Until last year, it seemed that Asia’s economies would never stop growing. Then currencies in the region crashed, stock markets collapsed, and the International Monetary Fund was called upon to shore up the finances of several governments. The Asian miracle was over.

Yet one area at least remained buoyant. Between August and December 1997, in the thick of the crisis, more than 400 mergers and acquisitions worth a total of $35 billion were completed in Asia (excluding Japan), an increase of more than 200 percent over the same period in 1996.

Although many of the deals were struck at huge discounts to valuations made as late as summer 1997, the deal-making was not driven solely by bargain-basement prices. Economic imperatives and changing attitudes were fueling the acquisitions trend, largely unnoticed, before the crisis erupted. In the five years from 1992, the value of M&A deals in the region rose from $25 billion to $75 billion; in Malaysia and Singapore, deals were worth the equivalent of 7 percent of gross domestic product by 1996, similar to the level in the United States. The recent economic woes of some countries in the region have served to accentuate the forces driving these developments.

Many would-be buyers are undoubtedly deterred by Asia’s continuing instability: with the Japanese economy now in recession, further rounds of economic and political turmoil in the region cannot be ruled out. Nevertheless, we believe acquisitions represent an important Asian growth opportunity—though eager purchasers should be wary of rushing in to snap up companies cheaply. Opportunism is no strategy for success.

Why M&A activity is growing

Foreign companies used to complain of a dearth of acquisition opportunities in Asia; government restrictions limited takeovers, and there was a reluctance to sell among targets. More recently, M&A has become a viable strategy for growth in the area, thanks to five factors:

Easing of regulations. Historically, regulations governing takeovers and foreign investment in Asia were restrictive. Economic liberalization and the recent crisis have now speeded up deregulation (Exhibit 1). In India—a country largely untouched by the financial problems that have hit other economies—foreign companies are now allowed to acquire controlling stakes in publicly-listed Indian companies (provided the owners give consent). And in Thailand, the government announced last October that foreigners could buy majority stakes in any of the country’s 15 commercial banks and 91 finance companies. This superseded an earlier ruling that foreigners could take majority shareholdings only in troubled institutions, and that their bids would be considered case by case. Similarly, South Korea has raised the limit on foreign ownership in local companies from 26 to 55 percent as part of an attempt to attract foreign capital to help it overcome its debt crisis.

Restructuring of family-owned conglomerates. Family-owned conglomerates have long played an important role in many Asian economies (Exhibit 2). In South Korea, the top ten chaebol (family-owned conglomerates that have led South Korea’s growth) contributed almost two-thirds of GDP in 1996. In India, seven of the top ten private companies are family owned, and the top 50 family-owned business groups account for 30 percent of total industry turnover.

These businesses once thrived in a protected environment where political connections mattered more than business acumen. In India, which companies grew and which stagnated was largely determined by their relationships with government. In Indonesia too, business empires have been built on little but connections, with favored companies cosseted by government concessions and policies discriminating against competitors. Inevitably, such guarantees also bred inefficiency. The result has been markets dominated by networks of privileged companies, many of which could not have stood up to competition from overseas.

Liberalization has forced change. Increased competition, reinforced by the arrival of multinationals, as well as by investors’ and consumers’ higher expectations, has made local companies consider shedding non-core businesses. In South Korea, for example, many of the chaebol found themselves under pressure from the government to restructure as early as 1995. The crisis has since intensified the pressure. The Ssangyong Group sold its cement business to Texas Industries, a California-based cement company, for $120 million in October 1997, and its profitable paper company to Procter & Gamble for $170 million the following month.

Sale of state-owned companies. State-owned companies account for a large proportion of most Asian economies (Exhibit 3). Generally, their performance has lagged behind that of private sector counterparts, and they have rarely returned their cost of capital. In China, over 40 percent are said to be losing money. In India, the estimate is half.

Privatization is seen as a way of raising performance as well as government funds. Aggressive privatization programs were under way in several Asian countries before the crisis. Early last year, Pakistan, for example, announced plans to offer stakes to foreign companies in the Water and Power Development Authority (the country’s largest power generation utility), Pakistan State Oil (the largest oil utility), Habib Bank (which has assets of $8 billion), and Pakistan Telecommunications. And even in India, where privatization activity has been relatively limited, the government has sold minority stakes in some 40 companies, including Hindustan Petroleum and Bharat Earth Movers. The Indian government has said it plans to raise at least another $2 billion in the next two years through further disinvestments.

