Spotlight on China

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With China’s escalating consumer demand, phenomenal economic growth and increasing foreign direct investment (FDI) opportunities, the China deal market has taken off. Interest from the international community has never been greater.

A world of opportunity

A message from Bob Partridge

Today’s transactions market presents a world of opportunity. As corporations and other investors turn their attention to international opportunities, they are looking beyond “With China’s escalating traditional markets to achieve growth and competitive advantage. Ernst & Young’s Cross-border transactions series aims to shed light on the complex and rewarding consumer demand, transaction landscapes in selected emerging markets transaction landscapes in selected emerging markets.

Spotlight on China provides an overview of the transaction considerations and challenges surrounding deal-making in this attractive Asian powerhouse, including several industry-specific insights.

With China’s escalating consumer demand, phenomenal economic growth and increasing foreign direct investment (FDI) opportunities, the China deal market has taken off. Interest from the international community has never been greater: in 2007,despite slowing markets in many countries, China announced deals totalling US$122.5 billion, an increase of 65.3% on the previous year, and leading the other emerging markets of India and Brazil.

With Ernst & Young Transaction Advisory Services in more than 80 countries, we are well positioned to understand the range of issues involved in investing in emerging markets, from target identification to due diligence and post-deal integration.

In China, our transactions team consists of professionals with extensive experience in navigating the country’s complex transaction environment. Our strength on the ground, knowledge of the industries and markets, and regulatory and technical knowledge help our clients make the most of their opportunities in China.

The China question

What to do about China? Whether as a market, a low-cost manufacturing base or as competition for current market leaders, the “China question” will at some stage confront every company of any size on the world stage. Given the current publicity surrounding the country, the chances are it already has.

A booming economy

China’s economic statistics make compelling reading:

