Despite a lacklustre performance in the mainland market for domestic and inbound mergers and acquisitions (M&A), industry specialists are cautiously optimistic about a pick-up this year. The doldrums have been caused by the impact of monetary policy implemented by the central government last year, when banks were obliged to increase reserve requirements to cool inflation and property speculation. 'Its effect has been combined with the general caution about the economic climate in the second half of 2011,' says Jeremy Fearnley, a partner at KPMG China. Domestic deal volumes in the first quarter of this year were down a third to 652 from 974 in the last quarter of 2011. It also represents a 27 per cent drop from the same period in 2010. 'There was a similar but less pronounced impact on inbound deals, which continued their steady decline since the second half of 2010. Inbound deals fell to just 133 in Q1 2012, compared to 174 in the last quarter of 2011. The average size of inbound deals almost halved to US$17 million,' he says. 'However, the picture is not all bleak. The downturn in the statistics belies our expectations of a tentative recovery supported, at least anecdotally, by activity among M&A practitioners. This may not transpire until Q3 and Q4, due to a typical six-month gestation period for deals, but we remain optimistic regarding the prospects for the second half.' Lawrence Chia, national managing partner of financial advisory services at Deloitte China, shares Fearnley's cautious optimism. 'Reading the tea leaves from one particular angle, inbound M&A activity into China could gradually pick up over 2012. Deal flow may primarily be driven by cash-rich United States-based corporate and first-tier private equity firms hoping to move beyond the difficult downturn in business cycles. These firms are looking towards the future for profitable opportunities in China,' Chia says. 'Their European counterparts will also look to emulate them, though to a lesser extent. Wider macroeconomic fundamentals indicate that the United States is now on the road to a recovery of sorts while parts of the euro zone are still mired in debt.' Fearnley believes the material and industrial sectors, which together account for about one-third of the mainland's M&A by number, will continue to dominate as China's manufacturing industries continue to perform strongly. 'With rising energy prices, any industries that are energy-intensive, such as steel, building materials, non-ferrous metal mining and chemical engineering, can expect to come under further pressure to modernise and increase efficiency. In many cases, that may be achieved through consolidation to achieve scale,' Fearnley says. 'Interestingly, the split of deals by sector has remained stable in the last few quarters. There is a slight trend towards the health care sector, which has doubled as a proportion of total deals from 4 to 8 per cent in the past 12 months. It reflects the attractive investment opportunities as this sector modernises and matures.' In a global market plagued by uncertainty and volatility, bidders must spend more time to ensure that prior deal drivers are still valid, Chia says. 'For instance, facing intense competition from state-owned counterparts, opaque regulatory agencies and stringent or non-existent financing constraints, many private Chinese businesses find it virtually impossible to secure financing arrangements to undertake a transaction,' he says. 'Furthermore, such situations are only likely to become more commonplace as China's financial markets are in the process of maturing.' Chinese acquirers should also engage qualified advisers to help them understand and mitigate some of these risk factors, financial and otherwise, Chia says. 'In the current climate, more effort is required to unlock the hidden values of an acquisition. Because capital markets remain very soft, valuation exercises become less relevant and meaningful as a way to properly assess target potential. Chinese buyers have to move back to the basics of valuation discovery. It's less useful than it once was to look at market multiples, as many are now severely skewed. Companies must find alternative methods of valuing their targets and recognise that value is often a function of the scarcity of a given asset.'