global rethinking of chinese state-owned enterprises ... · large-scale overseas mergers and...

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Global Rethinking of Chinese State-owned Enterprises Outbound

M&A

A thesis submitted to the Bucerius/WHU Master of Law and Business Program in partial fulfillment of the requirements for the award of the Master of Law and Business (“MLB”) Degree

Xiaoyuan Duan

July 22, 2011

121.000 words (excluding footnotes)

Supervisor 1: James J. Hanks

Supervisor 2: Stefan Jentzsch

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ABSTRACT

With the globalization trend and rapid development of China’s economy,

Chinese companies especially state-owned enterprises more and more involved in

global competitions. Outbound M&A become a new and hot choice that Chinese

enterprises choose for their overseas investment. The financial crisis also provided

good timing for Chinese companies invest abroad. In recent 10 years, no matter the

deal volume or the value made by Chinese enterprises had attracted global attention.

Chinese state-owned enterprises are the major force in the total outbound M&A deals.

This article mainly discuss the current situation and motivations lead Chinese

outbound M&A activities. China due to its special political and economic structure, is

facing challenges when launching overseas investments. Chinese SOEs have much

higher failure rate than private or foreign companies when conduct cross-border

M&A. The author tries to analyze the reasons behind it and propose appropriate

countermeasures for it. Cooperating with Private equity fund could be the new trend

for Chinese SOEs outbound M&A.

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LIST OF ABBREVIATIONS

M&A Merger and Acquisitions

SOE State-owned Enterprises

SASAC State-owned Assets Supervision and Administration Commission

FDI Foreign Direct Investment

R&D Research and Development

PRC People`s Republic of China

CFIUS Committee on Foreign Investment in the United States

SWF State Wealth Fund

IPO Initial Public Offering

LBO Leverage Buy-out

SAC Securities Association of China

PEF Private Equity Fund

GATT General Agreement on Tariffs and Trade

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I. Introduction

With China’s economy development especially after the outbreak of the

global financial crisis, Chinese enterprises set off a wave of rapid outbound mergers

and acquisitions (M&A). Their economic scale, volume and growth rate have reached

unprecedented levels. As Colin Banfield, the Citi head of mergers and acquisitions for

Asia-Pacific comments, “We’ve seen strong levels of outbound M&A activity from

China and I would expect that to continue.”1

After 30 years economic reform and opening up, China changed from a

closed, inefficient economy unit into the world’s largest capital accumulation country.

Chinese enterprises entered into a new stage of development – the capital export.

Although the economy condition improved dramatically, China's outbound M & A is

still quite young. Its overseas M&A activities only have a history no more than 10

years. 2002 is commonly known as the year China’s outbound M&A first began.2

With such a short history, China’s outbound M&A market expands rapidly from 200

million US dollars in 2002 to 38 billion U.S. dollars in 20103. According to

Accenture’s recent report conducted in 2010, from January 2008 to June 2010,

1 Clifford Chance, p. 3.

2 Wang, 2002-China`s starting year of M&A (2002 年，中国并购元年),

http://www.people.com.cn/GB/paper2086/6146/610122.html.

3 Zhang, The record of last year China`s overseas M&A total more than $38 billion US dollars (去年

中国海外并并购数创纪录总额逾 380 亿美元 ),

http://news.dayoo.com/finance/201101/18/53869_15020333.htm.

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China’s outbound M&A reached 120 cases and the total amount went up to 600

billion U.S. Dollars.4 A booming outbound M&A market has gradually emerged.

With more and more Chinese enterprises entering into the "International Competition",

strategic outbound M&As become the new trend for Chinese enterprises involved in

foreign direct investments.

II. China’s Overseas M&A Activities Attracted Global Attention

China began its huge overseas investments in the mid-2000s. The scale and

volume of overseas investment attracted global attention. Some representative cases

include Lenovo Group acquiring IBM's PC business in 2004, which opened prelude to

large-scale overseas mergers and acquisitions with more than one billion U.S. dollars

5; In 2005, CNOOC bid for Unocal in 18.5 billion U.S. dollars, ranked the third

highest in the year’s overseas M&A6. In 2006, China Construction Bank

acquired Bank of America in Hong Kong, a wholly owned subsidiary - Bank of

America (Asia) Co., Ltd. 100% equity with all-cash, Hong Kong dollar 9.71 billion7.

Geely spent 1.8 billion U.S. dollars on the acquisition of Swedish Volve in 2010,

4 Yan, China spends $91b on overseas M&As in 3 yrs,

www.chinadaily.com.cn/business/2011-01/06/content_11804737.htm.

5 Wang, Management World 2007, p. 4.

6 Shan, International Business Trade 2005, p. 14-17.

7 Liu, Development Research 2011, p. 72.

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which is the largest overseas acquisition by a Chinese company that year8.

This M&A wave is not seeing a stop and will continue into the future.

Recently, at the strategic and Economic Dialogue (the “S&ED”) held in Washington, a

new topic has burst on the scene: direct investment by Chinese firms in the United

States.9According to the Wall Street Journal, between now and 2020, China firms are

expected to deploy between $1 trillion and $2 trillion of direct investments abroad.

They find that over the past two years direct investment expenses by Chinese firms in

America have grown more than 130% a year.10

According to statistics from the United Nations Conference on Trade and

Development, direct investment by Chinese companies in foreign firms amounted to

$52.1 billion U.S. dollars in 2008. Mergers and acquisitions accounted for 54% of the

total investment. In 2009, direct investment increased to US $72 billion, with 40.4%

coming in via M&As.11

8 Zhou, Modern Business 2010, p. 81-82.

9 Rosen and Hanemann, America Gains From Chinese Investment, in: The Wall Street Journal

12.05.2011.

10 Id.

11 Cheng and Reporter, Majority of Chinese Overseas Acquisitions Will Fail: Accenture,

www.wantchinatimes.com/news-subclass-cnt.aspx?cid=1206&MainCatID=12&id=20110108000003.

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12

China's state-owned enterprises (SOEs) have been the major force in the

overseas acquisitions arena. According to statistics from The Economist, Chinese

firms made 172 overseas M&A deals that over U.S. $50 million from January 2004 to

November 2009. 81% of those deals were made by state-owned enterprises. 13

Although Chinese private companies more and more take active part in the global

market and started M&A overseas, their volume and value can barely compete with

Chinese SOEs. According to State-owned Assets Supervision and Administration

Commission (SASAC) statistics, “…at the end of 2009, 108 Chinese state-owned

enterprises set up over 5,901 overseas units. The SOEs overseas assets total amount

reached more than 4 trillion U.S. dollars. ” 14 Chinese enterprises also invest in

countries all over the world. North America, Western Europe, other Asia regions and

Australia are the most popular regions for them.

12 Deloitte report, p. 67.

13 Lee, Economist Intelligence Unit 2010, p. 5. 14 Liu, Chinese central enterprises investment goes out of “painaodai” period (央企海外投资走出“

拍脑袋”时代), http://finance.ifeng.com/roll/20110711/4247307.shtml.

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15

Since SOEs being the major force in China’s outbound M&A activities.

This article is mainly analyzing the motivations that Chinese SOEs start outbound

M&A activities. It is also notable that Chinese enterprises especially SOEs have much

higher M&A failure rate than private and foreign companies. The author tries to find

the reasons behind it and propose proper solutions.

III. Reasons why Chinese Enterprises Conduct Outbound M&A

Chinese enterprises’ outbound M&A becoming a interesting economic

phenomena in recent years and the reasons behind it are worth analyzing.

3.1 Globalization and International Competition Strength


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Different from national M&As that only aim at expansion of scale, reduce

costs and industry transfer, M&A under globalization is based on global economy

resource relocation and redistribution process and has become an important way to

corporate growth. Cross border M&A has now become a method that world-scale

companies used to conduct more complex integration in a larger economic region and

business scale, establish new operating standard, structure closely integrated global

production system, and post direct impact on the global economic landscape to

achieve their corporate strategies.

The timing of the financial crisis has no doubt provided great opportunities

for Chinese enterprises take part in the global market. China’s abundant foreign

exchange reserve and strong currency also provide a strong foundation for a policy of

external investment. “Outbound M&A activity has been very active during the past

few months with Asian corporations trying to take advantage of relatively depressed

market conditions and valuations in the Western economies whilst supported by

strong and favorable exchange rates.” 16

3.2 “Going Global” Strategy

In China, government policies always play an instrumental role in the

economy. Chinese SOEs are the mainstay of China’s national economy. Almost all

important industries are monopolized by Chinese SOEs, for instance, petroleum,

16 Rosen and Hanemann, America Gains From Chinese Investment, in: The Wall Street Journal

12.05.2011.

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chemical, machinery, electronic, metallurgy, nonferrous metals and etc. The

government always leads the way regarding how SOEs act, in what industrial sectors

they operate, and the extent of their involvement. This is not only due to China’s

socialistic political structure. The state’s role as a major shareholder in numerous

SOEs is the main reason that the government provided detailed policies and guidance

regulating the development of their enterprises.

