The volatility in the U.S. financial market that spiked in October last year has spread into Main Street. The stock market has been roiled since then. The impact on almost every U.S. company is evident as they desperately look for capital infusions. But the current market turmoil may offer a great once-in-a-lifetime buying opportunity for many types of buyers, strategic or otherwise.
Among the potential cash-rich foreign buyers are Chinese investors. With an estimated $2 trillion of foreign exchange reserve and an army of state-owned companies with excess cash on hand, China is regarded as one of the obvious investor origins that U.S. companies would like to attract.
Many of China’s large companies are well-capitalized and the books of its banks are mostly free of the subprime loans and doubtful investments afflicting their Western peers. Though it is true that China is not immune to the economic slowdown, it should be no surprise to see a surge in the cross-border M&A activity of Chinese companies.
Thus far in 2009, transactions involving Chinese acquirers account for almost 9% of total global M&A activity in terms of value. About 80% of those Chinese deals were made by state-owned enterprises in the energy, mining & utilities sector.
No doubt China is taking advantage of one of the best times to gain exposure to a portfolio of the key resources (e.g., raw materials) that it has long been eyeing. But there are other strategic reasons for Chinese companies to engage in mergers and acquisitions. These include achieving economies of scale, gaining access to U.S. markets, capturing technology or expertise, obtaining ownership of certain U.S. brands, gaining control over a supply chain, and increasing market share.
The current financial crisis and the distressed market could enhance the chances of success for Chinese companies to pursue acquisitions and investments abroad. But these should not dampen their sense of caution and the importance of screening target companies by performing due diligence work that normally accompanies cross-border M&A activities.
Risks and Concerns
Valuations. Finding and valuing an attractive deal is a challenge for most buyers. Often, bidders may overpay for a deal due to competitive auction pressures, incentive to complete the deal, overvaluing synergies and underestimating competitive responses and other factors. It is important for buyers to appropriately value the business, particularly in this volatile market.
Understanding earnings and EBITDA will directly impact on the buyer's view of the forecast and valuation derived from the financial model on the target. Any downward changes in revenue, upward trend in cost or other contingent liabilities identified can be used as a basis for downward adjustment in the purchase price.
Potential liabilities. Very often, buyers, including foreign buyers, who have various incentives to accomplish a deal appear to hasten the process, which increases the chances of overlooking potential liabilities that could be inherited by virtue of the transaction. These include environmental liability, tax liabilities, legal liability, ownership of intellectual property and litigation costs. The buyers thus end up paying additional costs.
Generally, these risks or liabilities could be identified more easily if the buyers did their homework by performing a thorough financial, tax and legal due diligence while pursuing a deal. Performing a thorough and detailed due diligence is pertinent and essential.
Warranties or indemnities given by a seller may not always be reliable. As such, a purchaser needs to be comfortable that the risks it identifies can be managed or mitigated. For example, a purchaser could use pricing mechanisms or require money in escrow for any future warranty claims, or ensure that identified risks can be controlled or minimized through a change in management post-acquisition.
Regulatory compliance and proper investment structures are common concerns of the Chinese investor when investing overseas. Proper tax considerations should also be taken into account during the structuring stage so as to ensure a tax efficient structure has been adopted.
With the rapid development in China’s economy and regulations, Chinese investors should always pay attention to updated domestic laws and regulations that govern outbound investment and the potential implications. Recently, the Chinese government issued several regulations, among them Order No. 5, to strengthen the administration and support for Chinese investors’ outbound investment.
U.S. Target Considerations
As discussed above, the need, at times, for a swift deal must be balanced against the need for a proper and thorough due diligence process. Often, even the simplest of sale transactions involving a distressed seller does not provide adequate time for a thorough and comprehensive due diligence of the assets.
An imperfect due diligence increases the risk that the purchaser will fail to identify potential deal-breaker issues. We briefly discuss some of the U.S. considerations in conducting commercial, financial and tax due diligence, and the major concerns in post-deal integration.
U.S. commercial due diligence. The difficulty of securing financing, the rising price of debt and the shifting market dynamics caused by the broader economic slowdown have all reduced companies’ margin for error as they seek to identify, acquire and integrate targets effectively. Tighter financing covenants, for example, are prompting buyers to seek greater insights into the sustainability of their targets’ business models. They also seek to factor in risks such as customer turnover, new market entrants or deferral of expenditures when negotiating the appropriate flexibility with their bankers upfront.
As a result, commercial due diligence (which assesses the target’s future revenues and margins in the context of the broader economic environment, the company's customer relationships and its competitive positioning) is becoming a more important and integral part of the deal process for many acquirers of U.S. targets.
If a buyer is considering acquiring a company, it needs to know whether there are issues that may impact the current and future value of the company. These may come in the form of market or competitive uncertainty in areas such as new technologies, customers, trends, legislation, powerful buyers, or a new geographic market.
One key area of increased interest to investors, especially in today's environment, is understanding the possible impact a recession may have on the target. In addition, the inflation/deflation factor could add to the complexity of determining a true value for the business.
Many dealmakers are tackling the subject head-on by incorporating sophisticated recession analyses into their commercial due diligence processes. These scrutinize the historic performance of the target’s industry sector and, where feasible, the company itself in periods of recession or economic slowdown. By conducting this kind of analysis, acquirers are better able to quantify the potential risks and upsides to which a proposed transaction is likely to expose them and their third-party financiers.
