In this special Fox & Hedgehog feature, Henry Lu examines recent trends and the future outlook for China’s outbound mergers and acquisitions (M&A) activity. The article also includes exclusive commentary from Richard Cooper, Harvard Professor of International Economics and former U.S. Under-Secretary of State for Economic Affairs.
In 2016, China’s outbound M&A overtook the United States for the first time, with $219 billion in announced deals. China’s outbound M&A growth has been dramatic: from 2004 to 2014, deal value grew at a 35% yearly rate. Record highs in 2015 led to talk of a “New Era” of Chinese overseas investment, and were surpassed again within the first five months of 2016.
Early this year, however, China’s outbound M&A fell sharply. In January and February 2017, deal value was 83% lower than for the same period in 2016. Up to one-third of the deals announced last year were canceled or withdrawn after regulatory scrutiny. Many commentators had predicted this slowdown, arguing that the “nose-bleeding rate” of growth “fueled by debt” would face regulatory headwinds.
Nonetheless, China’s outbound M&A is likely to pick up again in the near-term. Despite pushback from Chinese and overseas regulation, the fundamental drivers and long-term economic trends behind Chinese outbound M&A growth remain robust.
WHAT IS BEHIND THE M&A BOOM?
A J.P. Morgan report describes several key factors driving China’s M&A growth in 2015 and 2016. Chief among them is China’s economic transition. China’s economic slowdown encouraged firms to pursue overseas investments for growth, while China’s economic rebalancing incentivized firms to acquire overseas companies with expertise in consumer sectors. China’s economic slowdown also prompted monetary easing, increasing the availability of deal financing. These economic forces are likely to persist for many years.
The economic incentives facing Chinese firms boil down to the pursuit of higher returns.
“The rate of return on investment in China has been declining in the past decade. There is over-investment in some sectors, which of course make return mark-up difficult to achieve,” said Richard Cooper, Harvard Professor of International Economics and former U.S. Under-Secretary of State for Economic Affairs.
“There are better prospective rates of return abroad than in China. Insofar as businessmen have funds, they look around, and they see more attractive options abroad.”
Beyond economic factors, Chinese firms conducting overseas M&A are learning by doing. Chinese buyers are gaining experience, while Western sellers are gaining comfort in their Chinese counterparts’ ability to execute. Increased confidence on both sides leads to greater deal volumes.
The sharp decline of outbound M&A in early 2017 has widely been attributed to tightening regulation and growing protectionism in the West.
Last year, the United States blocked Chinese deals to acquire German chipmaker Aixtron and Philips lighting unit Lumileds on national security grounds. The United States also blacklisted state-owned Chinese telecommunications firm ZTE for violating sanctions on Iran, although the restrictions were removed last week after the company agreed to pay $892 million in penalties. These decisions not only affected the targeted deals and companies, but also raised costs for future deals with Chinese firms through heightened regulatory risks.
However, the effect of U.S. regulation is often exaggerated. High-profile setbacks generate a lot of attention but represent only a small minority of overall Chinese M&A activity.
“I think the sums are relatively small that warrant that kind of scrutiny,” said Cooper when asked about U.S. regulatory review. “The U.S. has a formal process, but only on national security grounds. We’ve turned down a few, but we’re not talking about tens of billions of dollars.”
On other Western countries, Cooper had a similar comment: “There was a recent attempted takeover of a German high-tech firm that was blocked for security reasons, and the Australians have raised questions of foreign ownership of large swathes of land. So, every country has its own sensitivities. But in terms of tens of millions of dollars—in economic terms, we’re talking about fringe activities.”
Rather than regulation overseas, it is regulation within China that is preventing many potential M&A deals.
“The Chinese are worried about the downward pressure on their currency. Technically, all overseas investment is under control by the Chinese authorities, so any serious investment has to be approved by the authorities. If the pressure continues, the authorities will tighten up as they have in the past six months on foreign investment,” said Cooper.
Chinese authorities are particularly concerned about firms using outward investment as an excuse to move capital offshore, exacerbating capital flight. Thus, regulators tightened rules at the end of last year.
“They’ve set out some general guidelines. Any investment above a billion dollars outside your core activity is going to garner special scrutiny, and perhaps denial if there is no justification for it,” said Cooper. “They’ve begun the tightening, but there’s a long way they can go.”
But while Cooper stresses the role of Chinese guidelines and downplays the scale of Western regulation, Rachel Morarjee from Reuters takes the opposite view.
“Protectionism is the top threat facing Chinese dealmakers,” wrote Morarjee in a Reuters 2017 Breakingviews prediction. “Beijing may clamp down on overseas acquisitions…but mooted restrictions would not have halted most recent big deals. A larger headache could be Western countries raising the drawbridge.”
Morarjee’s greatest concern is over Western backlash against globalization. In November, a congressional panel monitoring U.S.-China trade and security recommended to ban acquisitions by Chinese state-owned companies in the United States. The new U.S. administration, which has emphasized tensions in trade and security with China in its rhetoric, may prove more receptive to suggestions to curb Chinese investments.
While protectionist risks weigh in Western countries, opportunities are rising in the East. Investments in Asia are encouraged by China’s One Belt One Road initiative, a major development strategy that will pour massive investments into infrastructure and other projects connecting China to countries to the West. Central, West, South, and Southeast Asia lie on key routes along the belt, and countries around Oceania and the South China Sea are important investment destinations for China’s Maritime Silk Road.
To the extent that Chinese investment policies are tied to certain geographic locations, we might expect to see regional trends in Chinese M&A. As Western economies experience slow-growth, Asian countries may drive increasingly important shares of growth and investment opportunities.
However, Cooper cautioned against drawing sweeping conclusions about Chinese M&A moving to Asia: “Geographic generalizations are wide of the mark in the sense that these are very specific targets of investments, and they can end up in any places that are politically and legally secure and economically profitable. The U.S. and Europe remain the biggest markets in the world, both for investments and for exports.”
Japan also represents an enormous market but poses its own barriers to Chinese investment.
“Japan has for institutional reasons been a difficult place to have FDI [foreign direct investment], and that’s been for sixty years, so I don’t expect to see large Chinese investments in Japan,” Cooper said. “A hostile take-over is very difficult in Japan, and even a friendly takeover is often not welcome.”
Overall, the largest current obstacle to Chinese outbound M&A is China’s capital regulations, which will likely channel activity toward strategic investments, particularly in the consumer sector. A potential curveball may appear if U.S.-China tensions trigger a backlash against Chinese investment, or if protectionism mounts in Europe. While Chinese firms could shift some M&A activity to Asia, the impact from the United States and Europe would be immense due to their enormous investment and export markets.
On balance, however, there is reason to expect high Chinese outbound investment growth in the near-term. As long as the fundamental economic drivers for overseas M&A remain strong, stringent regulation in China and abroad will contribute to pent-up demand. PwC analysts predict a return to new records of Chinese M&A as early as 2018. In the long-term, as China moves up the value-added chain and Chinese firms diversify their markets, China’s appetite for foreign technology and markets will continue to expand, fueling overseas acquisitions.