  • Growth. An annual growth rate averaging more than nine percent over more than two decades has not only propelled China ahead of the UK into fourth place in the world economic league table, but it is also leaving Taiwan, Japan, Australia and much of the Asia Pacific region in its wake. Chinese exports in 2007 grew by 25.7% to US$1.218 trillion, while imports swelled by 20.8% to US$956 billion. According to a US Congressional Research Service Report, China’s exports exceeded US export for the first time in 2007.
  • Scale. China has a population of 1.3 billion, whose per capita income has grown tenfold since 1990, and its people are hungry for consumer goods of all descriptions. An estimate by the Chinese Academy of Social Sciences shows the country quadrupling 2000’s output levels earlier than expected. China’s rapid growth should boost the average annual personal income to an equivalent of US$3,000 by 2010. China constitutes the largest mobile phone market in the world, and by 2020, an estimated 140 million automobiles will be on Chinese roads. In 2002, China overtook Japan as the world’s second largest PC market and is now closing in on the largest, the US. China reportedly has 220 million internet users, overtaking the US by 6 million in 2008. The property market, booming in the fast-growing coastal cities, went into overdrive as Beijing prepared to host the 2008 Olympics. A total of US$160 billion worth of construction added the equivalent of three Manhattans to the Chinese capital, where work was undertaken on transportation and infrastructure projects, sports venues and an airport terminal. The scale of this unprecedented development means that China accounts for around 30% of global demand for many hard commodities, including oil, coal and steel.
  • Resources. Chinese wages are relatively low — as is average productivity, compared with the US and western European countries. On the other hand, for those willing to seek it out, the country also possesses an increasing pool of engineering talent from Chinese universities; an improving management group as “returnees” repatriate with their experience from Hong Kong, Taiwan, the US and elsewhere; and a legendary risk-taking and work ethic that encourages entrepreneurship but also permits failure.
  • Capital markets. The last few years have marked the emergence of China as a serious player in global capital markets. In 2005, China accounted for three of the world’s top 10 IPOs — the US$9.2 billion float of China accounted for three of the one of the largest IPO deals at the time. In 2006, the Industrial and Commercial Bank of China raised US$22 billion to become the world’s biggest ever IPO. Chinese companies raised US$107 billion domestically in 2007. As investors grew more cautious in early 2008, many analysts believed the buoyant Chinese markets had peaked in 2007. Nonetheless, in the first quarter of 2008, China was still a global front-runner with 30 deals, the highest number of IPOs globally, worth US$8.6 billion. The Chinese government is intent on reforming the industrial base; there are anumber of mega-deals in the offing as well as plans to sell off 1,300 secondranking, state-owned enterprises (SOEs), in whole or in part, in the coming years.
  • Foreign investment. China is attracting record quantities of FDI — US$74.8 billion in 2007, according to the Foreign Investment Department of the Ministry of Commerce. In 2007, China was one of the world’s preferred FDI destinations: reportedly more than 450 of the world’s top 500 companies have a presence in China, and many of these enterprises are profitable. According to the US Department of Commerce, US firms enjoyed net returns of US$3 billion in China in 2004. In the same year, the global average return on investment for US companies was 10.1%, but the return on investment in China was 19.2% — nearly double the US average. Profitable investors in China include Procter & Gamble, Coca-Cola, AIG, Alcatel, Carrefour, Kodak, Motorola, Nestlé, Novell, Siemens and Volkswagen, among many others. Given the macroeconomic landscape, it is not surprising that many foreign companies see China not as an option but as a competitive necessity. As the figures indicate, corporations are jostling to do deals in China, and many are succeeding. Yet they are finding that the optimist needs to be accompanied by an appreciation of other factors.
  • An emerging economy. For all its size, China is an emerging economy. Despite the evident frenzy of activity, it is often difficult to get an accurate handle on what is really going on, whether at an industry level, or even within a firm. The legal frameworks for M&A and property rights in general are developing, and cultural differences have a potential to lead to misunderstandings and a mismatch of expectations.
  • Growth deceleration. As the US-led global slowdown in 2008 becomes the baseline projection, China’s rapid growth, which has been traditionally supported by exports and investment, will face significant challenges in the face of weaker global demand, the US-induced global credit crunch and the Chinese central bank’s tighter monetary policy stance.
  • Extreme contrasts. Although the scale of the Chinese market is indeed huge, the contrasts are also extreme. According to the World Bank, the Chinese national average annual income reached US$2,025 in 2006; however, it is a fraction of that in the smaller cities — and some of the rural areas of the interior have hardly been touched by modernization. These areas account for nearly half of the Chinese economy. While there is a growing Chinese middle class, reaching mass consumer markets will likely require very different product- to-market approaches from those that corporations are used to at home.
  • Hyper-competition. It is a serious mistake to think of China as a virgin market offering windfall returns. On the contrary, unlike Russia, where the bias towards heavy industry in the Soviet era left both consumer and small-firm sectors underdeveloped, China is characterized by intense competition and entrepreneurial activity in almost every field. This is both natural inclination and a deliberate policy: while SOEs remain large in number, government ownership is declining rapidly as privatization is employed as a means of driving out inefficiencies. Apart from sensitive or strategic sectors such as energy, telecommunications and defense, most of China’s industrial output is now generated by energetic private sector companies, both domestic and foreignowned. Wafer-thin margins are typical in most industries, and entrepreneurial domestic companies are used to subsisting on them.
  • Overheating. With the Beijing Olympics, investors around the world (real estate funds, developers and multinationals) showed interest in Chinese real estate, which has seen a sharp rise in prices in recent years. Recently, various government measures were put in place to cool the real estate market: the enforcement of Land Appreciation Tax in 2007, and an idle land fee in January 2008. Also, in November 2007, real estate was included in the Catalog for Guidance of Foreign Investment Industries as one of the restricted foreign investment industries.

More complicated than it looks

Turning to the supply side, all this means that the answer to a corporation’s “China question” is not as evident as it might seem at first. The issue is twofold: the first relating to strategy, the other to deal execution. As to strategy, in the almost irresistible current buzz about investing in China, some investors are in danger of forgetting to establish clear strategic guidelines for the venture. Such a failure may create problems not only in a company’s initial approach to the market but also in the way it conducts the deal itself.

The first and most important question a company must answer about entry into China is “Why?” “Because it is there” or, just as common, “Because everyone else is there" is not sufficient.

Ten years ago, the China strategy was about sourcing: establishing a low-cost manufacturing base to serve the rest of the world. Today, the options have multiplied to include participating in China’s market growth from the inside, or exporting to it. Each of these involves a different path.

If the first, it is important to bear in mind Chinese determination to move up the value chain by moving from being “the world’s manufacturing center,” based on labor cost and effisiency advantages, to being a  “world-class innovation center.”

If the second, companies must be aware that in many industries — automotive, pharmaceuticals, food and beverage and consumer electronics, for example — earlymover advantages have come and gone, and industry positions are already well established. Volkswagen has been in China for over 20 years, Motorola for over 15 years. Correspondingly, much larger investments will be needed now to disturb existing industry patterns. Whatever the rationale for entry, incoming corporations will struggle unless they can demonstrate that they are bringing something distinctive to the market that isn’t already being contributed.