The “Going Global” policy was initially introduced in 1999 and has been

China’s national long-term strategy for almost ten years. “Going Global” is the banner

name of a national policy encouraging outward investment by Chinese companies.

Chinese government guided in their annual report and national 5 years plan to

encourage Chinese companies take active part in the global market, which in

particular encourage exploring natural resources and improve the industry structure

adjustment to transmit Chinese industries to a higher value chain. It has evolved over

time to represent a conglomerate of individual policies. 17

“Policymakers are increasing support for outbound FDI further due to

China’s massive foreign exchange reserves and the need to build up competitive

corporations to sustain a change in China’s economic growth model.”18 It also

provides a means of reducing appreciation pressures on China’s currency.

17Gu and Reed, Working Paters in Economics 2010, p. 4-6.

18Ebbers and Zhang, Eastern Journal of European Studies 2010, p. 8.

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Chinese policy makers start to notice the worldwide environment for

development and encourage outbound FDI especially after entering WTO. In early

2000s, China formally adopted a policy of encouraging main state-owned oil

companies to engage in global exploration projects. China also gradually eased and

reformed the regulatory process and foreign exchange control. Nowadays only large

amount transactions need to be reported to the central government. The local

governments have much more power to approve outbound M&A transactions. Central

government and local governments also begun to provide political and practical

assistance for firms with overseas expansion plans.

3.3 Natural Resources Demand

With the rapid growth of the Chinese economy, there will be a more

significant increase in natural resource demand. China now has the largest annual

increases in oil consumption in the world and still will be the largest single driver of

growth during the next decade. Natural resource intensity has reached national

security levels and constrains China’s sustainable development.

“Meanwhile, the Chinese domestic oil production, while substantial at 3.8

million bpd, will be foreseen to remain relatively flat or decline slightly. All

incremental increases in demand will have to be satisfied by imports.”19 In 2003,

Chinese Academy of Geological Sciences published a report anticipating that in

addition to coal, China has scarcity in all mineral resources. In 20 to 30 years, China

19 Eurasia Group Report 2006, p. 2.

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will face all kinds of resources shortages including oil and gas, and the dependence on

imports from other countries will dramatically increase. China’s energy per capita

cannot meet the growing demand for resources. The report also points out that China’s

industrialization needs require additional resources including oil, gas, copper,

aluminum, aggregate demand is at least two to five times of the current total Chinese

reserve. 20

This report raised wide attention by the Chinese government and society. It

addresses concerns that there be sufficient resources to sustain China’s growth over

the middle to long term. An energy shortage crisis may gradually build and be the first

noticeable symptom of the over demand of available resources. There is an urgent

need to secure the natural resource supply.

Citi`s Banfield cited that “There are a few themes at play here but the most

important remains the securing of natural resource assets, which has been a prominent

theme for several years now but which shows no signs of slowing down…the

mandated pipeline of activity remains strong.” 21

As an oil-consuming country, China is establishing its own strategic oil

reserve system. The Chinese government also regards China’s energy supplies,

particularly oil and natural gas, to be increasingly insecure. Chinese enterprises

20 Chinese Academy of Geological Sciences, Land Ressources Intelligente Report 2009.

21 Clifford Chance/FinanceAsia, p. 4.

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especially SOEs took vigorous acquisition of international energy resources to

implement the “going global, multi-channel” energy security strategy. China’s three

oil giants, China Petroleum, Sinopec, and CNOOC all exacerbated overseas

expansion. Large state-owned enterprises` internal restructuring and M&A action is

under the consideration of national economic security.

“China’s SOEs continued their quests to globalize, striking mega deals,

mostly in nature resources but in other select industries as well.”22 Sameera Anand

commended.

23

3.4 Growth of Company

22 Id, at p.2.


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According to the efficiency theory, international M&A will create synergy

effect. Two companies combined together could be better off compare to independent

existence. “Corporate Success” drives China’s outbound M&A as well. Chinese

enterprises especially SOEs have always carried the mission to enlarge the company

and gain global impact. This is another reason that Chinese companies are entering

into the global market. For example, Haier, TCL, whose aims now are entering into

World Top 500 companies series. Portfolio management is more concerned by leaders

of these companies. IBM`s acquisition of IBM PC business set a good example. Their

M&A activity is further expand business scale and rapid market access. “It presents an

opportunity to modernize Chinese business via the appropriation of foreign

technology and the assimilation of modern business practices.” 24

3.5 Technology

China has been known as the “World Factory” for many years. Cheap labor

and low cost drive China’s economic growth. But this growth model is at the expense

of the environment and raised various social problems. In particular, facing the recent

Chinese economy situation, although China is still managing to keep rapid annual

GDP growth, raising labor cost, fluctuation of raw material prices, sluggish domestic

sales and exports become more and more serious problems for Chinese companies.

And the low cost advantage is gradually disappearing. If China were to continue to

stay in the mere production business stage, future development can hardly be

24 Gu and Reed, Working Paters in Economics 2010, p. 5.

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sustainable. Technology development and upgrading become urgent for China to shift

its industrial level to a higher level and rise in the value chain.

The biggest stumbling block which hindered Chinese enterprises´

globalization effort is when they failed to fully grasp core technology in related

industries. Reality has proven that without core technology, Chinese enterprises can

hardly survive under a global competition environment. In this grim situation,

outbound M&A was recognized by some Chinese enterprises as the most direct and

effective way to obtain core technology. TCL acquired German television company

Schneider25; BOE acquired Hyundai Display Corporation, which gained direct access

to a fifth-generation LCD production technology26; Lenovo Group acquired IBM PC

business, which get access to leading-edge PC and notebook manufacturing

technology. These companies´ overseas M&As were more based on seeking

technology than acquiring physical property. They tried to combine the core

technology and R&D with their own to reduce cost and increase technological

production leading to cost advantages as well as certain increased marketing

capabilities. This allowed them to their enterprises by leaps and bounds.

Not only dealing with the global market, technology is also an important

factor to increase companies’ intense competition advantage within China. Outbound

25 Zhu, Business Figures 2003, p.20-22.

26 Id.

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M&A could not only capture the advanced technology, but also enable companies to

participate in the global competition and the domestic market.

3.6 Market

The global market is more and more attractive to Chinese enterprises. The

desire to find new markets will also drive deals. Nowadays, the competition within

Chinese national market is extremely high. In almost all non-government regulated

industries, there are over-competition problems. Some companies face serious surplus

issues. These companies always also have a large share in domestic market so there is

not so much space for companies’ development. Being in markets with a limited

growth potential can be a cause for diversification. Develop national market won’t

make any further impact. Under this situation, exploring overseas market becomes a

new arena for companies´ sustainable growth.

Moreover, with the access by other foreign companies to the Chinese

market, Chinese enterprises´ cost and distribution advantages will gradually disappear.

International competition is not avoidable. Enterprises must find new market, at this

moment, outbound M&A become an available choice. As TCL acquired Alcatel’s

mobile phone business27, this deal did not only get TCL have access to related

technologies and their R&D team, but TCL also obtained the brand and marketing

channels in Europe, which paved TCL´s way into European market. If Haier could

27 Wu, Marketing case 2011, p.54-56.

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have successfully acquired Maytag, it would have gotten 16% market share in U.S.,

which cannot be achieved in a short period by any company. However, this deal was

not successful in the end.

The anti-dumping issues are always a great pain for Chinese enterprises

entering the EU market. Circumventing trade barriers is another reason in particular

for Chinese enterprises to seek overseas acquisition. The typical deal is illustrated by

when TCL acquired Schneider. This acquisition enabled TCL to gain up to 200

million Euros in sales and more than 400 thousand color TV market share in

European market. This exceeds the total quota 400,000 units EU granted to seven

Chinese appliance enterprises together28.

Chinese enterprises mainly SOEs could take advantage of the host

country’s rich reserve of natural resources and raw materials, reduce transportation

costs, avoid trade barriers, reduce the cost of tariffs, and enjoy the preferential policies

for the host country. Furthermore, China’s economy in the last years has experienced

strong growth and the increasing overall strength provided SOEs protections for their

overseas investment. China’s high trade surplus and foreign exchange reserve also

bring SOEs strong financial support. China’s manufacturing ability also became an

advantage for SOEs cross-border M&A. It could be foreseen that in 3 to 5 years, with

government support, large SOEs still will be the main force of Chinese enterprises in

28 Zhu, Business Figures 2003, p.20-22.

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overseas M&A.

IV. Chinese Enterprises Especially SOEs has a Much Higher Failure Rate in

Overseas M&A

M&A itself is a very difficult object for all corporations, especially in

cross-border environment. Globally speaking, almost half of the M&A deals ends up

as unsuccessful. Although in recent years, China’s outbound M&A wave sweep the

world, more and more problems showed up during the process. Chinese enterprises,

especially SOEs, now suffered great pain for their foreign investments.

