Asia: Allure of the Chinese buyer begins to fade

Chris Wright
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Outbound M&A from China has been one of the big themes in global investment banking over the past few years, much of it driven by the need to reform China’s state-owned enterprises. But it is tricky work, subject to forces beyond an adviser’s control, and only some of it is lucrative. No wonder bankers, and many selling companies, are re-evaluating whether a Chinese buyer is unequivocally a good thing.

China Rusty Knight-600
Illustration: Peter Crowther

When rumours broke in October of a possible merger between SinoChem Group and China National Chemical Corp, it brought into focus many of the interesting and difficult issues surrounding state-owned enterprise reform in China.

If true – and neither company had confirmed it at the time of writing – the merger takes on new levels of complexity. China National Chemical Corp, better known to the world as ChemChina, has been one of the most acquisitive of all Chinese businesses in recent years, picking off overseas businesses on a roughly annual basis since it bought France’s Adisseo Group in 2006. 

Other highlights have included Israel’s Makhteshim Agan in 2011, Italy’s Pirelli in 2015 and the heavyweight of all Chinese outbound M&A, the $43 billion bid for Syngenta earlier this year, which, bankers close to the deal say, is unlikely to complete this year.

Attempting a merger of the two vast chemical groups at the same time that the largest-ever foreign acquisition by a Chinese company is still being completed would be ambitious by any standards. But domestic consolidation to create national champions and outbound acquisitions to acquire technology and international ability are both part of the same theme: China’s ambition to transform its vast but bloated state-owned sector. 

That ambition has also been a potential boon to international investment banks. In recent times, almost every cross-border M&A deal of note has had a potential Chinese bidder, many from the state-owned sector. Advisers say that to secure a sell-side mandate, a list of acquiring candidates needs to include at least one Chinese name. 

At the same time, most M&A bankers in Asia spend huge amounts of time presenting possible overseas acquisition targets to the reform-minded SOEs. 

But as the pace of reform slows, so bankers are starting to fret that the reform of China’s state-owned industries might not be the fee-led boom they were expecting. 

SOE reform

Euromoney is driving around the city of Shenyang, in Liaoning Province in China’s far northeast. This part of the country has an unwanted claim to fame. When Liaoning’s first-quarter and first-half numbers came out, it was the first Chinese province to show negative growth in seven years. 

This is China’s rust belt, its Teesside or Pennsylvania. One of the first Chinese provinces to industrialize, it was the heartbeat of China’s industrial growth, a leader in automotive manufacturing and heavy industry, particularly iron and steel. But the assets that helped it thrive now impede it in an era of chronic oversupply in the things that Liaoning makes. 

Dongbei Steel, the result of a three-way merger orchestrated by the provincial government a decade ago and now 70% state-owned, is a classic Liaoning story. It is the country’s largest producer of speciality steel, but it defaulted on a bond payment earlier this year and went bankrupt in September. It is one of 800 companies in Liaoning alone formally recognized as a zombie – one that is not viable without bailouts to keep running and servicing its debt.

This is what SOE reform is all about: a once-productive company, state-controlled, in an era of overcapacity, which needs restructuring to survive. And the government’s decision to let it go bankrupt rather than bail it out is also emblematic of China’s new attitude towards the role of the state in business.

"The bankruptcy indicates that government owners, as well as creditors, are taking a more market-oriented approach to resolving the debt problems of defaulted SOEs," says Moody’s. 

From now on, it says, the central government will only provide financial support to distressed SOEs if their activities are closely aligned to national policy or if the government thinks a default could have wider systemic implications. For everyone else, it is sink or swim; it is a free market and that ought to mean opportunities for banks.

Or that is the theory anyway. 

The whole architecture for evaluating a buyer from China has changed during the course of this year
 - Colin Banfield, Citi

The idea of SOE reform has been talked about since Zhu Rongji’s premiership in the 1990s, but has come into renewed focus since China began unleashing heavy stimulus in 2009 after the global financial crisis. SOEs, which have always been instruments of policy first and foremost rather than businesses run for profit, have grown in this period of stimulus and probably grown too much for the health of the economy.

"The SOEs control all the upstream areas of the economy," says Francis Cheung, head of China and Hong Kong strategy at CLSA. "The real problem is that they dominate so many industries that the private sector has no ability to enter those industries," particularly since around 30 industries are considered to be strategic and therefore protected. 

Worse, SOEs are debt-stricken and inefficient. On top of this, leading figures within SOEs have become increasingly politically powerful, which has become a problem for premier Xi Jinping.

So China is once again planning to reform SOEs. It has arrested many SOE managers for corruption and has pledged to make unviable businesses good again. The vision is to take the 112 national SOEs (itself an improvement from 196 when the State Owned Assets Supervision and Administration Commission of the State Council (Sasac) was set up in 2003) and reduce them to about 40 strategic, central SOEs. M&A will create state champions, bad assets will be sold, private ownership will be brought into state-owned companies and weak balance sheets will be consolidated.

This is a slight change of tack.

"The whole idea of SOE reform was to allow the entry of the private sector into some of those areas," says Cheung. "The latest version is not so much about opening sectors for private competition and making SOEs more market-driven, but about making them bigger and stronger champions: to consolidate them." 

Still, there is something to be said for this approach. It does reduce risk by strengthening balance sheets and, even if it does not make the company itself more competitive, creates a stronger base through which companies might acquire that competitive advantage overseas. But there are many challenges in making this happen, among them vested interests.