The second question concerns strategy: to source a product, or to go beyond sourcing and to acquire an equity interest? If the answer is the latter, it is critical to be aware from the outset that while doing deals in China can be good business, it is also different from anywhere else on earth. It is not only that deals cannot be done overnight, returns may take years to emerge. The bottom line is that, for a variety of reasons, the large majority of deals never get beyond the early stages.

Some of the reasons for the high failure rate of deals in China have to do with the unique environment: more difficulty in accessing information, governance issues, legal and ownership uncertainties, and the need for regulatory approval at all stages of the transaction. Others are the expectations that acquiring parties bring to the deal — for example, a surprising number of transactions fall through at a late stage when the acquirer discovers that, as often is 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. However, although it is easy to trip up, the record of successful corporations shows that the prizes for those that stay the course are considerable. Experience also shows that, with the aid of trusted advisors, determined and resourceful corporations can alter the odds in their favor:

a) by clearly understanding the context

b) by taking some simple but essential precautions, which both increases the chances of success and minimizes transaction risk

The rest of this report outlines how this could be done, and the prospects for transactions in some of the most important business sectors.

Toward transaction success

Marco Polo reportedly took 20 years to do his first deal in China. Modern transactions are less time-consuming than that, but they are still a test of patience, nerve and the ability to maintain a balance between flexibility and knowing when to stand on principle.

While the components of the transaction lifecycle (target identification, due diligence, valuation and post-merger integration) are, in principle, the same as anywhere else in the world, in practice, in China they are very different. This is the result of both cultural factors and the important role of the state in the economy, which directly affects potential investors in a number of ways:

  • The government exerts control over most of the country's financial resouces, generally favoring physical infrastructure and large industrial projects. The “softer” infrastructure — the institutional framework of law and intellectual property (IP) rights and the banking system — also has seen development, but generally to a lesser extent than physical infrastructure.
  • The economy is significantly regulated. The goverment can influence economic activity through tax laws and regulations, capital market and foreign exchange controls, and investment approvals. In the last several years, foreign private equity investors have exited their investments in China by listing an offshore special-purpose vehicle on a foreign stock exchange or by selling the shares to another fund or strategic investor. The new M&A rules, which came into effect in September 2006, prohibit an investment strategy commonly known as “round-tripping.” This regulatory change has affected many investors’ China investment strategies. Although investment restrictions have gradually been relaxed since the country’s admission to the World Trade Organization (WTO) in 2001, requirements and conditions are relatively complex, often varying from industry to industry, and across the central agencies that deal with them. Percentages of a company that foreign investors are permitted to buy vary by sector; in sensitive sectors only a minority foreign interest is allowed — or even none at all. These percentages too are subject to change, although typically in the direction of liberalization.
  • China’s tax system is also relatively complex: there are national, provincial, city and district tax authorities, each with its own regulations; Special Economic Zones are different again; and a wide variety of tax holidays may be available. How the various regimes affect a company depends on its industry, location and corporate structure. Taxes are a big issue in any China transaction.
  • Notwithstanding the progressive opening of the economy to market mechanisms after 1979, there were an estimated 119,000 SOEs at the end of 2006 (according to the State-owned Assets and Supervision and Administration Commission of the State Council). Many of these SOEs are small or medium-sized and are used to operating in a business environment essentially different from the free markets of more developed countries.

There are two important practical consequences for would-be investors. First, it is essential to engage a team of professional advisors at the start of any transaction process. The need to understand the context and keep up with rapidly evolving regulations means that the team should include mainland Chinese talent as well as industry professionals. Local experience is essential in conducting negotiations and building trust. Second, there is an ongoing need to establish professional contact with various levels in the local and/or central governments.

This needs time and persistance: laws and regulations passed by Beijing may be interpreted differently at municipal or provincial levels; sometimes the laws are a challenge to fully understand; and different levels or agencies may seem to have differing aims. Conversely, however, good professional contacts with government are helpful to doing business in China, and prudent investors will make establishing them an early priority. Many large corporations have set up specialist departments to handle them.

The other essential prerequisite for deal-making in China is to understand that most deals are asset sales and take the form of joint ventures or the purchase of a stake in a Chinese company. While Wholly Foreign-Owned Enterprises (WFOEs) are increasing as sectors are opened up to foreign investment, they are still not the norm. Even in industries where WFOEs are permitted, however, they may not be easily obtainable, since Chinese owners are often unwilling to give up the majority interest — or if they are, it may sometimes be because the deal is overvalued.

Many deals are not concluded because, even after a year or more of careful bridgebuilding, targets may refuse to sell more than a 49% interest and, therefore, it is important that parameters such as these are understood from the outset.

