capital agenda insights - investing in china

Capital Agenda Insights

March 2011

Boardroom issues

• DoyouplantoinvestinChina,butareconcernedaboutchoosingtherightChinesepartner?

• HowdoyoudealwithdifferencesinobjectivesandaspirationsbetweenyouandyourChinesepartner?

• AreyouconcernedaboutmaintainingtheChineseauthenticityofthepartnershipwhenyouareeitheramajorityorminorityowner?

• DoyoufacethechallengeofchoosingtherightteamtoworkinChinaandselectingthebestcandidatesforkeyofficerpositions?

• Howdoyoumaintainalignmentwiththelocalpartneronintegrationpriorities?

• Howdoyouensurethatthepartnershipcreatesthevaluethatwasanticipated?

Investing in China: mapping JV integration to deliver valueThe dynamism of the Chinese market remains a compelling story for western companies, as many continue to vie for stakes in Chinese companies. Yet, red-hot valuations and new regulatory regimes are contributing to a rapid change in the investment climate, and foreign investors need to be agile enough to consider different approaches and adapt their strategic options in China accordingly.

Tenyearsago,therewerenumerousopportunitiesformultinationalsseekingtoacquireChinesecompanies,althoughatthattime,thestrategicintentformostinvestmentswasaccesstolow-costmanufacturing.ManyChinesecompaniesinneedofwesterntechnologyandcapitalwerewillingtoenterintopartnershipsinwhichthewesternbuyerwouldhaveacontrollingstakeinthebusiness.However,theinvestmentclimatehaschangedrapidlyoverthepastfewyears.

RisingvaluationshavebeenoneofthekeyfactorshelpingtotransformtheinvestmentenvironmentinChina,asthecountryhasbecomeoneofthemostdesirabledestinationsforinvestorsinemergingBRICmarkets.Chinesebusinessesaremorecash-richandhaveevolvedrapidlyoverthepastdecade.Drivenbystrongeconomicgrowth,manylistedChinesecompanieshavebecomeincreasinglysuccessful,makingthemmoreexpensiveforpotentialforeignbuyers.

Atthesametime,newgovernmentregulations,includinganti-monopolylawsandlegislationongovernmentprocurement,aremakingdealsmorechallenging.Thisisinpartbecausethenewregulatoryclimatehasincreasedthebargainingpoweroflocalplayers,forcingpotentialamendmentstothetermsandscopeofacquisitionsofChineseassetsandreducingthebenefitsformulti-nationalcorporations(MNCs)lookingtoacquirelocalcompanieswithgovernmentcontracts.

Overall,Chinesecompaniesandpolicymakersarebecomingmoresavvywhendealingwithwesterninvestorsthantheywere10yearsago.Many,ifnotall,areasking,“Whydoweneedyouinourownmarket?”

Theaveragetransactionlifecycleis12to24monthsinChina,comparedtoaroundthreetosixmonthsinmaturemarkets.Theseprotractedtimetablesforconcludingdealsareclearlytakingatoll;in2007,just3outofevery10Chinesetransactionsweresuccessfullycompleted,andthosenumbershavechangedlittleintheinterveningthreeyears.

Giventhislongertransactionlifecycle,investorsneedtoremainpatientandmanagetheirheadquarters’expectations,whileatthesamesettingtherightexpectationsduringinitialJVdiscussions.Webelievethatforeigncompaniesneedtogetseveralcrucialstepsrightduringthepre-dealplanningstageinordertosetthetransactiononareasonablepathtosuccess.

Forallofthesereasons,multinationalsneedtorethinktheirinvestmentapproachesinChina,whethertheyarenewentrantsordabhandsatthemarket.Investinginminoritystakesorformingjointventures(JVs)isnotuncommonthesedays,especiallyinsectorslikeconsumerproducts,pharmaceuticalsandretail.Suchnewapproacheshaveimplicationsnotonlyfortheformationofinvestors’inorganicgrowthstrategiesinChina—namely,howthetargetcompanieswillfitintotheirexistingbusiness—butalsofortheirsubsequentapproachtointegrationanddecisionsonhowbesttoextractvaluefromthesetransactions.