In South Korea, stakes in state-run companies including the Pohang Iron and Steel Company, Korea Telecom, Korea Gas Corporation, and Korea Heavy Industries and Construction Company are likely to come up for sale soon. Most governments would prefer to find local buyers for national assets, but some will have little choice but to accept foreign investors.

Overcapacity. Booming demand from an increasingly affluent Asian middle class attracted foreign investment of more than $300 billion into the region during the six years up to 1996. The 20 percent annual growth rate of this incoming capital outstripped GDP growth, and led to severe overcapacity in the car, steel, and chemicals industries. The current decline in the region’s expansion can only make things worse.

Even before the crisis, capacity utilization in Asia’s car industry, for example, was forecast to remain between 45 and 65 percent until 2005—well below the 70 to 75 percent car makers usually need to break even. Many Asian economies now face contracting demand, with Thailand reporting a drop in sales of almost 40 percent in 1997 from the previous year. Forecasts indicate that car sales in most Southeast Asian countries will drop between 20 and 50 percent this year.

Excess capacity is likely to prompt struggling companies to consider selling out, and offer acquisitive companies a relatively cheap way to buy in

Excess capacity is likely to prompt struggling companies to consider selling out, and offer acquisitive companies a relatively cheap way to buy in. In November 1997, Honda acquired Peugeot’s 22 per cent equity stake in a loss-making manufacturing plant in Guangzhou province, southern China, for less than half of the investment required to build an identical 50,000-car capacity plant from scratch. Companies making such acquisitions in markets dogged by overcapacity—capacity utilization in China’s car market is expected to be around 60 percent by the turn of the century—will of course need superior skills to succeed where others have failed. Honda believes it will fare better than Peugeot partly because its higher stake (50 percent against Peugeot’s 22 percent) will give it greater leverage over its Chinese partners. Honda also has a network of local suppliers, which Peugeot does not, and has gained production and sales experience in China through previous joint ventures, such as that with Wuyang-Honda, a manufacturer of engines for motorcycles.

Deregulation of fragmented industries. Many industries across Asia are highly fragmented and uneconomic in scale. The average Chinese paper company, for instance, is a mere one-fifteenth of the size of its US counterpart. China’s consumer goods and pharmaceutical industries are similarly fragmented.

These small companies have survived in markets shielded from open competition, but as Asia’s economies integrate with the global economy and multinationals enter local markets, their future is threatened. To give them a fighting chance, Asian governments have been encouraging, and sometimes forcing, smaller companies to merge.

In 1994, Malaysia introduced a scheme to encourage mergers among banks in the run-up to the turn of the century, when the banking industry is likely to be opened to foreign institutions in line with World Trade Organization directives. Large banks classified as "tier 1" banks by the government are being given greater operational freedom to open new branches and offer wider services, whereas 30 or so smaller banks are being denied such privileges in order to force consolidation. The message is clear: merge or die.

Where the best value-creation opportunities lie

How far M&A represents a growth opportunity will vary by country, according to the degree to which the forces outlined above are at play and investors’ assessment of the political and economic outlook. It will surely take considerable time to restore confidence in Indonesia, for example.

That said, the companies that create most value through M&A will do so not merely by exploiting low asset prices, but by taking advantage of the current structure of Asian economies. Three value-creation strategies are likely to be particularly rewarding:

Improve operating performance. Labor and capital productivity in several Asian countries is far weaker than it is in the West. According to the World Competitiveness Yearbook, 1997, productivity in India and China is estimated to be as low as 5 percent of US levels. Poor operating performance is one of the main reasons, which means there are opportunities for companies with strong core operating capabilities that can buy poor performers, cut costs, improve processes, and raise product and service quality.

GE Capital, the financial services arm of the General Electric Company, has used this approach to expand its business rapidly over the past ten years, making acquisitions in excess of $27 billion. In Asia, its targets include United Merchants Finance of Hong Kong (for $160 million), SRF Finance of India ($15 million), PT Astra Finance of Indonesia ($42 million), and GS Capital Corporation of Thailand ($23 million). By improving systems and processes (especially in credit risk management and customer origination), lowering the cost of funds by virtue of its superior credit rating, and introducing a strong performance ethic, GE Capital swiftly improves results. Most of these acquisitions are privately owned, making performance figures hard to come by. However, it is recognized that GE Capital has turned around the performance of many of its Asian targets, and that several have already won leadership positions in their markets.