Target identification

Finding and closing on good deals is difficult in China. The challenge begins with target identification. On the one hand, the vastness of the country, communication issues and more difficulty in obtaining systematic industry information are all factors to be reckoned with.

Investors are increasingly looking outside Shanghai and Beijing for potential targets. On the other hand, Chinese companies tend not to come from a background of transparent disclosure. They have a lower level of understanding (and in some cases, suspicion) of what a foreign investor is looking for, and limited experience of professional advisors. In any case, the number of the professional advisors, although increasing rapidly, lags some distance behind demand, adding to the pressure on scarce resources.

In these circumstances, conventional methods such as desk research, testing the maket from abroad on a frequent-flyer basis or even using teams of advisors to draw up a list of candidates on the basis of strategic industry analysis, are of limited use.

Sourcing deals in China is as much art as science, and prudent companies approach it as a learning experience for both sides. On the one hand, it is a process for making local targets aware of foreign investors expectations; on the other, it is a cross between prospecting the market and clarifying what corporate decision-makers are prepared to accommodate in terms of control (or lack of it), regulations, and official procedures in return for the perceived advantages of growth and competitive positioning.

Sourcing transactions in China is best treated as a two-part process. The initial, prospecting part is primarily a matter of networking — that is, building industry and official relationships, informal networks and establishing contacts. Again, in this process, a mainland Chinese presence on the team is highly recommended. Building trust and mutual comprehension is a necessary part of the delicate initial process, and can mean the difference between making an exploratory contact and moving on to more substantive discussions.

Having established promising contacts — which may take several months — the second phase of target identification in the filtering of candidates that fit well enough, both strategically and culturally, to be worth seriously pursuing, from those that are not. Given the local sensibilities and questions about the reliability of initial information, this is a sensitive process in which many companies stumble, often because they fail to get professional help to weed out the deals destined to be among the majority that never close. Investors may believe that it requires more time to court a target with a view to building trust before getting down to business. Moving directly to due diligence is sensitive (the nearest equivalent to “due diligence” in Mandarin is a word meaning “investigation” that has a negative connotation); the target may wish to back off and play for time.

However, this may prove to be a mistake. Targets may try to exploit hesitation to stall or attempt to lock investors into untested valuations or conditions. Having spent a year or more reaching this stage, the investor may have become so heavily involved emotionally in the transaction that it becomes nearly impossible to draw a line, and cut losses and run. Instead, target selection (as opposed to prospecting) should be thought of as execution, the same disciplined approach used elsewhere Of course, the approach will need to be modified to fit with cultural expectations, and target companies will usually need assistance in understanding investor needs. But experience shows that companies that are serious about doing a deal will seldom turn down a polite but business-like request to bring in external advisors for “initial data gathering” to ‘facilitate’ a potential transaction. Those that resist are likely to be part of the majority that fail to materialize, at least without significant overvaluation.

A final point in target identification is the need to have an appropriate deal structure in mind at an early stage. This is partly to do with the regulatory environment, which can make late-stage alterations difficult. It is also important in relation to the exit mechanism, which needs to be considered from the outset, in both its worst-case and best-case form.

Due diligence

Due diligence is a critical step in any transaction, but particularly so in China: the backdrop is a country that is undergoing a dual transition from a centrally planned to a market economy, and from an emerging to an industrialized economy, in which the business environment is in constant flux.

Due diligence is the point where this evolving business culture meets the very different norms of more developed markets and, as such, it plays an important role as a process hurdle as well as means of reducing risk for the investor. Many potential deals fail at this stage. These are some common issues for potential acquirers:

