How Can Chinese Companies Make Fewer Mistakes in Overseas M&A?

In recent years, the number and value of overseas M&A transactions by Chinese companies have increased significantly with the advancement of the “Belt and Road” strategy and the globalization of the Chinese economy.
However, cross-border M&A is a difficult transaction with much higher uncertainty than domestic M&A, and external factors beyond the control of both parties often become important factors that hinder the process or influence the outcome of the transaction, such as unexpected global epidemics and governmental approval barriers for political purposes.Nonetheless, the behavior of the parties involved in a transaction can still have a decisive impact on the success or failure of a cross-border M&A. In particular, the buyershould take proactive stepsto improve the success of the M&A.The objectives of M&A vary widely, but there aretwo hard indicators that should be common to buyers:cost and benefit. As long as the costs of the M&A can be reduced and the benefits of the M&A can be increased, then the deal is not too much of a failure. From a technical point of view, unknown risks will raise the cost of the M&A, andproper integration of the M&A targetwill optimize the synergies between the buyer and the seller, thus increasing the benefits of the M&A.Therefore, the key to M&A success or failure lies in risk avoidance and post-merger corporate integration. Based on years of practice and observation, Elitestage has summarized eight lessons learned from the perspective of risk avoidance and optimal integration for the reference of Chinese investors.

Tip #1 

Clarify the purpose of the transaction

Overseas M&A is an important way for Chinese companies to achieve rapid development, therefore, M&A should serve the development strategy of the company.Defining the purpose of the M&A and aligning it with the development strategy of the enterprise is the primary consideration for Chinese enterprises before carrying out overseas M&A.At this stage, Chinese enterprises implement overseas M&A mainly for the following purposes.1、 To build an overseas structure to achieve overseas listing or financing.2、 To expand te sales market and digest excess capacity.

3、 To eliminate competitors and consolidate the market position.

4、 Transferring the origin of products to avoid anti-dumping, countervailing, and other trade protection measures.

5、Use foreign cheap factors of production to reduce production costs.

6、 To acquire foreign technology, patents, brands, data, or other intellectual property rights.

7、 Access to special natural resources.

8、 Use of M&A targets to increase the buyer’s visibility.

9、 Diversifying revenue sources and hedging exchange rate risks.

10、 Integrating upstream and downstream resources to achieve industrial integration.


Tip #2 

 Understand the counterparty 

In overseas M&A, the information asymmetry between the two sides of the transaction is even greater than in domestic M&A. In addition to the subject of the M&A itself, the sellershould also be the object of the buyer’s investigation and familiarization.Although the subject of the M&A is the equity or assets of the business, the buyer still needs to deal with the people, i.e. the natural shareholders or actual controllers of the target business. While most Chinese buyers have recognized the importance of conducting due diligence on the underlying equity or assets, they usually neglect to understand the counterparty.In fact, the key to the success or failure of a business is the people, and the key to the success or failure of a transaction is also the people. As the saying goes, “it is better to buy than to sell”. An honest, fair and reliable seller can help reduce the buyer’s risk, while a seller with a bad heart and a bad track record can hardly make the buyer feel the joy of victory.The more comprehensive the understanding of the seller, the better, including education background, work history, personality traits, professional expertise, hobbies, family situation, social relations, financial credit, transaction records, etc., the better to know a good deal.The buyer can gain insight into the seller’s value orientation, character and reputation, thinking style, behavior, negotiation style, economic status, and motivation, which will help the buyer to judge the feasibility of the transaction, design the transaction structure, determine the valuation and offer, develop negotiation strategies and control the transaction process.

They are selling their companies because of serious difficulties or crises, such as insolvency, criminal involvement, government sanctions, etc. The only purpose is to get rid of the burden, even at a favorable price as bait. In the face of such sellers, buyers have to realistically weigh whether they should pick up this bargain and whether they can fill the hole behind it.

There are many ways to get to know the seller, including positive, lateral, and negative methods. Asking the seller himself, checking with government agencies, and accessing bank credit records are common positive investigations.

Side investigations can include the target company’s customers, suppliers, partner organizations, employees, subcontractors, agents, etc. Doormen, receptionists, and cleaners are said to be one of the most valuable sources of information.

Conducting some activities outside of business with the selleris also a good way to conduct site surveys. For example, a major reason why playing golf is so popular with business people around the world is because it can improve mutual understanding and knowledge in a relaxed atmosphere.

The reverse side of the investigationcan start from the seller or target’s competitors, disputing parties or parties in conflict of interest, for example, to ask the target who has recently had litigation with the seller or target company, etc. If you can do all three, the buyer will not be far from “knowing the enemy and knowing himself”.