Planning for value: getting the initial steps right

Theportfolioinvestmentstrategyisgainingpopularityasmanyforeignbuyersfocusonaseriesofsmalleracquisitions,partnershipsorJVsinsteadofonetransformativedeal.OneforeigncompanythathasadaptedtoconditionsonthegroundinChinawhileatthesametimepursuingalong-terminvestmentstrategyisaBelgium-basedglobalbrewer,whichtookequitystakesrangingfrom20%to71%inaseriesofChinesecompaniesoveraperiodof20years.

Determining the strategic intent of the JV and objectives from both sides

ForeignandChinesecompaniescometothetablewithverydifferentaspirationsandperspectivesononeanother.ThereisanoldChinesesayingthataptlydescribesthechallengesofapartnershipbetweenaChinesecompanyandaforeigncompany:“samebed,differentdreams.”Thishighlightstheoftenlargedivergenceinobjectivesbetweenforeignandlocalpartners.Inordertosettheinitialdiscussionontherightpath,eachsideneedstomaintainaclearviewofitsownobjectivesforthepartnershipanddeveloparealisticassessmentofthelikelyunderlyingobjectivesofitspartner.

InarapidlychangingmarketlikeChina’s,partners’objectivesarelikelytochangeaswell.Therefore,itisalsoimportantforbothpartnerstothinkstrategicallyabouthowtopreemptorinfluencetheotherwhenonepartychangesitsobjectivesfortheJV.ThinkingcreativelyaboutreshapingtheJVand(or)developingrobustcontingencyplanswillbeimportantevenatthisearlystage.

2 Capital Agenda Insights

Appointing key officers

Whileminorityshareholders’influenceovertheboardislikelytobelimited,theabilitytoexercisemanagementcontrolofoperationsisimportant.Iftheminoritypartnerisabletonamethechieffinancialofficer,theyarelikelytoendupwithacandidatewhoismoreattunedtoWesternstylesofrunningacompanyandbetterabletofulfillcompliancemeasures,bothduringtheintegrationphaseandoverthelongerterm.

TheCFOcontrolsallfinancialmatters,fromsettingtheannualbudget(especiallyimportantforcompanieswithhighcapitalspend),tofinanceandmanagementreportingandinternalcontrols.

AsuccessfulCFOwillholdbroaderresponsibilityfortheoperationalsideofthebusinessandwillalsohavecomplianceofficersreportingtohimorher.

Anotherkeypositionthatmostforeigninvestorsplanforisinmanufacturingoperationsorqualitycontrol.Whilelocalemployeesoftenhavevaluableknow-howinthisarea,Westernleadingpracticesarefrequentlyneededtobringmanufacturingandqualitycontroltothenextlevel,especiallywhentheJVisseekingtoexportitsproductstooverseasmarkets.Bycontrast,salesanddistribution,whichtendtobemorelocalized,arebetterleftinthehandsofthelocalpartner.

In1996,aleadingChinesefastmovingconsumergoods(FMCG)brandformedaJVcompanywithaFrance-headquarteredglobalfoodandbeveragecompany.TheChinesecompanyowned49%oftheJVwiththeWesterncompanyowning25.5%.Twoyearslater,theWesternJVpartnerbecamethemajorityshareholderafterbuyingouttheinterestofanotherinvestmentpartner,takingcontroloftheJVanditstrademark.However,thischangeinownershipwasnotrecognizedbytheChineseJVpartner,whichcontinuedtomaintaincontroloftheJV’sday-to-dayoperations.TheChineseJVpartnerclaimedthatithadnottransferredownershipofthetrademarktotheJV,justitsexclusivelicense.By2000,theChineseJVpartnerhadestablishedothercompaniestosellthesameproductsastheJVandusedtheChinesetrademark,settingoffaseriesofarbitrationandlawsuitsonthepartofbothparties.