  • Accounting differences. Although new accounting standards effective from 2007 show significat conversion to the International Financial Reporting Standards, there are still differences in converting financial statements to the more restrictive US GAAP, often resulting in lower reported revenues, unexpected charges related to business combinations and reduces net profit due to stockoption accounting.
  • Transparency and management processes. Accounting and management practices and procedures are not always clear in Chinese companies, with information perhaps kept in heads rather than in books. A tradition of disclosure is not strong, with disclosure sometimes being kept to a minimum. Proper documentation and internal controls may be short, with implications for governance as well as everyday management. In fact, all management figures should be treated as a atarting point for review rather than as undisputed facts.
  • Governance. Corporate governance in China tends not to be strong or may be nonexistent in small firms. Financial and  accounting functions are not held in high esteem, and few of the protections for shareholders or aids to reputationbuilding deemed essential in foreign markets are in place. Since SarbanesOxley, governance matters are a critical due diligence area for corporate buyers. In some cases, they may be a dealbreaker; at the very least investors must recognize the need to start building the foundations for sound governance practices from the earliest stage to ensure their ability to exit.
  • Tax. Understanding a target’s tax situation is a critical part of due diligence. Chinese companies can take an aggressive stance on tax reduction. Tax due diligence can reveral significat hidden tax liabilities that affect the bottom line. Hidden problems need to be carefully probed: as there is no statute of limitations in China, a disgruntled employee can report tax violations to the authorities at any time, potentially exposing the company to prosecution. On the other hand, a variety of historical or potential tax holidays may render income tax liabilities negligible. In the new Corporate Income Tax (CIT) Law effective 1 January 2008, the range of tax holidays has been reduced, and preferential tax treatments enjoyed by existing foreign-invested enterprises (FIEs) are being "grandfathered" for a five-year period. The standart CIT rate is now 25% for both domestic enterprises and FIEs, helping to create a level playing field for these companies.
  • Ownership and land-use rights. A common issue encountered by potential acquirers of SOEs, and most other Chinese companies, is that land is owned by the state. Issues of transferability of land-use rights often arise during due-diligence, and sometimes they have significant financial implications as the state may require payments for land-use rights before allowing a transaction to close. Such land-use rights issues must be approached primarily as commercial issues, not merely as legal issues.
  • Social communities. Most SOEs in China operate as “social communities,” that is, they have responsibilities for maintaining employee housing, hospitals, schools, restaurants and even roads. As these are carved out from a target entity, foreign investors may be expected to continue to provide these social services post-closing.

This might seem a challenging list, and to the extent that the factors will affect each target and investor in different ways, every aspect will need to be analyzed in detail. On the other hand, the major areas where problems may hide are by now well known. The due-diligence process will undoubtedly take longer in China than it would elsewhere, but the careful selection of targets and careful observation of the ground rules helps ensure that a deal proceeds to a satisfactory conclusion.

The early involvement of professional advisors has already been noted as a success factor. However, there are others.

1. Manage internal expectations. Going into due diligence with the right expectations is critical for US and European investors. As we have seen, the quality of information and the business process is lower than investors are used to, resulting in the need to carefully explore risk areas. It is important to prevent deal closure from becoming an end in itself, irrespective of business rationale. Corporate development officers advise strong emphasis on managing internal company expectations and avoiding over-commitment to the potential of a Chinese investment before the implications of due diligence findings have been digested and incorporated into realistic valuation estimates.

2. Listen for the word ‘no’. One of the most fertile areas for misunderstanding is around the words “yes” and “no.” Asian cultures areless direct than Western, and just because Western negotiators rarely hear their Chinese counterparts saying “no” does not mean they are entitled to have understood “yes.” Avoid being drawn into a false, and prolonged, process of assuming cooperation without defined actions and deadlines. When discussing potentially contentious issues, it is best to put understandings in writing (English and Chinese) and agree on dates to discuss issues, where appropriate.

3. Be prepared to go the distance — but no further. In any overseas deal market, transaction success requires patience and tenacity. This is true in China, where the timeline from the Letter Of Intent to closing can stretch from 6 to 18 months or more. Not all deals will close, or are worth closing: knowing when to persist and when to walk away can be the difference between failure and success.


Valuation is not straightforward in China. The lower transparency of financial  information and hidden contingent liabilities (which only surface in a detailed due diligence) can negatively impact the initial finansil picture, so it is important not to get locked into a valuation estimate too early on. Does the company possess the licenses it says it does? Does it actually own the rights and property it is purporting to sell? Particularly on the part of SOEs, there is considerable resistance to revising a valuation downwards, even when the legal position turns out to be different from what was originally represented.

In addition, targets may hesitate to commit themselves to any valuation for fear of having to account for it later. Again, this is particularly the case for managers of SOEs who, to avoid any possibility of later charges of selling state-owned assets at below market value, may prefer a competitive auction for disposal. Investors should expect to spend significant time and effort explaining the transaction and ensuring that target managers understand what it entails. This is essential not only for valuation purposes but also to get the post-closing phase started in the right direction.

Under the prevailing regulations in China, an independent valuation (typically an asset appraisal) will be performed by a People’s Republic of China (PRC)-licensed valuation firm for all foreign acquisition transactions of domestic companies and/or assets, even for those deals not involving state-owned assets or equity interests. The transaction price should, in general, not be ostensibly below the appraisal result; otherwise, the transaction will have difficulty in being approved by the relevant government authorities. Investors should, therefore, engage reputable valuers to perform the appraisal, be actively involved in the valuation process at an early stage, and be well informed of the progress of the valuation — to avoid any surprises at the end.