Tip #3

Targeted Due Diligence

Due diligence is an important tool for buyers to overcome information asymmetry, but it is also necessary to avoid ineffective investigation with an unclear focus and targeted due diligence can more effectively help buyers identify risks.The main factors that determine the focus of due diligence include the type of subject matter (equity or assets), the industry to which the target belongs, the purpose of the acquisition (equity participation, holding, or sole proprietorship), the relationship between the two parties (whether affiliated enterprises, whether there are long-term business transactions), the type of target enterprise (state-owned enterprises, private enterprises, listed companies), etc.Industry characteristics will also influence the direction of due diligence. According to AIG China’s statistics, among the disputes related to the disclosure of information by M&A sellers, disputes in manufacturing industry projects are mostly related to financial statements, disputes in pharmaceutical industry projects are mostly focused on compliance, while disputes in technology industry projects are commonly related to taxation and intellectual property rights. Accordingly, due diligence on target companies in different industries should select the focus according to the areas where disputes are highly prevalent.In short, selective and focused due diligence according to project characteristics can achieve twice the result with half the effort.

Tip #4 

Be more rational in valuation

Buyers should be rational when valuing a target company or asset, try to restrain impulses caused by emotions or market fluctuations, and give themselves more room to enter or exit in valuation.There arethree main types of M&A valuation methods:the income approach, the asset approach, and the market approach. The income approach is based on the discounted value of the expected income of the target enterprise over a period of time in the future and is usually applicable to target enterprises with more stable cash flows.The asset approach is generally based on the book value or liquidation value of the target assets and is usually applicable to loss-making enterprises or asset acquisitions.

The market approach is relatively simple, i.e. the pricing of similar companies or past similar M&A transactions is used as the reference value for valuing the target company or assets.

All three methods are based on financial statements and research data, which appear to be objective, but in fact, are all susceptible to subjective factors.

In short, maintaining a moderate level of pessimism and humility when valuing M&A targets can put buyers in a safer position.


Tip #5

Complete the deal in stages

If conditions allow, the buyer can break a one-time M&A deal into multiple transactions in stages to allow more time for risks to be exposed and resolved, resulting in a higher level of deal security.The root cause of M&A failure is primarily information asymmetry. The risk of doing a deal with a stranger is much higher than that of an acquaintance. Although due diligence can help buyers understand the key information of the target company, the investigation time is limited, the information that can be obtained by professional investigators is one-sided, and the information is likely to be filtered or “embellished” by the seller.One of the most effective ways to overcome information asymmetry is to turn the seller from a stranger to an acquaintance.Two strategiescan be used: one is to conduct a transaction with the seller for a period of time and wait until sufficient trust is established before making the acquisition; the other is to make a phased acquisition, i.e., acquiring a small portion of the equity first, and then acquiring the remaining equity when the set conditions are met until a predetermined percentage of the equity is reached.Even if a phased acquisition is not possible, the buyer can at least consider paying in installments,lengthening the payment interval, and setting stricter preconditions, which can achieve a similar risk-averse effect.


Tip #6 

Plan your M&A well in advance

Everything that is done in advance is done in advance. M&A is a complex transaction that requires careful planning in advance. A well-developed M&A plan can help buyers anticipate obstacles and risks to the transaction and develop a plan to address them.Typically, an M&A plan needs to clearly answer at least the following questions.Strategic objectives: Why do you want to acquire? What is the acquisition intended to achieve? How will the acquisition target be selected?Financial analysis: What is the maximum acceptable price? What are the assets available to pay the purchase price? How much debt are you prepared to assume? What are the available sources of financing? What is the target return on investment for the acquisition?Integration plan: What synergies can be realized from the acquisition? In what areas will the acquired company need to integrate to achieve synergies? What are the general steps of integration? How much will the integration cost?

Implementation plan: What are the steps to be taken to implement the acquisition? What governmental approvals will be required? What third-party cooperation is required? What intermediaries will be hired? What kind of M&A task force should the buyer assemble?

Time plan: How long is the acquisition planned to be completed? How much time is expected to be spent on each step? What are the variables that may delay the progress of the acquisition?

Buyers should be conservative and cautious when planning an M&A and should not be overly optimistic, as M&A involves many participants and stakeholders, and changes in any one of them can have a butterfly effect on the entire transaction.

For example, failure to incorporate the BVI shell company as the subject of the acquisition on time will delay the signing and delivery of the transaction. Therefore, leaving more leeway in every step and indicator will help make the M&A plan more objective, pragmatic, and closer to the actual execution results of the transaction.