HavingwonthebattletohavetherighttoelectaCFOfortheJV,manyforeigncompaniesthenfacethechallengeofselectingtherightcandidate.Inarecentlycompletedtransaction,aUSindustrialproductscompanyelectedanexpatCFOfortheJV.AhighlyregardedveteranwithseveralyearsofoperatingexperienceinChina,theCFO-electhadthedilemmaofdecidingwhethertorelocatetoathird-tiercitywheretheJVisheadquarteredorattempttorunthebusinessfromShanghai.Inaddition,duetoalackofChinese-languageskills,theCFO-electcannoteffectivelycommunicatewiththelocalfinanceteamwithoutaninterpreter,makingitharderforhimtoforgeastrongrelationshipwiththelocalteams.

3Capital Agenda Insights

Protecting intellectual property (IP) and other rights

ForeigninvestorsneedtoensureadequatemeasuresareputinplacefromDayOnetoprotectIPrights,whetherforthetechnologyorforthemanagementprocessesandknow-howthatWesternpartnersareintroducing.Suchmeasuresmayseemunusual,butChineseJVshaveadefinedlifespan;therefore,itisincumbentupontheWesternpartnerstoensurethattheirIPisnotmerely“transferred”totheChinesepartner’shands,butinsteadreflectssomeofthevaluethattheWesternpartnercontributestotheventure.

Mapping out a clear path for the future

Finally,foreigncompanieswillalsoneedtoanticipatetheendgamefortheJV.Dotheyseeaneventualincreaseintheirequitystakesorabuy-outoftheChinesepartnerthatwillallowthemtobecomethemajorityowneroftheJV?DotheyanticipatelistingtheJVonthepublicmarket?Alternatively,dotheyexpecttoformsimilarJVsinotherproductcategoriesorgeographies?

MappingoutthepotentialevolutionoftheJVtheyaregettingintoisasimportantas,ifnotmoreimportantthan,settingtherightsetofobjectivesattheonsetofpartnershipdiscussions.Whileitwillbeextremelydifficulttoanticipatepotentialend-gamescenarios,foreigncompaniesinvestinginChinaareencouragedtoplanrigorouslyforsuchoutcomesandfortheirpotentialtriggers.ThishasimplicationsduringJVnegotiations,whethertheyinvolvethevaluationofthebusinessatatimeofsaleornon-competeclauses.Developingandrigorouslytestingasetofkeyassumptionswillhelptoshapedecision-makingandtrade-offsduringJVnegotiations.

InarecentlycompletedJVinametals-processingbusiness,theWesternparty’scontributionincludedtheir“know-how”aroundefficientprocessingsystemsdeemedleadingintheirindustry.InformingtheJV,theWesternpartnerinsistedthataportionofthefinalprocessingbecompletedbyoneoftheirwhollyownedfacilities,therebyallowingthemtoensurethatnotallaspectsoftheirhighlyvaluedsystemsweresimplygiventotheChinese-controlledJV.

Capital Agenda Insights4

Focusing on JV value creationBothpartiestoanegotiationarelikelytoagreeonvaluecreationasacommonbusinessobjectiveforanyJV.Chinesecompanieslookforforeignpartnersformanyreasons:toachieveaglobalprofileinascalablewayandgainaccesstomassiveexportmarkets;todevelopbrandingexpertiseandgainaccesstonewtechnologiesortolearnnewwaysofovercomingqualityissuesthatcanrestricttheirabilitytoexport.

Foreigncompanies,meanwhile,mustprovetotheirChineseshareholdersthattheyareactiveminorityinvestors;theyneedtoensureeffectivetransferofknowledgeandbusinesspracticestotheirlocalpartners.TheJVwillcreatevaluebyleveragingtheforeignpartner’smanufacturing,technologyandmarketingcapabilitiesandthelocalpartner’slocalmarketandregulatoryknowledge,marketaccessanddistributioncapabilities.