Chinese SOEs are starting to accelerate their pace of globalization, but the

results have been the opposite of what they expected. Huge losses resulted constantly.

If the successful acquisition is defined as completion of M&A deals, the Thomson

Financial Merger and Acquisition database used a data set containing 1324 announced

Chinese cross-border acquisition deals from January 1982 to April 2009, they finds

that that only 679 were completed. “This success rate of 51.2% is not only lower than

that of a developed country like the USA (76.5 per cent), but also lower than the

worldwide average (68.7 per cent)” 29, they figured that the likelihood of a Chinese

firm to succeed in a overseas acquisition is lower than average.

Internationally renowned financial data provider Dealogic`s report shows

29 Zhang and Ebbers, International Business Review 2010, p. 231

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that in year 2009, Chinese enterprises cross-border acquisitions has failed at a rate of

12%, highest around the world. Although it decreased in 2010 to 11%, it still ranks

first. Comparatively, US and UK companies in their overseas acquisitions in 2010

only has 2% and 1% failure rate.30 (This failure rate only refer to announced

transactions that have been withdrawn, rejected or expired, not include the after

acquisition integration.)

If successful acquisition is defined as good performance of a

post-acquisition, it is even worse for Chinese enterprises. Chinese enterprises had

invested over 600 billion Yuan ($91 billion) in overseas M&A deals from January

2008 to June 2010. And experts estimate that, in 3 to 5 years, Chinese companies

could lose 300 billion Yuan ($45.29 billion) from these 120 acquisition cases. For

instance, China Investment Corporation has already lost $3 billion after investing in

Blackstone Group and Morgan Stanley31.

Moreover, “Luedi (2008) analyzes 56 deals over the period 1995 to 2007

and reports that Chinese acquirers “overpaid” for foreign assets in 55 percent of deals,

30 Wei and Jiang, High Failure Rate, Chinese enterprises cross border M&A twists and turns ahead(失

败率高中国企业跨国并购曲折前行), http://news.163.com/11/0324/21/6VUKMAQT00014JB5.html

31 Wang and Feng, Chinese overseas acquisitions spent 600 billion in two years and half of them are

expected loss in five years(中资海外收购两年砸 6000 亿未来五年或损失一半), 06-01-2011,

http://biz.cn.yahoo.com/ypen/20110106/156186.html

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as measured by the change in share prices around the announcement day.”32

In 2005, CNOOC’s $ 18.5 billion failure bid for Unocal33; in 2007 Huawei

failed the $2.2 billion deal to acquire 3Com34. In 2009. China Aluminium and

Australia Rio Tinto’s $19.5 billion, “Centrury deal“ failed35. In 2010, Huawei’s bid for

Motorola’s business failed and Nokia Siemens get the deal with an offer lower $1.2

billion than Huawei36.

Other foreign direct investments made by SOEs also occured huge losses.

China Aluminum lost 340 million Chinese Yuan in Australia’s bauxite project37. Prior

to this, China Railway Construction estimate to loss up to 4.15 billion Yuan in Saudi

rail project in 201038. During the financial crisis, 68 China central state-owned

32Gu and Reed, Working Paters in Economics 2010, p.3.

33Shan, International Trade 2005, p. 14-17. 34Chen, Why Huawei failed acquisition of 3COM: U.S. national security concern (华为收购 3COM 失

败内幕：触动美国家安全神经),

http://tech.ifeng.com/special/huaweiyindushouzu/detail_2010_07/10/1750000_0.shtml.

35Yao, Liu and Sutherland, Xi´An Jiaotong University Journal 2010, p.41-49.

36Yang, Chinese Aluminium report investment mistake again, (中铝再曝海外投资失误),

http://www.pe86.cn/html/gqzx/touzizixun/haiwaizixun/3434.html.

37Chen, Failure acquisition of Motorola’s wireless division, Why Huawei lost? (收购摩托罗拉无线业

务部门，华为输在哪里？), http://blog.ifeng.com/article/6509914.html.

38Meng, Why Chinese SOE lost 4.15 billion in Saudi. (央企为何在沙特巨亏 41.5 亿元),

http://blog.sina.com.cn/s/blog_543bb3320100prnn.html.

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enterprises lost as high as 11.4 billion Chinese Yuan in financial derivatives39.

Due to the grim situation, The State-owned Assets Supervision and

Administration Commission (SASAC) issued regulations on management overseas

state-owned assets. On 27th June 2011, SASAC published the "Provisional Measures

on the Supervision and Administration of Overseas Assets of Central State-owned

Enterprises (SOEs)" and the "Provisional Measures on the Administration of

Overseas Property Rights of SOEs".

Both provisions include internal and external regulations on central SOEs'

overseas investment, management, and various operating activities. SASAC tries to

regulate the registration, assessment, examination, and transmission of properties of

overseas central SOEs and set out requirements for the equity management of

red-chips companies as well.

These measures show that SASAC started to concern about SOEs´ huge

losses overseas. SASAC pointed out that compare to their emphasis on overseas

investments. The problem regarding management of overseas assets is insufficient

risk control measures among some SOEs. SASAC try to improve the SOEs

management and establish the responsible chain since no individual liable for SOEs

overseas investment before. "We have weakness when supervising those SOE assets

39Li, SASAC: 68 central enterprises lost 11.4 billion in the financial derivatives business (国资委：68

家央企涉足金融衍生产品业务，浮亏 114 亿) ,

http://ccnews.people.com.cn/GB/142056/142071/10498879.html.

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overseas," SASAC acknowledged in a statement on its website.

Chinese government is starting to pay attention to the problems that

occurred to SOEs when they conduct overseas investments. This is a signal that

problems are unavoidable and there might be policy adjustment regarding SOEs

overseas investment.

Other than high failure rate of M&A activities. SOEs face negative attitude

from other countries. The deals with SOE acquirers are less likely to be completed.

According to Zhang and Ebbers, since 1982, 1,324 overseas acquisition attempts by

China have been recorded in the Thomson database. Among these deals, 354 deals

were in sensitive industries, and 256 deals were with SOE acquirers. These deals are

more likely to receive a negative reaction toward deal completion after announcement.

40 As stated above, among Chinese outbound M&A transactions, 81% of the deals

were launched by SOEs. The public ownership structure, government background will

remain a cause for concern abroad. This concern is not only due to many transactions

involve control of natural resources but also because “state ownership seems to confer

unfair advantages on the acquired companies.” 41

Why Chinese SOEs have more difficulties and face more challenges than

other regular companies in international merger and acquisitions. The author tries to

40Zhang and Ebbers, Journal of Current Chinese Affairs 2010, p102.

41Lee, p.6.

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analyze the reasons behind it and to find solutions for it.

V. Reasons Why Chinese SOEs have Such Higher Failure Rate

China’s outbound M&A activities just started in recent years and there

are not so many academic articles analyzing this phenomena and official publication

regarding Chinese SOEs M&A is even rare.

Zhang and Ebbers (2010) used a sample that consists of 1,324 overseas

acquisitions attempts by Chinese firms, they found that “different determinants

influence the outcome of China’s overseas acquisitions, the most important ones

being: bilateral economic relations, ownership of the acquirer, competitiveness of the

acquirers, global experience, and sensitiveness of the industry. All these factors

hamper Chinese acquisition deals to be successful.” 42

According to the Economist Intelligence Unit 2010 report, “A brave new

world-the climate for Chinese M&A abroad”, they concluded that the distinctive

domestic social and economic environment of acquirers, sensitiveness of the industry,

42Zhang and Ebbers, Journal of Current Chinese Affairs 2010, p. 124.

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ownership and low competitiveness of acquirers, and a lack of global experience all

hamper Chinese acquisition deals. 43

These analyses more focus on the business practice aspect of Chinese

enterprises but not specific Chinese state-owned enterprises and their legal aspect

analysis. Since majority outbound M&As were processed by Chinese SOEs, their

state ownership character under China’s particular economy structure determined they

are naturally different from other general companies. The author starts to analyze

from the internal aspect of SOEs.

Surprisingly, a simple question “what is Chinese SOE” is not clearly

defined. Even asking Chinese, they might give different answers as well. Under the

GATT/WTO system, there is a concept including state-owned enterprises (SOE) and

state-trading enterprise (STE). SOE is defined as part of STE. Chinese SOEs`

definition due to its particular political and social structure is different from SOEs in

other countries, which they only occupy small part of the economy and are restricted

to certain area mainly in social welfare and military sectors. Chinese state-owned

enterprises take active part in all aspects of China’s economy and play a major role in

day-to-day businesses. The recent economic reforms have lead to the booming of

large private companies and their strength in the market. Private companies become

43Lee, p.41.

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more and more important in Chinese markets. However, Chinese SOEs with no doubt

are still the market leaders. Due to their special character they also raise more issues

when they conduct outbound M&A.

