Multinational companies spent more than $60 billion on new businesses and joint ventures with Chinese companies in 2004. Cross-border mergers and acquisitions, by contrast, have yet to induce anything like the same level of investment fever. Inbound cross-border M&A deals were worth less than 12 percent of total foreign direct investment and individual deals have been small. By comparison, among the ten countries, apart from China, that attract the greatest amount of foreign capital, the average ratio of inbound M&A to foreign direct investment was 47 percent in 2004.

China's weak M&A market might in part be a legacy of a time when foreign investment was restricted largely to joint ventures. Now, though, the limitations on investment in many industries are being removed, and cross-border M&A activity is poised to increase. State-owned enterprises are cleaning up their asset portfolios and improving standards of disclosure, making them attractive targets for foreign investors. A number of private companies better managed than their state-owned peers are also emerging as candidates. In addition, the overcapacity resulting from China's excessive investment in fixed assets suggests that local and multinational companies could pick up assets and businesses inexpensively when the inevitable restructuring takes place. The automotive and beer industries, for example, are widely estimated to have overcapacity of more than 50 percent.

Although transactions more than tripled over the past seven years (Exhibit 1), the average inbound deal is still valued at less than $20 million. That too seems destined to change. In the first ten months of 2005, for example, investment in China's banking market alone has exceeded $10 billion more than five times the maximum amount that multinational companies invested in the banking sector in previous years.

Multinational companies hoping to tap China's M&A potential will have to master some well-documented challenges: they must ensure that transactions are driven by strategic considerations and that they are properly equipped on the local level to complete deals. Aspiring buyers must also consider the peculiar dynamics of the Chinese market specifically, the fact that conventional approaches to M&A are inappropriate in China. First, corporate control is more important than ownership to the Chinese, and overseas companies cannot secure or maintain control in the same way that they might do elsewhere in the world. Next, traditional valuation is often impossible, since benchmarks and reliable financial information are rare. Often, option value is everything. Finally, forecasting methods used routinely in more mature markets do not apply to China. Companies must thus be prepared to spend more time on due diligence.

Structuring a deal for control

Most strategic investors seek control of a business believing that they can run it more effectively than the current owner and generate greater value. In the developed world, control is commensurate with equity ownership; majority ownership gives a buyer the right to operate the acquired business. In China, though, government regulations still prohibit majority foreign ownership in more than 25 industries, including banking, telecommunications, and auto manufacturing. Furthermore, Chinese owners often desire control, or the appearance of control, for social or personal reasons.

Where buyers cannot acquire majority ownership, they must exert control by other means. A deal can be structured to give an investor adequate board representation, for example. Few joint-stock companies listed in China have an accumulative voting system, so foreign investors cannot assume that their representation on the board of a target company will be in proportion to the stake they purchase. They must thus ensure that their board standing reflects the true economics of the transaction and that they have a say in the election of independent directors. The use of governance provisions in this way by some multinational companies has led to different levels of control in different industries (Exhibit 2).

Buyers can also insist on the right to fill crucial posts, such as those of chief financial officer and chief technology officer. One global consumer goods company, for example, needed this kind of authority before it could meet certain important goals: to integrate an acquired company's operations with an existing management-information-system platform and to implement proprietary production techniques designed to eliminate waste and improve efficiency by up to 40 percent.

Another successful approach to structuring deals involves outlining important areas of decision making and establishing mechanisms to exercise control over them. If direct control of the board is impossible, a buyer might push decisions down to a level where it can exercise authority through day-to-day operational decisions. The general manager of a chemical joint venture, for example, was appointed by the multinational partner. This manager was given the right to make almost all important decisions including decisions relating to budgeting, hiring, and firing except for those that by law must be made unanimously by the board.

Some multinational companies, aiming to win as much control as possible, use several of these techniques in parallel. Often multinationals combine them with an agreement to increase ownership and control over time. Some arrangements will be easier than others for a Chinese seller to accept, so it is imperative that buyers mix and match according to the specific context of a deal. One global consumer goods company negotiated the right to nominate three out of nine board members directly, to select and approve three independent directors, to appoint the vice chairman, to establish and nominate executive committees, and to oversee essential functional tasks. The company thus wielded the degree of control necessary at least to voice its opinions at the board level and to influence board committees.

Determining intrinsic value

Many buyers confess that valuing companies in China is guesswork. There are few benchmark transactions or publicly traded companies to act as a guide and few completed transactions in any one industry. Relying heavily on a multiples-based valuation¹ can lead to highly distorted results, while the Chinese market is too dynamic for discounted-cash-flow analysis to be accurate; forecasting cash flows beyond three to five years is mere conjecture. In addition, Chinese counterparties often use a statutory valuation, which is similar to valuing assets at book value but does not take into account the level of cash flow the assets could generate. It is no surprise, then, that a statutory valuation might undervalue or overvalue an asset. Chinese negotiators just don't think in future-cash-flow terms, says one negotiator from a multinational company. The Chinese, for their part, complain that foreigners routinely offer purchase prices below the minimum required by law, so the deals are just not viable (Exhibit 3).