Successfulvaluecreationrequiresbothsidestoagreeonasetofintegrationprioritiesandrapidlytranslatetheseintospecificinitiativeswithineachfunctionalarea.Thisprocesswillalsoalloweachfunctionalareatodeeplyunderstandthecapabilitiesoftheotherandworkoutfeasibleplansthroughassignment

ofresponsibilities.Ifdonecorrectly,thiswillalsogivetheforeignpartyagreaterdegreeofmanagementcontrolandinfluenceinthespecificareasoffocus.

However,ourexperiencetellsusthatthisisoftennotastraightforwardprocess.

Watching your language

Let’sstartwithwhattocalltheintegrationproject.InChinese,anintegrationplanis“”(zhenghejihua),whichcolloquiallymeans“aplantofixthingsup.”WhileChineseseniormanagementwillunderstandthegoaloftheproject,linemanagers,whoareoftenproudofthehistoryandachievementsoftheenterprise,frequentlyreactnegativelyordefensively.China-savvyforeigncompanies,therefore,willrefertotheintegrationprojectas“”(xiaonengtigaojihua),whichmeans“performanceimprovementplan.”ThisislikelytogodownwellthroughouttheorganizationasthecentralgovernmenthasoftencalleduponallenterprisesinChina,betheystate-ownedorprivatelyowned,tocontinuethedrivetowardperformanceimprovementintheirrespectivesectors.

5Capital Agenda Insights

Getting behind a common plan

Nextcomesthechallengeofagreeingwhatintegrationprioritiesshouldbe.Bothpartiesoftenhavedifferentviewsastowhatisavalue-creationpriorityandwhatisnot.Evenwhenbothsidesagreeonprioritiesattheonset,thesemaychangeveryquicklyaseachsideabsorbstherealitiesofthepartnershipandthechangesthatarenecessarytomakeitsuccessful.Focusiscritical,giventhefast-changingcompetitiveandregulatoryenvironmentinChina.

MNCsoftenfocusonthecontrolelementsintheirintegrationplans.Forexample:checkingandensuringexistingsuppliersandcustomershaveproperlydocumentedcontracts,thereiscompliancewiththerelevantregulatoryandhealthandsafetyexecutive(HSE)requirements,checkingandensuringemployeesandcompensationaremanagedthroughastructuredappraisalsystem,cashmanagementhastheproperinternalcontrols,amongothers.

Chinesemanagers,bycontrast,sometimesdonotseethesecontrolprioritiesassoimportant;afterall,theyhaveachievedsuccesswithout“fixing”theseareas.Theyaremosteagertoseetheirproductsexportedoverseasandtheirplantsupgradedsotheycanstartproducingtheforeignpartner’sproducts,increaseutilizationandallowtheirsalesforcetoscaleupquicklyandsellmoreproductsinthedomesticmarket

—evenifgapsstillexistbetweenqualityrequirementsandimplementationoftheCustomerRelationshipManagement(CRM)system.

Agreementonintegrationprioritiesforbothsideswillrequirethemtoworkouttheirshort-termandlonger-termvaluecreationpriorities,whichunfortunatelymaymeananotherroundofnegotiations.Settingrealisticexpectationsaboutwhatcanbeachievedintheinitialperiodisimportantandwillrequireafinebalancingactbetweensecuringcontrolandaddressinglonger-termvaluecreationneeds.AnotherproblemisthatforeignpartnersoftenmakethefirstassessmentofwhatskillstotransfertotheChineseJVonthebasisofaWesternviewofwhatisneededinChina.Thisusuallyisdrivenbyamultinational’sexperienceinitshomemarketanddoesnotnecessarilytakeaccountoftheChinesecontext.Leftunchallenged,thesesortsofassumptionscanpotentiallyleadtoapooruseofresourcesandwastedmarketopportunities.

