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Opening the Chinese puzzle box

China General Interest

Overseas investors on their second and third experiences of doing transactions in China are discovering new layers in the puzzle box of Chinese negotiations. The Ernst & Young China Business Group, reveals some of the secrets to opening the box.

In 2007, just three out of every ten1 Chinese transactions came to fruition. Some of the reasons for this low closing rate are to do with the unique environment: lack of reliable information, unclear financials and governance, legal and ownership uncertainties, and the need for regulatory approval at various stages of the transaction. Others are in the expectations that acquiring parties bring to the deal. For example, a surprising number of transactions fall at a late stage when the acquirer discovers that, as often the case in China, the target is unwilling to surrender a controlling interest.

China’s unique circumstances make conducting cross-border transactions a challenge even for hardened operators. In fact, negotiating a new transaction in China is like your first attempt at opening a puzzle box.

Initially, the deal may look smooth, deceptively simple. The edges seem finite and self-contained, the rules easy to grasp. But, with only a few moves, the layers fall away to reveal a more complex situation with further rules and considerations. The change in each layer requires more careful planning and strategy. Eventually, this layer unlocks – to great celebration – only to disclose still further levels, sometimes more intricate than the last.

Of course, once you know a particular box’s secrets – what steps to take – the process becomes more efficient. And when you’ve tried opening many boxes, you develop strategies that help you figure out how to navigate through the layers of rules.

One of the most important strategies for ensuring transaction success in China is building integration into the pre-deal process.

Dispelling the myths

Traditionally, integration has been left out of the pre-deal process, partly due to the length of transaction execution times in China and partly because of a couple of myths.

To the first point: Chinese transactions often take well over a year from due diligence to close. So it has been easy for even seasoned investors to get lost in that extended execution cycle, forgetting about the importance of integration until the deal is done. This is a mistake you only make once. Tellingly, now that these seasoned acquirers are back for their second or third opportunity in China, they’re building every aspect of integration into the very early parts of their transaction process.

As far as the myths are concerned:

Myth 1: Integration is purely physical

In many other markets, integration is largely about the physical movement of assets, whereas, most transactions in China leave operations in place. This has led to the mistaken belief that such deals require less integration. In fact, you still need to integrate all your operating standards, systems and processes.

Myth 2: Joint ventures don’t need integration plans

The other myth is that only wholly-owned subsidiaries or wholly-owned investments in China need formal integration plans. Since most Chinese transactions are joint ventures (JVs), integration isn’t considered as important. In fact, your multinational may not control the business, but extracting the value in your new JV business requires the same integration discipline as if you owned 100% of the company.

Developing an integration strategy

Needless to say, an important success factor in transaction execution is having a very well planned integration strategy right at the start of the pre-deal process.

The fact that China doesn’t have an equivalent term for ‘due diligence’ speaks volumes. It is hard to get access to information early in the transaction process and that includes integration information. However, that shouldn’t stop you asking for it. You just need to accept you won’t have all the answers early on, but recognise where you’re lacking information. That way you’ll be prepared to focus on the right areas, and fill the information gaps quickly, once you get into the throes of integration.

When companies move into China as part of a low cost manufacturing strategy, they tend to only focus on the China aspect of the overall transaction.

They fail to plan for the fact that the strategy itself impacts an entire global footprint of a company. In fact, integration planning also needs to include the global picture: How much production will shift to China? What are the implications on other aspects of the supply chain? How will you get product from the Chinese manufacturing locations out to the end markets?

Increasingly, companies are also acquiring Chinese businesses to enter the domestic market. Such a strategy makes sense as it allows the acquirer to gain rapid access to a local product portfolio, distribution channels and end customers. In such instances, integration planning needs to position the acquisition for future growth domestically, keeping in mind fundamental questions like: How to manage the current low/mid-priced product portfolio while introducing higher premium priced products? How to build a national distribution network? How to align trade terms? How to cross-sell and up-sell to end customers?

Cultural integration requires more than just introducing new policies. It takes careful planning to take the steps required to fully move the culture, from that of perhaps a small Chinese company or a larger state owned enterprise, to a multinational’s subsidiary or business unit.