To understand why Chinese SOEs have such high failure rate, the first

thing is to understand what SOE means in China.

5.1. The Definition of Chinese State-owned Enterprises

Generally speaking, SOE is a special kind of enterprise. Its capital is

wholly or mainly invested by the state, which constitute the main difference from

private companies. Although SOEs are organizations, they only or mainly have

national investors. In China, the state acts as an investor but is generally not direct

involved in specific management and business activities. According to the “unified

leadership, decentralized management” principle, all levels of authorities representing

the state conduct specific management.

There are three different laws defined the concept of SOE. According to

article 65 of “Corporate law of the PRC”: “…The term “solely state-owned

company” refers to a limited liability company established through investment solely

by the state, for which the State Council or the local people's government authorizes

the state-owned assets supervision and administration institution of the people's

government at the same level to perform the functions of the capital contributors…”.

“Law of the PRC on Industrial Enterprises Owned by the Whole People”

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Article 2 states: “An industrial enterprise owned by the whole people” shall be a

socialist commodity production and operation unit which shall, in accordance with

law, make its own managerial decisions, take full responsibility for its profits and

losses and practice independent accounting. The property of the enterprise shall be

owned by the whole people, and shall be operated and managed by the enterprise with

the authorization of the state in line with the principle of the separation of ownership

and managerial authority. The enterprise shall enjoy the rights to possess, utilize and

dispose of, according to law, the property which the state has authorized it to operate

and manage. The enterprise shall obtain the status of a legal person in accordance with

law and bear civil liability with the property which the state has authorized it to

operate and manage.”

“General Principles of the Civil Law of the PRC” article 48 states that

“an enterprise owned by the whole people, as legal person, shall bear civil liability

with the property that the state authorizes it to manage. An enterprise under collective

ownership, as legal person, shall bear civil liability with the property it owns.”

The definitions of SOEs in the three laws are rather vague and

fragmented. Due to several restructuring and privatization processes of Chinese SOEs,

it is even more difficult to figure which kind of companies are qualified as

state-owned. Also for the benefit of governmental support and sponse policy, some

private companies also try to get the title of state ownership to enjoy some privilege

policies only avaliable for SOEs. In practice, SOEs are not limited to Industrial

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Enterprises Owned by the Whole People, nor limited to state wholly owned

enterprises. SOE is actually a broad concept. The common feature is the state own

whole or part of the assets. But what proportion of assets owning (non-controlling,

relative holding, absolute control) as qualify as SOE is not clear by law. Therefore,

Chinese SOEs not only have issues when investing overseas but also SOEs´ complex

shareholding structures even cause confusion about sovereign immunity application in

US court procedures.

National Bureau of Statistics jointly with Minisitry of public security

issued a letter to clarify the concept and range of SOEs.44 They define Chinese SOEs

are distinguished as broad and narrow views.

Under the broad definition, SOEs means enterprises with state capital,

which can be divided into three levels.

First, pure SOE. It includes state sole owned enterprises, state-owned

companies and state-owned joint ventures. All their corporate capital belongs to the

state.

Second, the state controlled enterprises. According to regulations issued

by National Bureau of Statistics45, state control includes state absolute control and

relative holding. Absolute control means in all enterprise capital, state capital greater 44 National Bureau of Statistics on the views of state-owned companies identified the letter, of the

National Unification letter [2003] 44, the public by [2003] No. 368. 45 “Statistic methods regarding classification of state-owned shareholding”.

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than 50%. Relative holding (including protocol control) refers to in all the enterprise

capital, state capital(equity) do not excered 50%, but larger than other shareholders in

the company, or although not greater than other shareholders but according to

agreement, the state has effective control over the enterprises(protocol control).

Third, state-owned shareholding enterprises. It means company partically

has state capital but the state do not control or be the controlling shareholder of the

enterprises. State-owned joint ventures with other ownership form enterprises were

classified in accordance with principles in the second and third category.

The unlear definition of Chinese SOEs caused an interesting phenomena,

the so-called “Chinese SOE premium”. This additional expenditure requested by

foreign sellers because they have a fear that many Chinese SOEs lack transparency.

SOE`s corporate governance structure defects also cannot meet the international

standard. It is reasonable for the target to consider problems might come out after

acquisition. The SOE premium is justified under this reasoning. So from the

enterprise itself considered, an acquisition deal with a SOE acquirer is less likely to be

completed than other forms of enterprises.

5.2 Chinese SOEs´ internal shortage limit their successful overseas M&As

5.2.1 Unclear Legal Status of Chinese SOEs

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American scholar Milton Friedman46 compared SOEs in different

countries and related legislations. He separated SOEs into 3 categories. First,

government controlled enterprises. This kind of company has no independent legal

personality, and belongs to part of the state administration agencies. Second, public

corporations that established by law or regulations with legal personality. Third,

commercial companies partially or totally controlled by the state. Generally, this SOE

type is difficult to distinguish from other commercial enterprises.

The first type SOEs do not have independent legal personality, no

independent property and is an integral part of national sovereignty and institutions.

The other two SOEs are state funded in whole or in part with separate legal

personalities. The relationship between state and SOEs is assets investors and

property owners, for commercialized SOEs, it is relationship between shareholders

and the company.

China’s SOEs after national restructuring, most of them now established

independent legal personality. They are able to assume civil liability and are economic

entities different from government agencies. But it is undeniable that they are still

under strong government influence when conducting business. And the property rights

of SOEs are not clear. As stated above, several laws all define property rights and

46 Friedma, National Encyclopedia of Comparative Law (《比较法国家百科全书》)

1972, P. 625.

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relationship between the state and companies. But the provisions themselves are

conflicting and vague. For example, Law of the PRC on Industrial Enterprises Owned

by the Whole People Article 2 states “the property of the enterprise shall be owned by

the whole people, and shall be operated and managed by the enterprises with the

authorization of the state in line with the principle of the separation of ownership and

managerial authority”.

While Article 41 of “General Principles of the Civil Law of the PRC” also

states that “an enterprise owned by the whole people or under collective ownership

shall be qualified as a legal person when it has sufficient funds stipulated by the state;

has articles of association, an organization and premises; has the ability to

independently bear civil liability; and has been approved and registered by the

competent authority”. In this situation, on the one hand, the state assumes the

ownership of SOE while on the other hand SOE itself also has independent

property/ownership rights. This may cause confusion that how could a company

without independent property rights have independent legal person status.

In 2003, the State Council issued “Provisional Regulation of State-owned

Assets Supervision and Administration”. It clearly states that assets in SOEs are

owned by the state. The State Council and local government represent the state as the

owners. They enjoy the rights and obligations of owners and manage the assets and

personnel. The state divided state-owned assets into three levels as the central,

provincial and municipal and set corresponding State-owned Assets Supervision and

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Administration Committees (SASAC) to exercise the property rights. It only formally

resolved the issue that SOEs absent of property rights. However, the SOE ownership

of property rights is still not properly in place. The SASAC as a national assets

shareholder also as the supervisory authority, whether its own structure, regulatory

laws and regulations has been perfect and whether it could exercise regulatory power

competent, whether this three level management could clarity all levels of

state-owned assets are still debatable.

Another issue is that until now, the positions in SASAC are actually act by

government officers concurrently. The management of state-owned assets still follows

the path of the former administration mode. SASAC actually did not implement the

government’s intention that separate society administration function and state assets

owner role. They still didn't clear their position with corresponding government.

Although the division of three levels management, in specific areas the property rights

have still not been firmed. The absence of state assets owner in fact is not really

solved.

The unclear property rights stopped their outbound M&A efficiency. It will

cause confusion of the foreign target and difficulties for the post merger integration.

For example, the internalization as combing product line or management might be

stopped by those practical issues.

5.2.2 Not Maximize Shareholder Interests

Vague ownership structure itself is not the only limit the development of

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SOE´s overseas investment. Chinese SOEs also have the tendency not putting

shareholder interest first.

According to Chen and Young (2009), there is a “negative relationship

between government ownership and cumulative abnormal returns.” 47 In China,

SOEs have the mission to implement the national plan and economic policy, and are

responsible for national economic management and regulation functions. They are

not like ordinary companies that always seek for profit and shareholder interest

maximizing. For some important industries and products, SOEs are even not aiming at

profit at all if the Chinese government tries to secure social welfare. There is a

potential conflict between the maximization of shareholder wealth and the pursuit of

Chinese national goals. The Chinese government has a tendency to enforce national

strategy even if the strategy is at odds with shareholder rights.48 “With tight

commodity markets, resource ownership has become a political hot potato even

outside those oil-rich countries that have shut out Western oil companies. China has

failed to complete big iron-ore and oil deals in Australia and the U.S.” 49 Outbound

M&A are often seen as strategic instruments to further government’s efforts.

State ownership is not fair to the target in some situations. The bureaucratic

47Gu and Reed, Working Paters in Economics 2010, p2.

