Forming alliances in China
August 28th, 2008 by AdministratorAlliances in China
The following is a full transcript of today’s podcast:
KENT KEDL: Newsflash. The U.S. economy stinks. Now I know I do not have the academic credentials to make an educated pronouncement about this – then again, a Master’s degree in Chinese philosophy qualifies me for very little – however, I think it is safe to say it is true. The Republicans thinks it is too many taxes, the Democrats think it is too much outsourcing, and Phil Graham thinks its all in our heads. No matter the cause, the fact remains that the U.S. economy is deep in the doldrums and there does not seem to be much hope that it will get out any time soon.
This was really brought home to me when I was back in the U.S. a few weeks ago for an all-too-brief summer holiday. I try to get back to the U.S. several times a year to visit family and clients, and it is always an education. No matter how informed I try to be here about what is going on back home, simply reading news stories does not give one the full picture, particularly the current status of emotions in the U.S. business community.
So it is from these conversations with U.S. clients and friends that I reached this conclusion: the U.S. economy stinks. More to the point, the many people I talked to seemed to question whether or not the U.S. economy was worth investing in as a stand-alone investment. There was not a lot of faith that we would be getting back to the hey-days of the U.S. economy where growth was easy, foreign competition was very low and return on investment nearly guaranteed.
Notice I qualified that last statement by saying that I heard people questioning the U.S. as a stand-alone investment. This is a key point – certainly, U.S. businesses are not giving up on their domestic markets completely; however, they are considering how their domestic and international strategies can work together. And this is where I heard some rumblings of optimism among U.S. businesses, that there were some investment opportunities outside of their domestic markets which, if successful, could help grow their domestic business.
One of the key investments we see companies making overseas is some form of equity alliance with a foreign company – be it joint-venture, acquisition, merger, etc. Here in China, over the past year, we have seen our M&A practice jump to a new level as Western firms interested in the China growth opportunities are looking for good companies to align with.
But when times are tough in domestic markets, this puts even more pressure on a foreign alliance to work the first time – there is no margin for error when sales are down and capital markets are tight. Over the past few years of these podcasts, we have addressed the subject of China alliances from various angles. Today, I’d like to update that perspective and talk a little about what makes China a unique environment for alliances. This is not meant to be an exhaustive list; rather, I want to point out what makes China alliances unique and identify potential potholes in the road ahead.
One of the biggest challenges to doing good alliance deals in China (or anywhere, for that matter) is finding good alliance targets. In other podcasts, I have talked about the all-too-common mistake we see foreign companies make here by being too opportunistic in selecting their alliance partners. A common pitfall is finding a partner at a trade show – what I have called the “industrial single’s bar” – and, after a few drinks and an exchange of product literature, both sides are ready to do a deal. I won’t harp on the fact, again, that it is CRUCIAL for you to “date around”, to assess multiple alliance opportunities and benchmark them against each other and against the strategy you have in mind for China.
But when you find these companies, they will, generally, share some similarities. Assuming they are a private company (and not State-owned, a whole ‘nuther can of worms here!), it is almost guaranteed that they will be a “first generation” owner, meaning that the founder of the company is likely to be the owner or at least one of the owners. In more developed and older economies such as the U.S. and Europe, good targets can be found among second- or third-generation owners. The kids or grandkids of the founder have run the business for awhile, have made some money but have lost the original emotional attachment to the business and, in many cases, are looking for an exit strategy.
Not so in China where modern business is still measured in years, not decades (or even centuries). Private businesses were allowed here starting in the late 80s and did not start becoming popular until the mid 90s, so we are still very much in our first generation of founder/owners. These are people who have put their very lives into their businesses, risking a LOT to do so. Many of them could have settled for a well-connected job in a State-owned company but they didn’t. Many of them gutted it out and became successful as a result.
So, psychologically speaking, these owners are in a unique place when someone approaches them about a possible alliance. In the first place, they are not actively looking to sell their companies nor are they even interested in capital investment. If they are good (and typically we are only targeting the good ones), then they are fully confident in their ability to continue to grow their company and be successful, without having to give anything away or ask for anything.
I have told this story before, so forgive me if you’ve heard it, but its like my oldest daughter (now 15) when she went to her first day of preschool here in Shanghai when she was 4 years old. A very confident and outgoing child, she walked in the front door of the school, put down her book bag and called out, “OK, I’m here … you can all play with me now!!” In the same way – and unfortunately – many foreign companies think that, because they are foreign, everyone here is just DYING to work with them. They can just show up and everyone will come running.
Owners of Chinese private companies want to know what the foreign partner brings to the table. Before starting a program, we work with our clients to define, very specifically, just what they could bring to the Chinese partner. Chinese companies are often looking for access to foreign markets (particularly big-name customers) and access to brand or technology. Many of these companies know that, to be a legitimate global player, they cannot copy technology or rip off trademarks. This – oftentimes more than money – is what the foreign partner can bring to the Chinese side and make a potential alliance very attractive to both.