InarecentlycompletedJVinSouthernChina,theEuropeanheadquartersoftheforeignpartnerquicklyassembleda“firststrike”multifunctionalteamarmedwithacomprehensiveintegrationplan.Theessenceoftheplanwasriskmitigation,fromensuringthelicensingandHSEcomplianceoftheChinesefactory,toputtinginplaceasetofrigorouscontrolsandbudgetinginthepartner’sfinancedepartment.TheintegrationkickoffinChinadidnotgowell.Therewasstrongresistancefromlocalmanagement,whowereexpectingtheroll-outofplanstoupgradetheirfacilities,prepareproductsforexportandshiftsomeproductioncapacitytoChina,henceincreasingtheChinesepartner’sfactory’sutilization.Bothsidesultimatelylearnedtheimportanceofinvolvingbothsidesindecision-makingaboutintegrationpriorities.Reachingacommonunderstandingofwhatareprioritiesandwhatarenotduringintegrationisthefirststepofasuccessfulpartnership.

6 Capital Agenda Insights

Choosing the right team to back you up

Finally,bothsideswillfacethechallengeofimplementingvalue-creationinitiatives.ForeigncompaniesfacethebiggerchallengeofselectingagroupthatcanparachuteintothenewlyformedJVwiththeappropriatemixoftechnical,businessandChina-savvymanagerstoaccelerateknowledgetransferandoperationalimprovements.Withoutproperpreparationandincentives,membersofthisteamoftenseetheircurrentassignmentastheir“dayjob”andcanlacksufficientfocustoworkwiththeJVpartner.OntheChineseside,theremaybealimitednumberofmanagerswiththerequisiteinternationalexperiencetoworkeffectivelywiththeincomingpartner.SuchamismatchofexpectationsandcapabilitiesoftencausethefirstchallengesintheJVrelationship.

7Capital Agenda Insights

Cont

act Yew-Poh Mak

OperationalTransactionServices—Asia-PacificT:+862122283002E:yew-poh.mak@cn.ey.com

ThedealenvironmentinChinacontinuestobeadynamiconewithstrongappealtoforeigninvestors,butinternationalcompaniesneedtorecognizetheextenttowhichtermshaveshiftedandadapttheirstrategiestotakeaccountofthesenewrealities.StartingandmanagingJVswillincreasinglybecomepartofanymultinational’swinningChinastrategygoingforward.However,thiscontinuestobeacomplex,uncertainandattimes,emotionalprocess.

PreparationismorecriticalthanevertothesuccessofaJVorsimilaralliance,andinvestorsneedtounderstandthestepsthatarekeytothisprocess,includinghavingaclearvisionoftheoverallstrategybehindthedealandwhatbothsidesviewastheobjectivesofthepartnership,choosingtheexecutiveswhowillhaveresponsibilityovermajorfinancialoperationsandenvisioningtheultimateendgameforthealliance.Successrequirescontinuedengagement,pragmatism,andfocus.Duetothedifferencesinculture,experienceandmanagementpractices,eachsideneedstopaysystematicandexplicitattentiontoclarityofcommunicationandtrust-buildingbetweenthepartners.Bepatient!

PartnershipsthatexcelintheChinesemarketplacearethosethatrelentlesslyfocusonmarketopportunities,remainalerttotheevolvingobjectivesofthepartnershipandfocuspost-JV-formationeffortsontheopportunitiesthatwillcreatethehighestvalue.Thosewhoseinitialpartnershipsfailtodevelopaccordingtoplanalsohavethepotentialtobecomewinners,solongastheyapplytheexperiencetheyhavegainedtonewopportunitiesinChina,eitherontheirownorwithnewand(or)existingpartners.Whatevertheroute,theChinesemarketcontinuestooffersignificantopportunitiesandrewardstothosethattakealong-termview,maketheeffortandperseveretotheend.

Conclusion

8 Capital Agenda Insights

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