48Id

49 Curtin, Cross-border M&A deals get harder, in: The Wall Street Journal Europe of 08.11.2010.

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nature and at times politically driven decision-making of SOEs distinguish them from

their non-state counterparts. On one hand, Chinese SOEs wish to be seen as

independent commercial entities, but on the other hand they play on their

government’s relationship with the host country’s authorities to obtain deals. This

unfair play will cause other countries´ negative attitude toward Chinese SOEs.

5.2.3 Defective Corporate Governance Structure

Chinese SOEs are famous for their business scale. The huge company scale

will unavoidable separate the companies into different subsidiaries and branches.

Normally there will be 3 to 4 levels of holdings within one state-owned enterprise

group. And some subsidiaries are joint ventures with foreign partners or private

Chinese companies. These complex shareholding structures are very difficult for the

parent company’s effort to conduct efficient management. Moreover, as stated above,

SASAC were divided into three level management as well. The multiple level

management will certainly cause information asymmetry. And most outbound M&A

activites were launched by independent subsidiaries. The central management may

not have sufficient control the overseas investments. The non-transparent corporate

governance will lead to deals getting bogged down in host countries.

Another issue regarding corporate governance is that according to article

67 of Chinese corporate law, state solar owned companies do not elect board of

directors and supervisory board. The two boards are appointed by administrative

orders. The administrative character limits development of a company and not

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suitable to the modern concept of separation of ownership and management. The

biggest flaw both boards appointed by the same agency is that the supervisory board

will become a mere formality.

For other types of SOEs with state share holding, although other laws and

regulations states that SASAC or other authorizations will propose candidates for

directors and supervisors which still are needed to be elected through shareholder

meetings. In practice, based on the strong state owned background, the state

shareholder always recommend or direct appoint, remove directors supervisors and

managers. Therefore, the state ownership shortcomings are likely to show up and hurt

the other minority shareholders interest. SASAC also have the conflict of interest

issues, there lack agent to supervise its own activities.

5.2.4 SOE Anti-trust Issue

The public power character of state ownership determined that there are

natural monopoly tendencies. Whether SOEs` oversea M&As could be considered as

de facto control by host countries government remains an issue. SOEs also may have

“stronger incentives than profit-maximizing firms to pursue activities that

disadvantage competitors.” 50

In recent case, Norwegian company Elkem acquired by China National

Bluestar. 51 The EU commission carefully examined the proposed acquisition,

50 Sidak and Gregory, Antitrust Law Journal 2003, p.480. 51 European Commission clearance: EU Commission, IP/11/394, 01/04/2011, EU report, p.13.

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including looking for possible coordination by the Chinese State regarding market

behavior of different State owned firms. The commission would assume all Chinese

state-owned firms in the same sector where coordinating and subsequently treat them

as one firm. The commission investigated in detail to determine the extent Bluestar

and ChemChina are taking their business decisions independently from other

state-owned undertakings in the same sector. The assessment of the links between

Chinese state-owned companies in the same sector is a signal for anti-trust issues and

a hurdle for SOEs.

In fact, this concern has led to many transactions ending in failure,

including China Nonferrous Metal Mining Group Co., Ltd planed to acquire a

majority stake in Lynas 200952. This deal was not approved by Australia’s Foreign

Investment Review Board. The reason given was that China already has more than

90%53 market share of rare earth resources worldwide. Australia considers all SOEs

in China as a whole. This certainly will raise anti-trust concern.

Chinese SOEs faces similar issues in other countries as well. From the

perspective of German Merger Control, all undertakings, upon which the foreign state

52 Zhao, China Nonferrous missed the opportunity of acquisition of Australia rare earth, pursuing

control lead to the failure. (中国有色失手澳洲稀土追求控制权致使机会丧失),

http://finance.ifeng.com/news/special/xitu/20101115/2880162.shtml.

53 Id.

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can exercise a dominant influence, either directly or indirectly, are treated as affiliated

companies (§ 36 (2) Act Against Restraints of Competition ("Gesetz gegen

Wettbewerbsbeschränkung")). Therefore, the appraisal of the concentration focuses

on the influence of the whole group of affiliated SOEs. Especially when Chinese

SOEs has the same owner, SASAC, it will raise the doubt that whether affiliated

enterprises has been created in fact.

5.2.5 Lack of Experience and Managing Ability

“Chinese enterprises show aspirations of global expansion, and they have

affluent cash flow,” Deng Ying from Accenture Plc, said, “but the question is how far

a newly internationalized company could go.” 54

Since the 30 years economic reform, no matter from enterprise ability or

national power, China already has certain ability to invest abroad and will continue to

increase with the China’s strengthening international competitiveness. However,

fundamentally speaking, China is still a developing country and is in the middle of

industrialization process. It has not obtained full international competitive advantages.

It is very difficult for the country to become a net capital exporter in a short time.

Compared to other countries which have decades years of M&A practices,

China just started with M&A. Other foreign countries always go through the path that

54 Yan, China spends $91 billion on overseas M&As in 3 years,

http://www.chinadaily.com.cn/business/2011-01/06/content_11804737.htm.

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getting experience in their national M&A transactions first and then launch their

overseas activities. China is on a different routine. China’s economic reform itself

only has only 30 years of history and Chinese enterprises experienced constant

restructuring until now. Not only the privatization but also the equity reform within

companies and between companies. The government lead Chinese SOEs to adapt to

new environments constantly. For Chinese SOEs, their M&A activities started both

inbound and outbound at the same period. This certainly caused Chinese SOEs to

have less experience in their overseas investment. China’s Macro economic structure

is also different from other countries. The management style and cultural difference

always make the after-merger integration more difficult. SOEs due to their own

defects and characters will face more management issues.

Chinese SOEs outbound M&A are restricted by their ownership structure,

management style and philosophy. Its human resources, management, technology,

products, services etc. and basic elements reserve and external system constrains are

far less than needed. Chinese SOEs use their competitive strength created by

non-open market administrative monopoly in the domestic environment to participate

in overseas mergers and acquisitions. Their risks certainly are higher than other

private companies.

Cultural difference and distance is a very essential and sensitive element

that should be taken into consideration as well. Deloitte newly issued “Chinese

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Enterprises After-merger culture integration survey” 55. It shows that, Chinese

enterprises failed their M&A 60%, and 2/3 of them can be attributed to the poor post

merger cultural integration.

John. H. Dunning’s eclectic paradigm56 is a framework widely used in

international business research. Explain why, where and how FDI is chosen over other

internationalization modes, which is also known as the OLI-Model. The theoretical

construction provides a three-tiered framework for a company to follow when

determining if the pursuit of direct foreign investment is beneficial.

According to the framework, whether or not an FDI is beneficial

essentially depends on an ownership advantage, location advantages and

internalization advantage. These three tier requirements are preconditions for

international activities and when companies meet the three advantages, it is suitable

for their corporate strategy to launch overseas M&A. Based on this theory we can

clearly see that Chinese SOEs lack those advantages or do not have them at the same

time.

According to Dunning, due to SOE’s unclear property rights, after

acquisition, the company will face difficulties to allocate internal resources through

ownership advantages and to complete the internalization advantages. Overseas M&A

55 Deloitte, p. 2.

56 Twomey, p. 8.

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are also difficult to establish the ownership advantages afterwards. Because of

insufficient control, the know-how of production, operation, and marketing cannot be

well grafted to domestic enterprises. The monopoly advantage is also difficult to play

in a global market.

5.2.6 Government Background and National Security Concern

"Chinese firms are in an interesting situation," notes Bethel of ChinaVest.

"Their increasing wealth means they can afford to make acquisitions, but oftentimes

Chinese buyers are regarded with suspicion.” 57

Political risk becomes one important factor in China’s outbound M&A.

Other countries present negative attitude toward Chinese government’s political

influence. Nowadays, national security check for Chinese SOEs is more intensive.

The host country’s government is likely to turn down the acquisition attempt for the

sake of local industry protection and national security.

M&A in same or similar political system between countries tend to be less

subject to political interference. Even if the merger involves petroleum, mining and

other nature resources, Japan as a capitalist country is less influenced by politic and

ideology. China is very different from other economic entities. SOEs in most

countries are always regarded as part of foreign countries. Subsidization by home

government is often seen as an unfair business practice by the host’s bidders.

57 Knowledge @Wharton, All About China’s Overseas MA Push,

http://www.thestreet.com/story/10440704/1/all-about-chinas-overseas-ma-push.html.

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It is also true that political or foreign policy reasons creep into the

commercial decisions of Chinese SOEs when they plan to invest overseas. Chinese

government intervention has been deeply rooted in the mind of host countries.

State-owned has a strong government backed impression and other companies would

assume that the company acts under control of the government.

Undeniably, presently China’s M&A deal has a strong government

influence. Chinese government also encourages Chinese enterprises` outbound

acquisition through tax benefits and favorable financing. The Chinese leadership

always tries to draw up policies that will secure supplies of natural resources in detail.

