is happening across Asean and sporadically in markets like Bangladesh, but for it to really take hold, the economic benefits of doing so have to outweigh the complexity. Chao says they don’t, yet. “If you are talking about manufacturing, that means dealing with local labour practices, unions, and all those things which can be very challenging for Chinese companies,” says Chao. “Labour costs are still relatively low here in China, and while land costs have been rising dramatically along the east coast, there’s still a vast supply of industrial land if you move further inland. As the economies of inland and western provinces improve, there is a need for Chinese manufacturers to service those markets. Before you see a massive outflow of manufacturing capacity overseas, a lot of Chinese companies would look further west in China first.” Macdonald, though, argues that this sort of direct investment is likely to become more widespread. “There is a tremendous amount of trade within the Asian region, with other territories supplying into China,” he says. And as China’s population enters the middle class, the cost of manufacturing locally is definitely rising; sooner or later the benefits of outsourcing bricks-and-mortar industry to cheaper markets are going to become compelling.

Any sense of Chinese buyers as wide-eyed ingénues going out into the world for the first time is wide of the mark. “Chinese institutions are increasingly getting more sophisticated in M&A situations,” says Elalingam. “With a multinational, the dialogue is relatively simple: where can I find growth opportunities and how much do I need to pay for that growth? Whereas the Chinese have plenty of growth already at home, so it is more important to justify the rationale for a transaction. It usually comes down to ideas with a specific connection back to China.”

One banker recalls meeting a Chinese client in Indonesia recently. “Most people would fall over themselves to enter Indonesia. But for them, it was relatively interesting, but no more. ‘Yes, it’s growing at 8% a year, but so what?’ That was the feedback.”

BOX: ICBC/ACL

ICBC’s acquisition of Thailand’s ACL Bank was the first major bank M&A transaction from China into Asia. It started in September 2009, when ICBC bought 19.3% of the bank from Bangkok Bank and announced a tender offer of the remaining shares; by the following April it had acquired 97.24% of the stock, including a 30% stake from the Thai finance ministry.

As is common in deals involving big Chinese acquirers, ICBC insisted on 100% ownership of the asset (or close enough) and had no interest in a minority stake. That was not straightforward. Thailand had allowed full foreign ownership of banks before, but only after the Asian financial crisis when the banks were in a distressed state; it had never allowed a 100% sale overseas of a healthy bank, as this was. Also, the norm for big asset sales in Thailand was to go through an auction process. Getting certainty on the sale required convincing Thai regulators that the deal was in Thailand’s best interests.

The deal, at $529 million according to Dealogic, was not material for a bank of ICBC’s size: ICBC recorded RMB166 billion (US$25.66 billion) of profit in 2010. But it was considered significant as a rare example of a Chinese bank expanding not through organic growth but an outright acquisition.

It was also closely watched to see what happened next. The name of the bank has changed, bringing it under the ICBC umbrella, but it is largely the same organisation as before. Under a new Chinese CEO, Youbin Chen, most of the executive vice presidents in charge of the various operating divisions are Thais who were there before the takeover. “At the end of the day, it’s a Thai bank,” says one analyst. “They added services to serve Chinese clients. But on its own, does the business work? Yes it does, so changing the management is not top of their agenda. Despite negative perceptions of China, they let the thing run as it is.”

BOX: Tencent/Sanook.com

People tend to get very excited about Tencent. It is one of broker CLSA’s top picks in China; Nomura has a buy recommendation on it, and its latest research report on the stock carries the title: “The X-Factor.”

It generates such excitement because it is China’s largest internet portal, with a leading position in instant messaging as well as internet software, gaming and online advertising. Based in Shenzhen, it listed on the Hong Kong stock exchange in 2004.

It is also one of the relatively rare examples of a private sector company buying cross-border in Asia. In 2010 it bought 49.92% of Sanook, a Thailand internet search and content provider, for $10.5 million. Sanook also provides internet content such as news, entertainment, games and social networking.

It was not, by any means, a huge deal, and tencent itself did not respond to repeated requests for comment to explain it. But analysts considered it significant. Billy Leung, an analyst at OSK Group in Hong Kong, called it “a positive step for Tencent, as their user base in China has reached a high level.” [Over 500 million users by that stage, and over 600 million now.] “While this is a small investment, we believe it shows that the company is embarking on its second phase of growth whereby it actively monetizes its large user base in China, and increases its geographical reach.” Overseas expansion, Leung said, was “a logical step.” It has made similar investments in Russia and, more recently, the US.

Tencent got two seats on the Sanook board as part of the deal and has the right to nominate candidates for executive president. But you wouldn’t know if from the web site, which remains much as it was: Thai, local and populist. As elsewhere, the approach appears to have been to buy something that works and, if it’s not broken, don’t fix it.