Haier, China’s largest white goods company, has completed more than 13 acquisitions since 1991 using the same strategy, and today boasts sales about two and a half times greater than those of its nearest rival. In 1997, the company sold 1.5 million refrigerators, 1 million washing machines, and 450,000 air conditioners. Haier typically buys loss-making companies with fundamentally sound products, then applies its operating and brand management skills to enable it to charge premium prices. A strong distribution network—it has a presence in all China’s leading cities, and some 7,000 sales points abroad—increases its product reach. Between 1993 and 1997, Haier’s sales grew by more than 48 percent (compared with 15 percent for the industry as a whole), and its market capitalization by more than 77 percent (against a rise of 1 percent for the Shanghai stock exchange index). Over the same period, the company generated an impressive 68 percent return to shareholders.

Capture scale economies. Industries such as pharmaceuticals and banking that could exploit scale economies have long failed to do so in several Asian markets. There is therefore tremendous potential for buyers to create value by acquiring small companies and consolidating manufacturing, distribution, and selling.

Rashid Hussain Bank of Malaysia has created value in this way. In 1990, when still a broking house, it acquired a controlling 20 percent stake in DCB Bank for $850 million. In 1996, it pulled off the country’s biggest ever bank-ing merger by combining DCB Bank with Kwong Yik Bank to create Rashid Hussain Bank. The resulting scale won the new entity "tier 1" status under Malaysia’s new banking scheme, and synergies across its businesses. When Renong, a construction group, wanted to float its toll-road operations on the Malaysian stock exchange, for example, Rashid Hussain agreed to provide funding only if its brokerage arm undertook the stock market listing.

Rashid Hussain is today Malaysia’s third-largest bank, and its largest brokerage house. But the buying spree is not over. Its owner, Tan Sri Rashid Hussain, wants to merge the bank with Commerce Asset Holding, Malaysia’s sixth-largest financial services group, to create the country’s second-largest banking group.

Lack of competition has enabled local companies to thrive despite poor products and services

Restructure the industry. Lack of competition has enabled local companies to thrive despite poor products and services. There are therefore opportunities for buyers to acquire these companies with the principal aim not of improving existing businesses or capturing synergies, but of building entirely new business models.

Hindustan Lever, a subsidiary of Unilever, is changing the face of India’s ice-cream market in this way. A few years ago, the market was the preserve of small regional ice-cream makers. After acquiring the three largest for $60 million, Hindustan Lever now boasts a market share of about 70 percent and is expanding its product range, investing heavily in advertising and promotion to build stronger brands, and improving refrigerated transportation and retail cold storage facilities to increase product shelf life and market penetration. What used to be a slow-growing, fragmented market is now expanding by more than 20 percent a year.

Although Hindustan Lever will create some value by improving the acquired businesses and capturing scale economies, most will derive from the way the company is transforming the industry, creating a market for a higher-quality product and a broader product range, and boosting demand to new levels.

What will it take to succeed?

Funds are an obvious requirement for would-be buyers. Raising them may not be a problem for multinationals able to tap resources at home, but for local companies, finance is likely to be the single biggest obstacle to an acquisition. Financial institutions in some Asian markets are banned from lending for takeovers, and debt markets are small and illiquid, deterring investors who fear they might not be able to sell their holdings at a later date. The credit squeeze and the depressed state of many Asian equity markets has only made an already difficult situation worse.

Funds apart, a successful M&A growth strategy must be supported by three capabilities: deep local networks, the ability to manage uncertainty, and the skill to distinguish worthwhile targets. Companies that rush in without them are likely to stumble.

Asian markets are being prised open, and deals are no longer the preserve of those with the right connections

Build local networks. As we have seen, Asian markets are being prised open, and deals are no longer the preserve of those with the right connections. Nevertheless, change will not happen overnight. In 1996, almost 70 percent of M&A deals in the region consisted of one Asian business buying another. Because doing business in Asia is still so driven by relationships, it is companies with local market networks that will hear about the best deals, and those that have a personal relationship with the seller or high market standing that will be invited to bid.

Relationships that deliver these kinds of privileges are often the product of networks developed over decades, and give companies that enjoy them an undeniable lead over foreigners in these markets. But less fortunate companies cannot afford to throw up their hands in despair and try to manage without. Strong local networks will be crucial for corporations that wish to grow though acquisitions in Asia, although they need not be as wide-ranging as those enjoyed by many Asian companies, and can sometimes be built fairly rapidly.¹

One way to go about the task is to hire and develop a high-performing team of local managers who have ready-made insider networks. When GE Capital entered India in 1993, it recruited the best and most experienced managers from the country’s financial services and banking industry to share their knowledge about local conditions. A team like this buys instant insight into tax, legal, and regulatory complexities, and an industry network that can help in recruitment, obtaining regulatory approval, and gaining access to new deals. Today, with more than 100 man-years of local operating experience, GE Capital’s networks in India compare with the industry’s best, and the company has had its pick of the plum financial services deals.