While other Western countries’ governments take different approaches. They usually

take a “hands off” style of national management. Recently, Chinese government

indicated that China would use more of its foreign exchange reserves to support and

accelerate overseas expansion and acquisitions. “There is a consensus in China that

the state must use policy tolls to secure ownership of foreign upstream production

assets by Chinese companies.” 58 This political impact limited a successful overseas

M&A.

Since the strong character of government background, Chinese SOEs

outbound M&A always face political restrictions in other countries. Although China’s

economy continues developing, its market economic position has not been admitted

by many countries. Other countries´ governments also issue certain restrictions

58 Eurasia Group Report 2006, p. 2.

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particular to Chinese SOEs. For example, Australia promulgated guide to consider

whether the operation of investor is independent from its government.

Under German Foreign Trade Law, namely § 7 (1), (2) number 5 and 6

Foreign Trade Act ("Außenwirtschaftsgesetz") and §§ 52, 53 Foreign Trade

Regulation ("Außenwirtschaftsverordnung") the acquisition of a German domestic

enterprise or the purchase of at least 25 percent of the shares of a domestic enterprise

by an undertaking domiciled outside the European Union or the European Free Trade

Area, can be prohibited by the German Federal Ministry of Economics and

Technology for reasons of public policy or public safety. Although this section is not

expressly directed to limit foreign SOEs, an acquisition of a domestic enterprise by a

foreign SOE is, due to the political and economical powers backing the SOE, more

likely to raise concerns with regard public policy or public safety matters, for example

with respect to deprivation of know-how or key enabling technologies.

U.S. promulgated a similar rule to check Chinese enterprises overseas

investments, which was hypothetical for China’s strategic expansion. The

Exon–Florio Amendment59 is a law that was enacted by the United States Congress in

1988 to review foreign investment within the United States. All foreign investments

that might affect national security may be reviewed and if deemed to pose a threat to

59 50 U.S.C. app 2170,

http://www.law.cornell.edu/uscode/search/display.html?terms=2170&url=/uscode/html/uscode50a/u

sc_sec_50a_00002170----000-.html 50 U.S.C. app 2170.

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security. According to the amendment, the president may block the investment when

"there is credible evidence that leads the President to believe that the foreign interest

exercising control might take action that threatens to impair the national security." 60

President Reagan delegated the review process to the Committee on Foreign

Investment in the United States. The amendment was proposed over concerns of

foreign acquisitions by Japanese businesses. It provides sounding foundation to

regulate M&A. The amendment should have expired, but considering its huge effect,

President George H.W. Bush signed another Act to make the amendment permanently

valid.61 In recent years it has been suggested the amendment be used on Chinese

companies.

CNOOC bid for Unocal raised U.S. political outcry. U.S. Congress ground

as “energy threat” and “national security” asked the U.S. Treasury Department’s

committee on Foreign Investment (CFIUS) critical review of what role Chinese

government play in this acquisition. U.S. politicians also use “energy security”,

“economic security” to stop CNOOC’s bid62.

A similar political issue was involved in China Aluminum Corporation’s

failure acquisition of Rio Tinto. There were two main concerns that drove Rio Tinto to

60 Id.

61 Jackson , Congressional Research Service 2007, p.4.

62 Shan, International Trade 2005, p. 14-17.

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reject Chinalco's investment63. One of them was political anxiety. Chinalco's status as

an entity wholly owned by the Chinese Government was the core of the concern.

Despite the fact that the company is commercially managed, Chinalco is funded by

the China Development Bank in which the China Investment Corporation (the

Sovereign Wealth Fund of China) is the largest shareholder. Clearly, there is a very

strong connection between Chinalco and the policy makers in Beijing. Since the

announcement of the proposed deal, the Australian government has been confronting

a growing protectionist clamor from trade unions, opposition politicians and local

businesses, not to allow a state-owned Chinese company to gain control of strategic

mining assets. Sections of the military establishment were also opposed to the

Chinalco deal, warning that it would cut across Australia’s longstanding ANZUS

defense alliance with the US.

Owing to SOE´s state backing and various political reasons, they have

failed in overseas acquisition.

VI. Solutions

6.1 Improve Chinese SOEs Corporate Governance

Chinese SOEs are still experiencing restructuring internally. The related

laws and regulations are gradually implementing. Improving corporate governance

within SOE will be smooth for their further development in the global market

63 Id.

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environment and easier to conduct M&A activities. Independent from the Chinese

government is also the requirement of market economy.

6.2 Low Profile Style Acquisition and Adjust Share Percentage

Chinese SOEs always try to bid for controlling position of target

companies. Most seek for 50% to 100% share holding. Empirical evidences have

shown that this train of thought is not the best way to invest overseas. Control can be

accessed through ways other than majority shareholding. In particular facing the

stricter foreign national security check and Chinese SOEs invest in sensitive industrial

sectors. Knowing high rejection rates are likely while try to acquire large share

percentages is meaningless.

In addition, Chinese SOEs still lack cross border M&A experience and

management ability to handle the integration afterward. Acquiring lower share

percentages is becoming a new trend. China’s state wealth fund (SWF) mostly adopt

this way when they invest abroad. With some exceptions, China Investment

Corporation (CIC) only acquire small amount shares of target companies. Chinese

SOEs are starting to notice the protectionism of other countries and find their new

way.

One example of this method is illustrated in Beijing Automotive Industry

Holding Co.,Ltd investing in Swedish car manufacturer Saab from its parent company

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General Motors64. The Chinese party only acquired the core technology but not the

brand and factory, which avoided the restructure process of the company and brand

management. This constitutes sharp comparison with the Geely-Volvo deal.

Acquiring less portion could not only accumulate experience for further

complex transactions, but companies also could integrate into the local environment

like the Royal Dutch Shell together with CNPC acquired Australian Arrow Energy

case65. CIC acquired Teck Resources also give us an example. CIC only acquired

17.2% shares of Teck and did not seek control of the company66. This structure could

not be criticized by others that China tried to grab a large resource company of

Canada and do not need to face national security check.

Another choice could be the so called mushrooms tactics. For SOEs lack of

overseas M&A experience, acquiring large overseas target is not the best strategy.

Find smaller but high quality targets that fit companies´ requirements then conduct

several times, small amount acquisitions, then integrate them steadily. The portfolio

of target could cover companies in the same value chain and related industries. This

64 Xiao, Auto Time 2010, p. 37-38.

65 Wassener, Arrow Energy Agrees to Sell Australian Assets to PetroChina and Shell.

http://www.nytimes.com/2010/03/23/business/global/23energy.html.

66Mining Exploration News, China To Invest Billions Dollars In Canadian Mining Company,

http://paguntaka.org/2010/02/13/china-to-invest-billions-dollars-in-canadian-mining-company.

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strategy could increase competitive advantage of one company in specific sector and

develop companies´ M&A operational capabilities.

6.3 Set Up Joint Venture or Enterprise Alliance with Other Private Companies,

Foreign Companies and Launch M&A Jointly

To fly below the radar screen, Chinese enterprises have recently sought to

partner with Western firms when bidding for foreign companies, especially private

companies when invest abroad. Private companies have their advantages that could

make up the state ownership shortage. Private companies also could provide more

channels for information and management. Risk diversification would be another

consideration.

Chinese SOEs due to their public ownership statues, do not as eager as

private companies that care about profit or other aspects. The owner agency problem

could be weakened under the joint venture structure. Set up joint venture with target

itself is also a good way to complete overseas M&A step by step. For example, the

China Steel Group set up joint venture with Australia Midwest Corporation in 2005

and then fully acquired it in 200867. Through this way, Chinese companies could

familiar with target’s company management and culture from the long term

corporation with each other first and finally successfully acquire it later.

67 Huang, The invisible power behind China Steel Group`s success (中钢完胜背后的隐性力量),

http://www.china.com.cn/news/txt/2010-06/29/content_20378413.htm.

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From 2009, the empirical statistic also shows this trend. This reflected that

Chinese enterprises has realized the potential risk in overseas investments and finding

the way to diversify it. China Railway Construction and Tongling Nonferrous Metals

acquired Canadian Copper is the result of “joint force”. Tongling Nonferrous has large

scale of production but due to low resource self-sufficient rate, the company always

has disadvantage in competition. While China Railway Construction has a

technological advantage in mine excavation, the two companies could complement

each other68.

From the competition point of view, joint acquisition will help maximize

the advantages of Chinese companies abroad too. From a business perspective, the

joint acquisition is a very common practice internationally. It will help diversify the

investment risk. In addition, with the expected wave of industrial restructuring in

China, there will be more and more enterprises working jointly for overseas

acquisitions.