In an active deal market, investors should be aware of the recurrent danger of entering into a transaction on the basis of limited information by the threat of information being passed to someone else. At a time when everyone wants to do deals, and buyers outnumber sellers, this may be hard to resist — particularly when valuations can be partly guesswork.

Despite the institutional downsides, prices in China are rising as entrepreneurs play investors off against each other and buyers begin to explore areas outside the main cities. As ever, accurate valuation depends on timing, as much as on the quantity and quality of assets, and may onlybe confirmed by hindsight. The high price of an apparent bargain may only appear several years down the line; the reverse can also be the case.

Post-merger integration

Closing a deal in China is a cause for celebration. But it is a common mistake to assume it is the end of the challenge. In reality, it is day one of a new and equally critical phase: ensuring that the previous hard work of completing the transaction pays off by putting in place processes, structures and people who can both manage and develop the enterprise on the ground.

The structure will already have been agreed, but it is important to implement it correctly — and to insist from the outset that agreed standards are adhered to in the running of the business. The traditional approach of Chinese owners, for example towards risk, may not be acceptable in some aspects of the new venture. Raising the bar will be considerably easier if the investor has control and if it can steer the business, in its own way, towards international standards. Even so, it will still have to deal with local middle management and staff and, as with any acquisition managers, will need to spend time communicating the expectations, values and management principles that will apply going forward.

On the other hand, investors will frequently be working with Chinese business partners in joint ventures where they do not have full control. This puts understanding the needs and viewpoints of the Chinese business partner at a premium, and aligning the goals of both sides is essential. Again, failure to build trust, or to clarify issues around exit or continued business expansion, and what is negotiable and what is not, is likely to come back to haunt investors further down the line — sometimes even several years later.

Even assuming complete control, building a balanced management team in China presents challenges. While domestic managers are entrepreneurially oriented, they typically lack global experience. Now, however, a steady stream of management returnees is beginning to supplement local talent with their valuable international experience — but they may have forfeited the local networks and understanding of local markets that are another crucial ingredient in getting an operation up and running.

This means that management teams in China will require significantly more oversight and hands-on mentoring than in the case of an acquisition in the US or Europe. Particularly important is clear guidance in implementing corporate governance, financial reporting and other documentation and management processes.

In particular, as in any emerging market, investors need to factor in the cost of building robust financial functions from day one. As a deal closes, acquirers should ensure that they have the appropriate financial control function in place. Failure to do so can increase risk. Even large quoted Chinese companies concede that they are not yet at the finising line in respect of fully complying with international standards for internal controls and governance. Hard work on improving these processes at every level of the company is the first priority in any Chinese transaction.

Investors will need to put in place a robust business planning process — often lacking in Chinese companies — with clear goals, milestones and resources to realize the premium paid for their investments: business as usual should not continue unaltered.

Industry sectors


With a recent growth rate of more than 20% a year 1 , the Chinese vehicle market is the third largest and fastest growing in the world, making it a magnet for cross-border investment. From a base of extremely low ownership levels (just 1.6% of the population owned a vehicle in 2007 compared with 45% in the US, according to Global Insight Automotive), latest estimates are that by 2020 there will be 140 million cars on Chinese roads, while annual sales could rise from 8.8 million in 2007 to 20.7 million units. China is expected to account for 30% of global market growth between now and 2010.

The Chinese auto industry is already the world’s third largest after the US and Japan. It comprises more than 100 producers, three of which (FAW, SAIC and Dongfeng) are already among the world’s 22 largest.

Until now, the auto industry has been tightly regulated, which has resulted in differing effects. On the one hand, since WTO accession, prices have fallen and consumer demand has grown enormously, creating opportunities in ancillary markets such as repairs, replacement parts, petrol retailing,insurance and even valet services. On the other hand, government policies have impacted foreign investors by confining foreign investment to joint ventures, compelling investors to purchase components from local suppliers and by using tariff barriers to shield the market from import competition. Productivity in foreign-related joint ventures is low compared with plants in Japan or the US, despite low labor costs.

Under the current industry plan, revised in 2004, the government is turning the automobile industry into a “pillar industry” of the economy by 2010. Goals include consolidation to create five large and competitive automotive groups, coordination of the industry and its infrastructure to boost competitiveness, and the creation of powerful brands.

Some of the restrictions on foreign capital are being relaxed — joint ventures can be more than 50% foreign-owned if producing for export — and tariffs are continuing to come down as the government aims at self-sufficiency in production by 2010. Investors will be expected to bring in international-standard know-how and technology, and to develop proprietary intellectual property.

China exported a total of 612,380 units of vehicles in 2007, up 78.8% from the previous year’s total of 342,400. Total vehicle export value reached US$7.3 billion in 2007.