Tip #7 

Purchase M&A Insurance

M&A liability insurancecan be a powerful supplement to the inherent weaknesses of liquidated damages clauses in protecting the buyer’s interests and can facilitate the closing of the transaction.Generally speaking, a buyer’s greatest risk in an M&A transaction comes from the seller’s breach of contract, including the withholding of information or even fraud prior to signing. As a result, the buyer will pay particular attention to the seller’s breach of contract liability provisions during the negotiation of the agreement, expecting a strict agreement to ensure that the buyer will be compensated for damages in the event of a seller breach. However, in practice, this strategy also has drawbacks to the detriment of the buyer.First, the more stringent the liability for breach of contract, the higher the risk that the seller will raise its offer or refuse to concede other significant claims of the buyer as a check, thereby increasing the probability of a breakdown in negotiations.Second, in the case of multiple buyers bidding, the buyer with higher requirements for breach of contract will be at a disadvantage in bidding.Third, it is often difficult for a buyer to pursue a seller for breach of contract without lengthy and expensive judicial proceedings, especially for cross-border claims; even if the buyer is successful, it may be difficult to obtain actual compensation due to enforcement difficulties (the seller is insolvent or the seller’s assets are scattered in different jurisdictions).

Finally, in cases where the seller retains a portion of the equity or continues to participate in the company’s operations after the acquisition, the buyer’s claim is not conducive to maintaining a cooperative relationship and negatively affects the post-merger integration, with the buyer still losing out in the end.

As a hedging tool, M&A liability insurance can effectively alleviate the above conflicts. The principle of M&A liability insurance is to transfer the seller’s liability for breach of contract to the insurance company, which provides protection to the buyer through its own financial strength and credit.

For example, the most popular type of liability insurance is a representation and warranty policy, which, under the terms of the policy, allows the buyer to recover from the insurer in the event of a breach of representations and warranties made by the seller in the M&A agreement, without having to recover from the seller.

Of course, there is no conflict between the insurer’s claims and the M&A agreement’s liability for breach of contract, and the buyer can still recover from the seller under the M&A agreement for losses that are not covered by the insurance (e.g., losses up to the deductible and losses above the liability limit).

Compared with the default liability clause, the advantages of M&A liability insurance mainly include:

It can significantly increase the amount of compensation and enhance the protection for the buyer;

The insurance period canexceed the liability period promised by the seller, so that the buyer has more sufficient time to discover defects and seek compensation;

The buyer candirectly obtain compensation from the insurance company without seeking judicial remedies; fourth, through the transfer of liability, it is conducive to buyer and seller to establish and maintain a good relationship and improve the success rate of the transaction and integration.

Currently, in addition to representation and warranty liability insurance, M&A liability insurance available for purchase in the international market includes tax liability insurance, litigation buyout insurance, environmental liability insurance, fraudulent conveyance, and successor liability insurance. M&A liability insurance entered the Chinese market around 2010, and Chinese buyers can purchase liability insurance applicable to domestic or cross-border M&A in China.


Tip #8

Good cultural integration

M&A is only the first step in achieving the goal of outbound growth (M&A); post-merger integration is the key to generating returns. Cultural integration is the most difficult and critical part of M&A integration and can determine the success or failure of an M&A.The boundaries of corporate culture are blurred and can include corporate vision, values, business style, management philosophy, management system, evaluation system, and even dress style. For cross-border acquisitions, differences in corporate culture may also include language, customs, religion, ethnic relations, social class, ideology, etc. As the active party in an M&A, the buyer should carry out integration based on respect and tolerance of the other party’s corporate culture; unbridled cultural superiority is the biggest obstacle to cultural integration.Numerous studies have shown that most M&As do not turn out as well as they should, and that cultural integration is the biggest challenge to successful M&As.Generally speaking, there are three types of cultural integration strategies:Fusion, in which a new culture is created that is different from the existing culture of both parties;

Assimilation, in which one party accepts the culture of the other party in its entirety;

Separation, in which each party retains its original culture. Therefore, when to integrate, how to integrate, how fast to integrate, and to what depth should be considered under the framework of strategic objectives.

Overseas M&A is a risky challenge for both Chinese multinational groups that are among the top 500 companies in the world and Chinese private companies that have just stepped out of the country.

The challenges come from the external environment, from the counterparties, and from the Chinese buyers themselves. Chinese buyers cannot influence the external environment, nor can they control their counterparties, so they have to find their own path to reduce risks and approach success. Experience shows that a Chinese buyer can effectively improve the success rate of a transaction by doing a good job in eight areas: transaction purpose, counterparty profile, due diligence, subject valuation, transaction steps, M&A plan, risk transfer, and cultural integration.

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