6.4 Corporate with Private Equity Funds

6.4.1 PEFs Get Rapid Growth and Ttake More Active Part in the International

M&A

Private Equity Fund is fund raising from several institutional investors

68 Liu, China Railway Construction and Tongling Nonferrous Metals acquired Canadian Copper by

4.27 billion RMB(中国铁建核铜陵有色 42.7 亿购加拿大铜矿企业),

http://hkstock.cnfol.com/100601/132,1709,7789305,00.shtml.

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through a non-public way and invest to unlisted companies for equity, ultimately exit

though IPO, M&A or LBO. Since the 1990s, as the global financial innovation

accelerated in different countries and the spurred by financial deregulation, private

equity has entered a rapid expansion period. Their investment scale expanded

exponentially. In 1969, private equity commitments was approximately $ 2.3 billion

US dollars, while by 2006, it had reached $335 billion US dollars. And the amount

that used for M&A reached $ 275 billion69.

More and more PEFs were used for cross-border M&A transactions. In the

traditional foreign direct investment theory, FDI is done by multinational corporations,

which establish global integrated production system, gain strategic assets, accounting

target market, and enhance effectiveness of the internal division through overseas

direct investment. With M&A become the dominant mode of FDI, PEF gradually

involved in the industrial capital territory. PEF`s annual investment in developed

countries has accounted 4% to 5% of some countries GDP and become a main

financing channel second to bank loan and IPO. PEF more focus on the global market

and finding new value-added opportunity. According to the “World Investment

Report”(2007), the percentage cross-border M&A led by PEF has raised from 6.1% in

1987 to 18% in 2006. 70

6.4.2 Advantages of PEF in Cross-border M&A

69 Chung, Sources of Value in Private Equity Acquisitions,

http://www.frbsf.org/csip/research/symposium200710.pdf. 70 Id.

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Private equity is not only a profit method for overseas investment, but also

a financial means of mergers and acquisitions. Private equity has broad network of

relationships and could get in-depth information. Its involvement could dilute the state

background, broaden financial channels, improve the M&A ability of SOEs. Private

equity also could use its experience and talent pool to provide support for the overseas

investment.

6.4.2.1 Financing Advantages

PE could increase the financing capacity of one company. The involvement

of PE in after merger integration will enhance the company’s future financing capacity.

Especially there is monetary tightening and excess liquidity in the market. Companies

must seek to reorganize funds to implement the acquisition while then industrial

capital is often powerless.

Other than bring money, PE could raise debt for the company to improve

the ability of M&A. when company enter the mature stage from expansion period, PE

fund could increase return on capital through financial leverage. One example is the

well known private equity group KKR´s first action in China. In 2007, KKR invested

in TianRui total amount $115 million US dollars and hold 43.2% stake, in addition,

KKR arranged a $335 million equivalent RMB and US dollar dual-currency

syndicated financing. This syndicated loan fist replaced several short term bank loan

that Tian Rui held. KKR also added new fixed assets and working capital loans to be

used for establishment of new projects, M&A and business operation. Syndicated

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lending rates are 10% lower than Chinese central bank benchmark lending rate. This

method greatly reduced the companies` cost of loans71.

6.4.2.2 High Quality Human Resource and Local Experience

Moreover, high quality human resources are guarantee for PEF to conduct

cross border M&A. PEF use high salaries to attract host and own countries` talents.

Many PEF fund management themselves originally were executives of emerging

industries. They are not only versed in investment skills, but also master large number

industry information and network. Their practical experiences also help them

accurately grasp the future market demand and appreciation of the potential

acquisition target.

PEF gathered their information through accumulative resources, also a

knowledge transfer and learning process. PEF`s investment method determined their

special way of gathering these experiences. PEF enters a target market in early stage

always by investing in its stock market. Their local branch will apply non-geographic

knowledge (general knowledge of project selection and management). When the local

branch accumulated some local experience, it will transmit it back to the head office

and has impact on their decisions. Through several rounds of the knowledge transfer,

PEF obtained huge information amount and structure, which cannot be obtained by

normal enterprises that seldom have overseas experience. This international

experience and ability could contribute to China’s outbound M&A and make up the

71 Guo, Wisemoney 2007, p. 92-93.

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lack of experience shortage.

PEF also has extensive experience in restructuring. Some of the targets

Chinese SOEs currently always focus on are in tough situations. Although share

prices of these companies slump, their brand impact still there. If Chinese SOEs could

combine the China special low cost advantages and integrate the production chain, it

could increase the successful rate of restructuring after merger. This is also the reason

why PEF seeks to corporate with Haier, Huawei, and other companies, to provide

restructuring after transaction.

6.4.2.3 Excellent Management and Organizational Skills

Industrial capital could learn management experience, international

perspective and advanced way of daily business. PEF could be Chinese M&A coach.

PEF not only provide financial instrument, but also a set of financial

management services. Enterprises also could improve themselves through optimizing

their financial management. Some PEFs have wide range of investment, which

formed an interactive network, could help enterprises expand overseas market.

Corporate with international PEF also could bring other added value: PEF

also provide operations of the transaction itself. In certain degree, they could promote

and accelerate the transaction and save costs. Many Chinese enterprises do not

familiar with foreign natural resources situation, operational environment, staff

management and government connections. PEF could provide such cooperation

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opportunities.

6.4.3 PEF and SOE Could Complement Each Other in Overseas M&A

6.4.3.1 Complement Objectives

Overseas expansion is mainly due to imperfect market competition.

Corporations participate in the market aimed at strategic needs as market, technology,

natural resources and seek for long-term development and company growth other than

short-term profits.

PEF has more simple motivation and objectives when participating in

overseas investment. PEF generally do not expect continuing benefit from the

company, nor does it require long term control over the target. Its motivation is to get

higher return on investment, which is the primary factor drives their decisions. The

basic mode private equity invest in companies is: first, acquire company equity at

lower price. Secondly, PEF tries to add value to the company through restructuring

and business operations. Finally, sell the held shares fort the purpose to obtain huge

profit. PEF has successfully invested in Chinese companies. Through private equity

investment, companies could get development and the PE investors could get high

return.

In this regard, PEF and SOE could complement each other and form their

strategy not only contain short-term profit but also long-term strategic development.

As financial investors, PEF might exit years later. PEF could get easier exit channel

55 / 73

through SOE buyback and SOE could obtain financing easily and get the company

control over certain period. In particular, at that time, SOEs would be familiar the

operations of the target already. After PEF`s exit, Chinese SOEs could control wholly

of the target. If PEF exit through IPO, Chinese SOEs also could structure its IPO in

Chinese capital market and easier buyback.

6.4.3.2 Advantages Complement

As above mentioned Dunning´s theory, companies should have three

advantages together to succeed in international M&As.

PEFs do not have all the three advantages when they invest in cross border

M&A transactions. PEF do not have the traditional meaning of ownership advantages

and internalization advantages. Ownership advantage mainly shows as market

monopoly power, including technology, trademarks, patents and other intangible

assets, economic scale, corporate management ability and etc. Compare to ordinary

companies, PEF do not have advantages over these elements.

However, PEF has its special ownership advantages which could not

obtained by other normal companies. This advantage contains two aspects: assets

ownership advantage, mainly refer to the size of the fund, industrial structure, human

capital; the other is the transactional ownership advantage, mainly refer to

management, information advantages.

The assets ownership advantage is reflected by their fund scale. PEF

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engaged in cross-border transactions often has larger fund scale than other securities

funds. Their financing ability could contribute to international M&A deal. This

advantage also shows by PEF`s financial innovation, which follow every step of

changing financial instruments and derivatives.

The transactional advantage reflected by excellent management and

organizational skills. The special management structure of PEF determined higher

management efficiency. Management of PEF has incentives to focus on investment

returns and business performance. Superb negotiation skill is another management

advantage of PEF. This not only acquire target in best time and reasonable price, but

also dramatically enhance corporate value in the transaction itself. PEF`s transactional

advantage also shows in their unique ability to explore information of target.

6.4.3.3 Internalization Advantage Complementation

Unlike companies, PEF do not have internalization advantage and do not

want to participate deep in the target company’s business management by

internalization process. PEF rely on their management, information and other

advantages, make use of difference of capital return, exchange rate fluctuation and

other geographical conditions change, enhance the market value of the target.

PEF could bring advanced capital operation mode, which will benefit host

country’s capital market development. With information advantage and practical

experience will choose companies with highest potential development ability and

57 / 73

profit. So they can pick up most efficient target. But PEF cannot meet the needs of

host country as use foreign investment, gain technology transfer, management

experience and export channel. PEF’s exit also has conflict with host country’s

long-term object as company development since PEF always exit through IPO in

foreign countries, which would not benefit the host country but foreign investors. This

is the reason some countries has very conservative attitude toward PEF investment.

Under this situation, companies could make up this concern and complement each

other.

6.4.4 Other Advantages Particular for Chinese SOEs

6.4.4.1. Improve International Status and Reputation

Chinese SOEs want to go global. The first thing is to obtain its popularity.