For Chinese domestic vehicle exports, Russia, the Middle East, Central Asia and North Africa are the major target markets.

Financial services

Since December 2006, the last year of the transition period for China’s entry into the WHO, China's finansial services industry has opened up completely to foreign investors. The common theme observed is the speed up of the reform mainly to cope with the competition from foreign finansial organizations.

Prior to 2006, foreign investors had done deals worth US$18 billion with some of China’s largest state-owned banks. After the reforms carried out by the Chinese government over the past five years, which have led to economic liberalization and more foreign investors completing their investments, we now see a growing number of Chinese finansial institutions investing overseas. In 2007 and early 2008, banks in China were not only investees, but also investors. The major deals have been significant investment:

  • The Industrial and Commercial Bank of China acquired 20% of South Africa’s Standard Bank for US$5.46 billion
  • China Investment Corporation purchased a 9.9% stake in Morgan Stanley for US$5 billion
  • China Development Bank invested US$3 billion to acquire a 3.1% stake in British bank Barclays
  • Ping An Insurance spent US$2.6 billion on a 4.2% share of Fortis Group to become its largest shareholder

These are some of the investments made by the ,ajor financial institutions after the IPO heat of 2005 and 2006. Moreover, the investments in foreign banks have fast-tracked the inflows of foreign capital and technological know-how for Chinese companies. The time and effort spent by a Chinese bank to acquire a stake in a foreign company is significantly shorter and easier than the experience other foreign investors have had in targeting Chinese companies. As of the end of 2006, there were four state-owned commercial banks, 14 joint-stock banks and 113 city commercial banks.

The Chinese insurance sector is characterized by low penetration but strong premium growth. Among the emerging markets, it is the second largest after South Korea. Total insurance premiums were forecast to rise 24% to US$96.6 billion in 2007. At the end of 2007, there were 107 insurance companies in China, 45 of which were foreign-funded . With the elimination of the “iron rice bowl” social security net and the increasing geographical and product expansion, both life and nonlife sectors are anticipating continued strong growth in the years ahead.

For foreign players, the increased quota cap for the Qualified Foreifn Institutional Investor’s (QFII) investment from US$10 billion to US$30 billion creates opportunities for new entrants by providing them increased access to the domestic A-share market. The Qualified Domestic Institutional Investor (QDII) programs, which allow domestic institutional investors to access a variety of financial instruments and capital markets outside of mainland China, present foreign investors with a chance to tap into the renminbi market through the establishment of joint ventures.


China has for some time been a focus for the global pharmaceuticals industry. With the rapid growth of the economy, the Chinese pharmaceutical market grew at rates of up to 28% before 2005. According to Datamonitor and IMS Health, this is slowing down, with a growth rate of about 15% observed in 2006. Although this represents a slowdown compared to previous years, it is considerably higher growth than in the developed markets.

Although per capita healthcare spending continues to be far below international levels, increasing demand is generally driven by population growth coupled with a rising middle class that is rapidly becoming both more health conscious and affluent. This market is expected to spend a higher proportion of its income on healthcare as it grows.

However, there is a vast gulf between the situation in the wealthier cities and the rural interior where healthcare provision is minimal and costs are almost entirely borne by individuals. To keep healthcare affordable for less well-off citizens, the government maintains pressure on pharmaceutical firms to restrain prices. Over the last decade, prices of reimbursable drugs have had over 20 price cuts. The latest cut, in May 2007, lowered the prices of 182 Western drugs. The price cuts, averaging 19%, are expected to save consumers around RMB5 billion (US$649 million) a year.

On the production side, the industry is both highly fragmented and fiercely competitive: according to the Economist Intelligence Unit, 70% of the market is distributed across more than 5,000 domestic manufacturers. The top 10 control only around 15% of the local market 6 , compared with up to 50% in developed markets. Unsurprisingly, the focus is on low-cost manufacturing, and R&D and quality levels are low. Counterfeiting is an endemic problem which China has already taken steps to combat. The State Food and Drug Administration (SFDA) reported that, as of October 2007, it had closed down 900 companies that were manufacturing counterfeit drugs.

Foreign pharmaceutical firms are not new to China, some having maintained a presence for over 20 years. Of the world’s top 25, 20 are already in China; in total an estimated 1,700 Sino-foreign pharmaceutical joint ventures worth US$2 billion are estimated to be in operation. Despite the already substantial foreign presence, observers believe that today’s circumstances and policies are creating new opportunities and incentives for market participation:

  • WTO accession has reduced entry barriers and freed up areas such as pharmaceutical distribution to foreign firms. While intellectual property rights and patent protection undoubtedly remain issues for multinationals, the authorities are responding to pressure from global watchdogs as well as the domestic industry to enforce patent rights and crack down on counterfeiters.
  • The government is using both regulatory pressures and the threat of consolidation to raise industry quality and efficiency levels. It is counting on foreign know-how and scale to boost R&D and to help move the industry up the value chain. Multinationals are better placed to weather these and margin pressures, and are expected to take market share in the future.