Another option is for companies to choose private equity partners who have the required insider capabilities. In return for their investment (typically anywhere between $5 and $50 million) and their knowledge and experience of the local business environment, private equity partners are likely to seek a return on equity in excess of 25 percent.

Manage uncertainty. The potential to create value through acquisitions will hinge on three variables: the economic outlook (even as crisis-hit countries embark on reform, it is uncertain when and how fully their economies will recover), regulation, and the level of competition. Exhibit 4 shows how these variables could affect the value created by the purchase of two Thai telecommunications companies.

To manage the high degree of uncertainty that currently exists in some Asian countries, buyers must define and monitor specific indicators to get an early warning of the scenarios that might unfold, then develop contingency plans that allow them to protect themselves in worst-case scenarios, but to maximize any possible gains.

Assessing companies in Asia can be fraught with problems, and several deals have gone badly wrong because buyers failed to dig deeply enough

Assess target quality. To say that a company should be worth the price a buyer pays is to state the obvious. But assessing companies in Asia can be fraught with problems, and several deals have gone badly wrong because buyers failed to dig deeply enough. The attraction of knock-down price tags may tempt companies to skip crucial checks. Concealed high debt levels and deferred contingent liabilities have resulted in large deals destroying value. But in other cases, where buyers have undertaken detailed due diligence, they have been able to negotiate prices as low as half of the initial figure.

Due diligence can be difficult because disclosure practices are poor and companies often lack the information buyers need. Moreover, most Asian conglomerates still do not present consolidated financial statements, leav-ing the possibility that sales and profit figures might be bloated by transactions between affiliated companies. The financial records that are available are often unreliable, with different projections made by different departments within the same company, and different projections made for different audiences. Banks and investors, naturally, are likely to be shown optimistic forecasts.

The economic climate has probably made things worse, pushing some desperate companies to conceal liabilities or grossly overstate assets in a way that is hard for outsiders to detect. It should be borne in mind that seeking recourse under the local judicial system is likely to be slow and frustrating.

The best solution is prevention: taking more time over due diligence than would be normal elsewhere. GE Capital spent more than three months completing due diligence for a recent acquisition in Asia. In the West, the process usually takes no more than a few weeks—even for the largest deals.

Buyers should complement their own efforts with those of local experts, especially in the areas of tax, accounting, and compliance. Accounting items, particularly debt, intercompany advances, payments due to creditors, and contingent liabilities, need to be probed in greater detail than would be usual elsewhere. Detailed interviews with customers, suppliers, and finan-ciers—rarely conducted in the West—can be valuable sources of information to validate data from the target company. In short, it is better to spend time and resources on checks at the outset than face surprises and perhaps huge losses later on.

The way forward

The economic and political outlook in the different Asian countries will determine where would-be purchasers should focus initially

The economic and political outlook in the different Asian countries will determine where would-be purchasers should focus initially. From there on, an individual company must decide the extent of M&A opportunities in its own industry, which will depend on the extent to which the five forces driving M&A are at play.

The next step is to decide which value creation strategy to pursue. This will largely depend on the industry’s current structure. In industries where the operating performance of players varies but cross-company synergies are limited, for example, the best strategy is likely to be to improve operating performance. In industries where substantial cross-company synergies exist (for instance, sales and distribution in banking and financial services), or certain functional areas have important scale economies (for instance, R&D in the pharmaceutical industry), capturing scale economies is likely to be the best value-creation strategy. If the economics of an industry can be altered by improving the intrinsic value of the product or service, or by creating a new way of delivering it, then restructuring the industry is likely to be the most effective strategy.

However, a buyer’s own strengths are also important. Each of the three chief value-creation strategies requires different skills of a buyer. If the plan is to improve operating performance, the buyer will itself need to be a strong operating performer, and have institutionalized systems and processes to transfer its operating capabilities. If the plan is to tap scale economies, then a buyer needs the skills to integrate organizations and harness cross-company synergies. And if the aim is to restructure an industry, a buyer must have the ability to consummate a stream of acquisitions.

Finally, companies will have to act decisively to build the three key capabilities that support a successful strategy—local networks, the capacity to manage uncertainty, and the ability to distinguish prime targets—because many of the best targets will almost certainly be sounded out by buyers over the next two to three years.

Those that move quickly, that understand the region’s long-term potential, that have the courage to dip a toe in what may be unknown and turbulent waters, and that have staying power, will be in the best position to capitalize on Asia’s growth opportunities in the coming decade.