These contrasting views highlight the importance both of calculating a range of valuations based on different scenarios in order to arrive at an acceptable value range and of using the right methodology. Most overseas companies say that they will not pursue a deal unless it fits within their value metrics or their framework for return on investment. Some attempt to account for the additional downside risk by including a large risk premium in the discount factor. Uncertainty has upside as well as downside potential in China, however, and buyers that use the wrong methods of valuation might forgo strategically important deals. In our experience, a few practical tips are useful.

Use a wider range of valuations and let strategy be your guide

Past growth rates and margins do not provide an accurate guide on how an industry will develop in China. Yet the boards of multinational companies often insist that their valuation teams come up with a single, bottom-line number. As a result, deal teams frequently feel pressure to under- or overprice a purchase rather than explain why the value realized could be higher or lower, depending on the industry's evolution. Using a wider range of valuations would give a buyer leeway to assess the most likely outcomes and to base its decisions on the way China fits into the overall company and industry strategy.

Be realistic about synergies

Buyers often look to the synergies of deals to justify investments. But capturing synergies in China is difficult. Cross-selling products, for example, is unrealistic if brands and products are positioned for different market segments: it is just not feasible to try to cross-sell, say, a premium brand of beer through a largely rural distribution network. Synergies in revenues and labor (through massive layoffs of workers) are also hard to achieve. In addition, buyers must be aware of potential postacquisition cost increases owing to the expense of an expatriate staff and spending on health and safety improvements. Savings in production and operations are easier to capture, although sometimes a deal's value resides not in its synergies but in its long-term option value: capturing the potential and growth of the sizable Chinese market.

Share upside and downside risk

When differences over the valuation of a company cannot be bridged, buyers should seek to structure a deal so that it takes this uncertainty into account. In one joint venture, the multinational partner agreed that it would make an additional payment three years after the transaction date if the venture achieved an agreed-upon earnings target and if tax regulations changed. Such earn-out mechanisms are useful when opinions vary over other external factors, such as industry growth and the cost of key inputs. The trick with earn-outs is to focus on matters that are generally beyond the influence of either negotiating party; otherwise, there is room for gamesmanship, which should be avoided.

A detective force for due diligence

Due diligence is the core of acquisition procedures. In our experience, buyers tend to be either overly cautious (thus missing potentially attractive opportunities) or overly optimistic (and likely to find surprises later on). The information needed for robust due diligence is elusive in China, where IT systems are generally weak, databases lack breadth and capacity, and legal systems and requirements remain opaque. Furthermore, agreements are often oral, and the high proportion of cash deals makes it difficult to validate the true ownership of stated assets.

For these reasons, investors should expect a high level of liability and risk exposure and make sure that any team conducting due diligence on their behalf has enough time and people to dig for information. Accounting and legal advisers with local experience are essential. Wherever possible, teams should be based locally and have the insider knowledge and relationships needed to understand target companies fully.

The most delicate due-diligence issues for negotiations in China include the following:

• Asset ownership. Many newly formed Chinese companies do not have adequate documentation to show what assets belong to them. Furthermore, problems often arise in transactions between related parties, where there is little evidence on the nature and details of such deals. Buyers should confirm the ownership of assets, investigate related companies, and ascertain whether acquired assets are subject to a bank pledge.
• Business scope licenses. Companies are normally allowed only a narrow scope for business in their articles of incorporation and business licenses. Certain specialized lines of business require licenses from government agencies, and Chinese law does not always permit the transfer of these licenses in M&A transactions. In addition, foreign ownership can often affect applications and license renewals. Due-diligence teams should sort out these matters.
• Land use rights. In China, land is owned by the state, and companies and individuals hold allocated or granted land use rights. When Chinese partners contribute capital to a deal in the form of land, it is essential to understand what land use rights are attached to it.
• Tax and financial liabilities and benefits. Different legal entities might be entitled to different tax and financial benefits and incentives from the local or central government. These incentives might not be transferable to a foreign owner. In addition, Chinese companies are often exposed to off-balance-sheet liabilities. Buyers should draft and sign indemnification agreements to protect themselves against damage from hidden liabilities.

If an overseas company remains unsure of a target company's value after due diligence has been carried out, it could insist on a clause requiring the shares it has bought to be repurchased at a fixed price in certain circumstances. The acquisition of Bank of China shares by the Royal Bank of Scotland, in September 2005, provides an example. If additional due diligence finds any surprises, the price per share will change in Royal Bank of Scotland's favor; and if Bank of China does not pursue an initial public offering within three years, it will be required to buy back all of Royal Bank of Scotland's shares. This type of structure gives a multinational company more confidence when acquiring a business and puts the Chinese seller under pressure to implement proposed changes. It also ensures that both the buyer's and the seller's objectives are aligned for value.

Multinational companies planning M&A ventures in China will be breaking new ground. To succeed, they must be prepared to adapt their deal-making mechanisms to the characteristics of the local market.