China’s outbound M&A volume has contracted significantly since the beginning of the year. The Chinese government’s attempt to curtail acquisitions outside the core business areas of Chinese companies and the resulting breathing spell could have a favourable effect on M&A success probabilities.
After China’s outbound foreign direct investment, particularly outbound M&A activities, had reached a historical record high in 2016, the Chinese government has stepped on the brakes to limit foreign exchange outflows and to prevent so-called “irrational” investment projects. Due to this more restrictive approval policy, China’s 2017 first quarter outbound M&A volume dropped by about 60 per cent compared to the same period in the previous year. Some market observers predict that this drop signals the end of the Golden Age of China’s global foreign direct investments. Contrary to these prophecies of doom and gloom, the slowdown of China’s outbound M&A deal flow can actually yield positive results.
In general, M&A is a risky growth strategy. Many studies argue that about half of all M&A transactions worldwide end up destroying value. M&A failure rates are particularly high in cases of acquisitions outside the buyers’ core business area. In other words, industrial acquisitions are most likely to be successful when the acquiring and acquired companies hail from the same industry. In the case of China’s outbound M&A deals, however, Chinese buyers often are willing to make acquisitions outside their own core business areas – for example to gain a foothold in new industries or to acquire vanity assets in the real estate or entertainment sectors. These types of deals outside the core business of Chinese state-owned or state-proximate companies have been subject to enhanced monitoring by Chinese regulatory authorities since the beginning of this year. Given that acquisitions outside a company’s core business tend to be characterized by higher failure probabilities, this refocusing represents a positive development.
Companies need time between deals to apply lessons learned
M&A-based growth strategies often lead to value destruction. However, on average, serial acquirers tend to achieve a better M&A batting average than companies that only engage in single deals. M&A success probabilities tend to go up when acquirers engage in multiple transactions and allow sufficient time to pass between deals to derive and implement lessons learned. In contrast, prominent Chinese serial acquirers of Western targets are often characterized by a high frequency of M&A deal making. Outbound M&A transactions follow each other quickly and hardly allow for sufficient time between individual deals to optimize approaches to due diligence, transaction, and post-acquisition integration as part of a continuous improvement process. The more restrictive approach to outbound M&A deal approval on the part of Chinese regulatory authorities results in a de facto deceleration of China’s deal-making speed. This forced breathing spell enables Chinese serial acquirers to learn from their acquisition spree during the recent past and thereby potentially increases success probabilities for already closed and future deals.
One of the drivers of the rapid growth of China’s outbound foreign direct investment has been the “Made in China 2025” strategic initiative via which China plans to achieve parity with the world’s leading industrial economies. In this context, Western governments have been concerned about and have closely tracked Chinese acquisitions in strategically important high-technology sectors. In the United States, the Committee on Foreign Investment in the United States (CFIUS) reviews foreign investments in US companies in order to determine potential national security risks. So far, a formal regulatory institution or investment control mechanism comparable with CFIUS does not exist in the European Union. Instead, in July of this year, the German federal government issued a new regulation that allows Germany’s federal government to block takeovers in case of risks for critical infrastructure. Representatives of the German business community have expressed concerns that this measure might make Germany less attractive as a destination for FDI. But regardless of potential flaws, it enhances procedural clarity for foreign investment approvals and represents a first step in the direction of reciprocity vis-à-vis China, which severely limits foreign investor’s access to its own market.
Focus on core business areas eliminates a major source of failure
Outbound foreign direct investment will continue to play an important strategic role in China’s long-term economic development. It is thus unlikely that outbound M&A activities – particularly in high-technology industries – will grind to a complete halt. Regardless of the Chinese government’s original intent, the recent slowdown of such activities could end up increasing the chances of success of China’s outbound M&A dealmaking. Forcing companies to focus on acquisitions within their core business areas eliminates a major source of M&A failure. A lower deal-making frequency allows Chinese serial investors to apply lessons learned from previous deals. The resulting breathing spell also helps the targets of China’s outbound M&A wave. It would, for example, give the German government more space to engage in dialogue with the business community to enhance foreign takeover protections and to minimize procedural uncertainty.
Ultimately, both Chinese acquirers and the employees and communities of acquired European companies will benefit from higher M&A success probabilities. From an employee’s point of view, a smaller number of deals with a higher success probability surely would be preferable over a larger number of more risky deals.
This article is a slightly modified version of a commentary piece that was first published in German and Chinese language as “Chinas Outbound-M&A-Bremsung könnte sich als Segen erweisen” and “中国放缓海外并购业务的速度很可能是一件好事” in Unternehmer Edition – M&A China/Deutschland, 3/2017