A desire of many Chinese companies is also to go international and this can be a key motivation for them to do a deal with a foreign company. If the foreign company has access to good channels and customers then, often, they can work with the Chinese company to expand their product portfolio by either providing a broader range of products or more price, quality and brand tiers. However, before you go offering this to a Chinese company, you must think VERY carefully about how that will impact your current business and how to avoid diluting revenues and margins with additional – often lower cost – products.
Another characteristic of first-generation owners is that their objectivity in valuations can be a bit skewed. If you have just invested your heart, soul and savings account into a business and have succeeded, you are not going to be satisfied with more “objective” calculations such as multiples of earnings or discounted cash flows. The cold, objective, CPA-driven valuations that many Western companies take can really be a turn-off to a Chinese company. When we approach the topic of valuations with a Chinese alliance target, we do it very carefully and slowly, helping them see just how the foreign company is looking at the deal as well as the final numbers.
Very often, I will represent the foreigner’s perspective and will say to the Chinese partner “You know, we foreigners have our own way of looking at things and the board of directors for Company X is no different. This is how they will be doing their valuations…” and I launch into a description of the criteria and methods our client will use. But then I continue, “However, we all know that there are many more issues that need to be taken into account when evaluating your company and we want to make sure we are able to capture all of them.” Then we start to have the conversation about the assets – tangible and intangible – that the Chinese partner brings to the deal and start drilling down into the details of just how valuable they really are.
For example, we just went through this with a Chinese company that a client of ours is considering doing an alliance deal with. The Chinese company, though small, has captured some very big customers, in particular the largest Chinese company in this industry, a Big Name. The Chinese target is, rightfully, proud that they are a supplier to this Big Name and they point to this as being a reason that they are such a valuable partner. However, when we started digging down into the actual metrics of this relationship, the picture changed – we discovered that the business the target was doing with the Big Name was barely break even and, in fact, had prevented them from serving other, potentially more profitable, companies in a similar space.
After some time – and it did take some time – the owner of the target company started to see that maybe this Big Name was not such a big deal after all. In fact, this started a very good discussion about how, with our client’s participation, they could both go after even bigger names and could demand the kind of premium that would result in a sustainable, profitable business. And, in addition, we were able to get to a much more reasonable and agreeable approach to valuation.
Finally, these first generation owners – while very “modern” by Chinese standards – are still often very traditional in that relationships are of central importance to them. All of them, without exception, cultivated good relationships to get them where they are today. And I am NOT saying that they succeeded only BECAUSE of key connections which, to foreign ears, implies some form of under-the-table dealings. In some cases, this is true, but that is fairly easy to discover in a rigorous course of commercial due diligence. No, successful Chinese companies got that way because they sought out and nurtured relationships all along their value chain – from suppliers, to customers, to regulators and even competitors. They work very hard on getting and maintaining these relationships.
In the same way, they are going to judge the value of a potential partnership on the basis of the type of relationship that they are going to be able to build with you. You might dazzle them with your company’s success and the animated PowerPoint slide show about how you are going to dominate the market might be kind of cool, but they will follow through with an alliance ONLY if they trust you. There is no set path to developing these relationships – suffice it to say that everything you do, every word you say has an impact. If you are truthful and fair in the due diligence and the negotiation process, then chances are you will be able to continue that going forward. If you are cheap and are trying to “win”, then you can just give up now – because even if you “win” the deal, you are going to loose the business eventually.
A very practical way to show the importance of this relationship is to clearly identify the role of the owner going forward. The fear of every business person is to go from owner to employee. And, even though the org chart might say “employee”, no former-owner should be made to feel that way. In China, it is appropriate to just “hang-out” … spending an afternoon having a conversation. I would recommend that the role of the owner be a topic for several of these sessions. You are not going to solve it in one sitting, but if you keep returning to it and talk about it over time, you will show that you are serious about it and you will get to a conclusion that feels right to everyone.
A Chinese friend of mine asked me yesterday what I thought of the U.S. economy and what the chances were of recovery. “I don’t know,” I told him, “I don’t think anyone knows. We are such a new territory here – while the U.S. has certainly seen some down economic times in its history, never before has much of the rest of the world been as strong. This is certainly a threat in that, if they U.S. cannot bounce back or find their feet, then other global economies will come in and fill the vacuum (and one might argue that this has already happened in the manufacturing sector, particularly for commodity goods). However – and I hate to sound like a bad fortune cookie here – with every threat comes and opportunity, and a well-planned alliance in China could be just that opportunity.
Thanks for listening to the China Business Podcast. Remember, in China, everything is possible but nothing is easy. We’ll see you next time.