Buyers definitely need to test or validate the feasibility of realizing the projections or the reasonableness of the assumptions. Therefore, analyzing the attractiveness of the target’s market and the strength of its competitive positioning, assessing the source and sustainability of revenues and margins, and challenging or validating management forecasts in the context of the business model and commercial environment are particularly important.
U.S. financial due diligence. Once identification of a target has been completed, the process of valuing the target begins. Valuations tend to be a lot trickier in a volatile market environment because there is so much economic uncertainty.
In a typical financial due diligence exercise in the U.S., due diligence teams usually analyze, qualitatively and quantitatively, how an organization has performed financially to get a sense of earnings on a normalized basis. It’s crucial to examine at the anticipated performance of a business as represented by the seller, look at the underlying assumptions they used in preparing their projections, and ensure that the assumptions are reasonable and objective.
Often, anticipating the future by understanding the past is also very important. This is meant to assure that a plausible bridge is built to meet the metrics that the seller claims are achievable on a going-forward basis.
There is a common misconception that the reported retained earnings represent the earnings of the business that the buyer is acquiring. And often, the buyer tends to look only at the figures reported in the audited financial statements that are prepared in compliance with federal or state regulatory requirements – but not specifically for the buyer and the buyer’s earning-based valuation model.
To understand the reality behind the reported numbers and quality of the information reported, an in-depth review of the business and detailed management accounts must be performed. Such review generally consists of the following:
- assessing the quality of portfolio valuation procedures;
- analyzing the target's quality of earnings, normalizing EBITDA for periods driving the deal valuation;
- linking historical results to projections/valuation models;
- understanding historical working capital, cash flow management and future capital requirement; and
- scrutinizing the projections and commenting on potential risks in the seller's ability to achieve them.
In addition, financial due diligence analyzes the quality of assets, debt and debt-like items and liabilities to be acquired. For privately held companies, it’s common to find assets without a business purpose on the books, as the owner or management does not separate business and personal assets. Assets used in a business may also be held by the beneficial owner or by other external entities.
Adjustments with respect to write-offs for aged receivables, obsolete inventory, idle assets and inappropriately capitalized costs may need to be made. Some companies may have significant amounts of off-balance sheet liabilities, which could make the target look better than they are, for example, leases and securitization.
Financial due diligence can also add value to buyers during the process of negotiation. Issues identified during the financial due diligence can assist the buyer in determining the key warranties and indemnity terms in the negotiation process.
U.S. tax due diligence and structuring. The acquisition of stock or assets of a U.S. company will have drastically different tax consequences from the perspective of the buyer and seller. It is important that the Chinese buyer understands this issue before trying to negotiate a purchase price, and even before the negotiation of a letter of intent.
Acquiring the assets of a U.S. company generally should not result in the buyer inheriting historic (i.e., pre-closing) income tax liabilities, although certain non-income tax liabilities may be inherited. The acquisition of the stock of a U.S. company, however, will result in the buyer inheriting historical income and non-income tax liabilities from the seller. Therefore, identifying and quantifying these historic U.S. federal, state and local income and non-income tax liabilities is very important in a stock deal.
The other major difference between a stock and an asset deal is that an asset deal will potentially create additional tax depreciation from the “step up” in the tax basis of the assets acquired, which is not available in a stock deal except under certain limited circumstances.
Tax due diligence and structuring are imperative for Chinese investors setting foot on American soil due to the complex and expansive nature of U.S. tax rules. Issues and opportunities missed during the due diligence and structuring stage may result in significant cash tax cost upon acquisition, during ownership, and upon exit.
It is imperative that management is able to rapidly and effectively implement its business strategy in the period immediately after a major merger or acquisition. Effective integration is critical for business and places great demands on management.
Many Chinese companies are not conscious of the importance of post-deal integration. While some Chinese firms are experienced at managing a portfolio of businesses in diverse markets, others are relatively inexperienced. This is reflected in their strategic thoughts and understanding of customers, competitors and the regulatory environment in the target market.
Chinese buyers also face various obstacles when it comes to post-deal integration. One major challenge is the cultural difference. Chinese companies tend to be highly entrepreneurial and often are run by a small group of owners-managers who regard company loyalty as a given.
This compares with the more professionalized managerial culture of U.S. firms, which require a certain level of commitment from senior management and a high level of determination. As a result, recruiting and retaining foreign managers has become a challenge for Chinese companies.
Another major obstacle is business perception issues that typically arise when Chinese companies sell their products abroad using acquired brands or their own brands. For years, Chinese companies have relied on their low-cost advantage, not on building a brand. Building and maintaining a global brand image will be key to Chinese companies' expansion overseas.
Buying and selling a business is risky, particularly in today's market environment. Given the multitude of the risks and other considerations, Chinese companies seeking to acquire U.S. business (stock or assets) should retain experienced U.S. advisors (financial, tax and legal) at an early stage to coordinate the various teams working on the transaction. U.S. advisors will also be able to assist the Chinese company in conducting due diligence and in structuring of the U.S. business to identify specific issues and concerns and quantify the various risks.
About the Authors
Jules Reich is a partner at PricewaterhouseCoopers in the United States. Danny Po is a partner at PricewaterhouseCoopers Hong Kong.