You have to walk the fine line between making sure you are culturally sensitive and understand local perspectives, while still being clear about what’s important from an operational, management or financial practice perspective. Years ago, many companies simply had an expat model where people would arrive from the acquiring company and issue forth policy statements. Now acquirers are engaging with the local people who know how the business actually operates. They are also working with this local talent to make sure the organisation really understands what needs to change and why.

The ‘why?’ is really important. Asking people to change, without explanation, implies they were doing it wrong. If you put the required changes in the context of moving to a global operation, people are less defensive. The conversation is not: “You need to adopt a different culture” but rather “let’s figure out how we can adopt the behaviours required to succeed in the global market”. Then you can all consider how to achieve those behaviours in the context of the cultural environment.

That’s a much more complex equation, but it’s doable, as long as you accept it takes a little longer and needs proper resources. The point is: an expat strategy doesn’t work, but nor does a 100% local strategy. It takes a combination that can only be created by talent from both sides of the transaction.

Demystifying finance integration

When you’ve seen multiple sets of books in the diligence process, integrating finance seems like a whole new puzzle box in its own right. The first step is to decouple the problem – break it into reasonable chunks. Typically, this involves splitting it into tactics and policies.

From a tactical perspective, that means harmonising the general ledger, aligning the closing process, and getting hold of the cash in the business.

From a policies perspective, you may need to train the Chinese company on new accounting standards and put in place clear credit policies. Then you need to address management reporting, budgeting and forecasting – to make sure the business will be able to understand, work towards and achieve its financial target.

As hundreds of millions of Chinese join the ranks of the middle classes, we’re seeing new demand spiking in consumer segments.

Generating value through operational integration

As a basic rule of thumb: if you can’t get the operations to work right, you probably shouldn’t have entered into the transaction in the first place. Operational integration is where most of the value comes from.

This starts with manufacturing. Even if the entity will continue to operate on a stand alone basis, you have to make sure that the right quality standards are in place, consistent with your global enterprise. This is important, regardless of whether manufacturing is initially only for local consumption. Down the track, you may wish to export these products to the rest of the world.

You also need to identify and address supply chain issues as early as possible. Many Chinese businesses have very fragmented procurement processes, with multiple sources of supply going into manufacturing plants. Integration gives you an opportunity to use more leverage to get better quality raw materials at lower prices. At the other end of the supply chain, you’ll probably also find a fragmented distribution network, with numerous channel conflicts. You need to work with local people to identify which relationships are most valuable. With high growth expectations post-deal, such challenges, if not fixed early during the integration process, will become major inhibitors down the road.

A recent addition to the pre-deal integration checklist is customer relationship management. Investors were initially drawn to China as a base for low cost manufacturing, but now they’re recognising the value of the Chinese marketplace itself. As hundreds of millions of Chinese join the ranks of the middle classes, we’re seeing new demand spiking in consumer segments including retail and telecommunications.

However, many Chinese companies currently serving these markets lack good business practices around customer service. Thus, a vital part of integration is on understanding the customer base to make sure the company is targeting the right customers and addressing customer retention issues.

All of the above operational functions require robust systems. However, marrying a Chinese business with an acquirer’s core systems isn’t just a question of compatibility and automation. China has regulations as to what information systems are and are not allowed in China – yet another reason you need to consider integration at the pre-deal phase. You may find your global systems can’t be implemented in China unless you navigate the regulatory environment correctly. Equally, you may need to find a different system that both suits your organisation’s global operations, while falling within the allowable system requirements in China.

Making transaction integration work in China

The keys to opening the Chinese transaction puzzle box are: timeline, information, and the right mix of resources. First, allow for an execution cycle of at least a year. Then, in the pre-deal phase, see if you can drill down to a detailed level of information on the priority areas of finance, operations, information technology and human resources. Finally, make sure you have a mix of resources that brings local knowledge to decisions, while making sure there are people accountable for the integration who understand the global environment it must integrate with.

Integrating and transforming a Chinese company is a slow, multi-year process. Expectations need to be set all around that demystifying this puzzle box, after figuring out how to open it, will take time and patience.

While the process can be time consuming and challenging, the moment you figure out the secrets of your puzzle box, it all becomes worthwhile.

Ernst & Young New Zealand China Business Group

Global Transaction Leader Study 2007, Cross-border Transactions: Emerging Markets, Ernst & Young, December 2007