The fastest way is to find a partner who is famous worldwide. Establish strategic

alliance with a PE partner with extensive social relations is the most valuable. In

addition, the desire for other resources such as technology and new customers could

be satisfied by strategic alliance that plays a leading role. PEF could increase the

reputation among current and potential customers and financial investors. So that to

improve business performance.

6.4.4.2 Increase the Reliability of M&A

Companies always seek support from investment banks for their consultant in

their M&A transaction. But investment banks for the purpose of closing, might

58 / 73

deliberately omitted some key terms, or fully obtain the most favorable terms, such as

share buy-back clause, convertible conditions and etc. in this regard, corporate with

PEF could reach the best deal structure and transaction terms.

One example would be Zoomlion joint Hony Capital acquired Italian CIFA.

Zoomlion intended acquire 60% stake while Hony Capital acquire 40%72. In fact,

Hony Capital is the driving force behind the acquisition and also the financial

provider. In this joint alliance, Hony Capital raised a lot of capital operation ideas.

Their international vision and practical overseas expansion experience helped

Zoomlion opened their mind and improved the reliability of the M&A transaction.

6.4.4.3 Increase the Transparency of the Corporate Governance

The development of PEF not only contributes to the ways mentioned above,

from management point of view, it also can effectively improve the corporate

governance structure of the enterprise, which is very suitable to SOEs.

PEF would let the acquiring company manage the target after M&A, but

also posted directors and use their social resources and business experience. PEF

could assess the performance of management and provide capital. This could improve

the corporate governance of the company.

4.3.4.4 Reduce Transactional Cost and Price

72Xu, Construction Machinery and Equipment 2007, p. 92-93.

59 / 73

Generally, when developing countries try to acquire enterprises in develop

countries; they always pay too much premium. This is more serious for Chinese SOEs.

PEF also could structure special transaction and financial model to avoid extra cost

and price.

6.4.4.5 Industrial Capital and PE Cooperate Each Other

Industrial capital and PE capital could create a variety of option value,

such as growth option. Through equity ratio distribution at different times and points,

so that to properly assess the business value of strategic investment and not miss some

strategic investment opportunities which has potential growth ability. Huaqwei used

use abandonment option when acquiring 3Com, in this situation, even if the

acquisition fails, Huawei still can easily give up. Another could be option portfolio.

When Lenovo acquired IBM PC business, it joint with Texas Pacifc, Atlantic public

and Newbridge Capital three PEF, Lenovo could gradually buyback PE shares.

6.4.4.6 Overcome SOE Political Image

Since Chinese SOEs has monopoly status within China, a lot of

decisions did not follow the maximization of shareholder value and act too political,

which caused a lot of uses when cooperate with PE. If the 2005 deal target Unocal

could cooperate with a local PEF, the result might be different.

PE could make up Chinese enterprises´ shortage as unfamiliar with

60 / 73

foreign laws and regulations, culture acclimatized and other deficiencies. Many PEF

not only provide financial support but also provide a sophisticated professional

management services, which can optimize and standardize the financial and personnel

management, standard and improve corporate governance and pave the way to future

IPO. Some PEF own a wide range of investments and gathered rich investor relations,

which will form a positive interactive network to help companies develop their

overseas market and also play an active role in the integration process. PEF could act

as boosting agent in overseas M&A for Chinese SOEs.

6.4.5 How Chinese SOEs Corporate with PEF

The private equity fund here not only refer to equity capital, but also

refers to the management and value-added services provided by PEF to the invested

enterprises and expect achieve capital appreciation through exit.

Chinese enterprises didnt aware the important functions of PEF in

overseas M&A, especially in natural resource outbound M&A, Chinese enterprises do

not use international PEF regularly as their international competitors. Most SOEs still

finance their project mainly by bank loans. Means of payment and financing

instruments are very simple. After merger, many companies fact cash flow pressure.

61 / 73

73

PEF could mainly play two roles in Chinese SOEs overseas investments:

First, it is profit model of business overseas investment. From PEF´s international

experience, PEFs have advantages in rate of return compared to other types of

investments. PEF has highly professional and abundant investment experience, their

investment rate of return is always higher. Under the background that China has huge

foreign exchange reserves, Chinese SOEs should pay more attention to the role PEF

played in investment portfolio and helped by their global investment experience gain

higher return.

Second, as a financial instrument in overseas M&A. As a financial means

of M&A, PEF has certain features, it could conduct LBO, lower acquisition costs and

improve the capital structure

73Deloitte report, p. 70.

62 / 73

Some empirical evidences also showed this trend. In 2008, many M&A

deals over 1 billion US dollars can see Chinese enterprises jointly cooperate with

foreign PEF. This enabled financial amount and accumulate experience for Chinese

enterprises and avoid political risks and operational risks.

There are two ways for SOEs to corporate with international PEF. One is

SOEs jointly with PEF conduct international M&A. Another way is Chinese SOEs

could invest in PEF (become PEF´s shareholder or partner) to invest indirectly

overseas. The second way could be qualified as long term strategy. It could decrease

the defense of other countries and gain a series of financing. Also, this strategic

alliance could overcome the broader concept.

China will set up the first overseas investment RMB fund and will

introduce SOE as limited partner. In March 2011, the European private equity

company A Capital (Asian-Europe joint capital) announced the company has signed

the memorandum of understanding with Beijing Municipal Finance Bureau to form a

RMB foreign investment fund. This “A CAPITAL China Outbound RMB Fund” plans

to raise 3 billion yuan to support Chinese enterprises expand overseas investment.

This is the first fund designed to raise RMB only for overseas investment74.

This fund will introduce Chinese SOEs as limited partner. The investment

area will focus on European market as automobile, environment, clean energy and

74Han, First Overseas RMB fund established, PE help Chinese enterprises overseas expansion(首

只海外投资人民币基金成立，私募助力中国企业海外扩张), http://finance.sina.com.cn/roll/20110326/01389596634.shtml .

63 / 73

aerospace technology. It mainly will contribute to technology intensive enterprises,

European distribution channels. Since SOEs are the main force in overseas investment.

Being partners of the fund will contribute to themselves. The establishment of this

fund shows the practical trend that Chinese SOEs change their investment style when

facing overseas opportunities and proved that cooperating with PEF conducting M&A

is an realistic and already on its way75.

Whether sovereign wealth funds will participate in PEF and help Chinese

SOEs international M&A remain a question. In 2007, CIC has invested in Blackstone

Group76. Recently, Chinese Administration of Foreign Exchange also invested 2.5

billion US dollars into the Texas Pacific Group (TPG) 77. In order to better manage

China’s huge foreign exchange reserves portfolio, Chinese SWF will more and more

participate in international private equity funds. A further guess would be, whether

CIC will help Chinese SOEs´ outbound M&A through cooperate with international

PE funds and their business network.

Currently, CIC do not have experience and talent for overseas direct

investment and do not have the strength to compete with foreign fund management

company. So CIC´s involvement in national or international M&A will have better

performance if alliance with international PE funds. Through this way, CIC not only

75Id. 76Tao, CIC lost in investment in Blackstone(中投投资黑石浮亏),

http://finance.qq.com/a/20100807/000610.htm . 77Admin, CAFE plan to participate in TPG fund(外汇局计划入股TPG旗下收购基金),

http://www.pefund.com.cn/rongzi/rongzixiangmu/whjjhrgTPGqxsgjj_17510.html.

64 / 73

could gain the advanced experience but also accumulate personal connections for the

overseas M&A in the future. Under the boost of private capital, Chinese SOEs´

operating capacity will be further improved and emerge a more excellent

performance.

The rise of PEF provide Chinese enterprises outbound M&A a new

strategic path. Stand on the shoulder of PEF, Chinese enterprises could improve its

international status and reputation, reduce the defense psychological side of target,

reducing the acquisition price and finally win the international combat.

V. Conclusion

Economic globalization pushed multinational companies establish

production system worldwide and maximize utilization of resources and profit. With

the raid economic development of Chinese SOEs and China involved deep in WTO

and world economy, China will more and more participate in cross border M&A

transactions. But when Chinese SOEs found natural resources, technology and market

worldwide, they continue to expose their shortcoming and problems in overseas

investments and also facing constraints and challenges. These problems limited

successful M&A achievements. China SOEs´ outbound M&A activities are still in the

early stage and need to gather more foreign direct investment experience. Chinese

SOEs should change their acquisition style and think prudently when launch outbound

activities as acquiring jointly with other private or foreign companies and diverse the

risks. PEF participate in Chinese SOEs outbound M&A activities not only could

65 / 73

enrich the subjects in cross-border transactions, but also strength the integration of

industrial capital and financing capital and provide experience and management to

Chinese SOEs.

66 / 73

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Provisional Measures on the Administration of Overseas Property Rights of SOEs".(《中央企业境外

国有产权管理暂行办法》)

global rethinking of chinese state-owned enterprises ... · large-scale overseas mergers and...

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