Torrent of outbound FDI poses challenges as well as opportunities

Hong Kong firms need to carefully examine potential mainland partners before agreeing to partner with them in bids for foreign enterprises

PUBLISHED : Friday, 30 December, 2016, 12:04pm
UPDATED : Friday, 30 December, 2016, 8:44pm

More and more Hong Kong investors and business executives have engaged in strategic alliances, and even partnerships, with mainland companies in foreign investments. Understanding the backdrop to and challenges posed by the dramatic surge in mainland foreign direct investment (FDI) is crucial for Hong Kong companies when making strategic decisions and managing risks.

Mainland FDI continued to show tremendous growth in 2016. By the end of August, China had already made 173 deals worth US$128.7 billion, making it the top acquirer of foreign companies.

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Many of the transactions were gigantic. ChemChina acquired the Swiss pesticide and seed producer Syngenta for US$43 billion – the largest cross-border acquisition by a Chinese company to date. Tencent bought Finnish mobile game developer Supercell for US$8.6 billion. Haier Group paid US$5.4 billion for General Electric’s home appliance division. Even the Chicago Stock Exchange was being sold to a Chinese investor group.

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The strong growth of mainland outbound FDI has, in fact, been extending for over a decade. From 2002 to 2015, mainland FDI dramatically increased from US$27 billion to US$1,456.7 billion. Meanwhile, China’s global ranking in outbound FDI has risen from the 25th to eighth , accounting for 4.4 per cent of FDI worldwide.

The industries which Chinese firms invested in have also become more diversified. In 2015, Chinese FDI covered 19 industries, including manufacturing, financial, information technology, science and technology, entertainment, public utility, and food and hotels.

Growth factors

The surging mainland FDI, especially in mergers and acquisitions, was driven by a combination of economic and political factors.

Firstly, China’s economy is slowing down. With the gross domestic product growth expected to slow to an estimated 6.5 per cent, domestic opportunities for mainland firms are diminishing. Structural problems with growth, mainly driven by quick credit expansion and a real-estate boom, and overcapacity are still major issues. Hence mainland firms use FDI as a way to diversify and enter new markets. In other words, Hong Kong companies could wait to choose the right investors.

Secondly, the FDI wave has been driven by favourable government policies. The central government actively encourages mainland firms to become global champions through acquisition, and has taken specific steps to make it easier for them. For example, restrictions in approving foreign investment for State Owned Enterprises (SOEs) have been eased since early 2015. As long as the purchase price is below US$1 billion and the target company’s business falls within the SOE’s primary business, regulatory approvals are no longer required.

Thirdly, China is shifting its focus towards producing higher-value added products. Instead of being involved in the lengthy and costly process of developing advanced manufacturing techniques, many Chinese companies opt for acquiring technology and research and development through external acquisitions. So companies engaging in high-end industries will be more able to identify investors.

Finally, the depreciation of yuan. The International Monetary Fund included yuan in the basket of currencies that make up the Special Drawing Right (SDR) from October 2016; and the yuan will become fully convertible by 2020. With a weakening yuan, mainland firms are seeking to turn their operating cash flows into those denominated in stronger currencies through cross-border acquisitions. This is a factor that needs to be taken into consideration when Hong Kong companies price their business.

Uprising challenges

China’s strong overseas investment growth could extend into the future but will be far from smooth sailing.

One fundamental yet persistent challenge is effective due diligence. Many Chinese acquirers are making their first attempts. They have limited knowledge of overseas commercial and legal environments or profitability models and limited capability to organise commercial, legal and financial due diligence. Yet language, cultural and mindset gaps always hinder them from accepting professional advice. Also, the decision power in many Chinese firms is highly concentrated at the top of the hierarchy, leaving the due diligence personnel in the field less capable to make punctual and efficient decisions. Ineffective due diligence usually leads to information asymmetry and many firms end up overpaying in acquisitions. This is indeed a gap that Hong Kong professionals, particularly those with actuarial audit expertise, could fill. It is also an area in which the big four (accounting firms) in Hong Kong could play an increasingly important part.

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Post-merger integration is another fundamental challenge. Many Chinese firms prefer acquiring mature or leading industry players who already have an established systematic corporate governance policy, which makes integration of the two firms more difficult. For companies which plan to scale new heights after merging with a Chinese firm, they have to pay particular attention to the integration issues.

Increasing regulatory scrutiny has become another major obstacle in acquisitions, especially for information technology and manufacturing industries – the fields more and more Chinese firms are interested in. For example, Fujian Grand Chip Investment Fund’s recent acquisition of Aixtron US, the division of the German semiconductor maker, was blocked by the United States government. Earlier this year, Washington blocked the sale of Philips’ US lighting business to a Chinese-backed private equity firm.

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All such regulatory objections stemmed from the US’s growing concerns over China gaining the competitive edge in international competition. Under the incoming Trump administration, which has pledged to play tough on China, coming years will witness efforts to thwart Chinese firms’ acquisition sprees.

The final, yet very important, challenge comes from many Chinese firms’ vague strategy in launching foreign investments. Many firms take foreign acquisitions as a way to hedge against the currency risk from dramatic depreciation of yuan. Some blindly launch bids overseas without sufficient strategic planning.

A positive example is Lenovo’s acquisition of IBM’s personal computer business in 2004. The transaction seemed formidable to generate substantial synergies as Lenovo then was much smaller firm than IBM. Yet, the combined company’s compound annual growth reached 41 per cent. The success was attributed to Lenovo’s detailed prior-acquisition strategic planning: it clearly identified PCs as its strategic focus, hence its acquisition target.

As the Chinese economy struggles to restructure and upgrade, against increasing regulatory scrutiny on acquisitions imposed by the US, the wave of Chinese FDI will eventually stabilise. On the other hand, as Chinese firms are gaining more experience in investing abroad, better structured transactions with clear synergy logic and strategic benefits can also be expected. There will be more win-win scenarios if the executives taking care of the mergers and acquisitions are well aware of issues involved and proactive enough to solve them.

Wu Hong is an assistant professor at the School of Accounting and Finance of the Hong Kong Polytechnic University