Retail and consumer goods

Fuelled by a vast population, increasing spending power and a rapidly expanding middle class, China’s booming consumer market is increasingly attracting attention from foreign retailers eager to share in the country’s robust growth. Although the consumer goods sector is already competitive in many areas (including consumer electronics, processed foods and others), the fast-developing retail industry is being given a significant boost as China moves to implement WTO commitments, for example, freeing investors from previous zoning and other restrictions. Since the end of 2004, limitations on the number of outlets, ownership and geographical location of stores have been removed.

As well as by the freer operating environment, further retail development (particularly for hypermarkets, specialty stores and discounters, among others) is favored by the following:

  • US$2.7 trillion a year in retail spending predicted within the next 20 years; almost as much as all Japanese households spend currently.
  • An emerging middle class with a consequent move towards added value (higher product/service quality), more attractive shopping environments, and an increasing brand awareness.
  • Continued rapid movement from the cities to the countryside. 45% of Chinese now live in the cities, compared with 27% in 1990. Urban disposable incomes grew 12.2% in 2007 to US$1,889 . Sales tend to be concentrated in the coastal cities — in the top three (Beijing, Shanghai and Guangzhou), total retail sales reached US$275.9 billion in 2007, making up one-fifth of the national aggregate of US$1.2 trillion 8 . From 2010 to 2025, as the urban population swells to approximately 63% of the total population, the middle class will emerge as its largest segment, with per capita income rising from US$3,425 to US$13,699.
  • Low levels of consumer lending, which only began in 1997. By 2013, China’s consumer credit market (encompassing credit cards, mortgages and other personal loans) will account for 14% of profits in the banking sector. Credit cards, today barely a break-even business in China, will be second only to mortgages as the most important consumer credit product.

Foreign retailers are well represented in China: four of the world’s top 10 chains, 35 of the top 50, and 78 of the top 250 have all opened stores. Carrefour, Wal-Mart, Hoyondo and EK-Chor Lotus figure among China’s largest chains, and have also made the country a key supply source. Carrefour opened 22 new hypermarkets in both 2006 and 2007, compared with 10 to 15 a year before that. Wal-Mart is currently growing square footage in China by approximately 30% annually. In addition, Wal-Mart directly exports about US$9 billion from China every year. There were 6,338 foreign-invested enterprises at the end of 2007 with a growth rate of 35.9%.


Although the sector is tightly controlled, Chinese energy in all its forms continues to attract high levels of cross-border investment.

Fuelled by high economic growth rates and the rapidly rising standard of living, Chinese energy demand is outstripping domestic supply. This, plus growing environmental concerns, makes oil, coal and gas a major strategic and domestic preoccupation for the authorities. As they try to ensure supplies, increase efficies and modernize outdated facilities, there is a ferment of restructuring and consolidation underway, yielding opportunities for M&A and new joint ventures in major projects.

Sixty-nine percent of Chinese energy is supplied by coal, of which China consumes more than 30% of the world’s output. China is the largest producer and consumer of coal in the world 11 and it has rich coal reserves. By 2006, coal reserves stood at 1,035 billion tonnes, and the remaining verified reserves exploitable acconted for 13% of the world total, making China third in the world. However, the industry is highly fragmented and inefficient, with many large concerns coming to the end of their working lives. To reassert control and boost production, in February 2006,China’s National Development and Reform Commission announced a plan to establish five ot six giant conglomerates in China's main coal-producing provinces, and to close down all small coal mines by 2015. Although reserves are plentiful — and cheap, despite steady price rises since deregulation in 2002 — there is a concern with pollution. Cleaner coal technology will be greatly in demand going forward.

According to the Energy Information Administration (EIA), China is the world’s second largest consumer of oil behind the US, and the third largest net importer of oil after the US and Japan. Demand can only grow as incomes rise and more households can afford cars and energy-consuming household appliances. Heavily subsidized by the government, the Chinese national oil companies (the “Three Sisters”) are themselves investing aggressively across borders. According to EIA, the China National Petroleum Corporation (CNPC) has acquired exploration and production interests in 21 countries spanning four continents. In 2005, CNPC announced its intention to invest a further US$18 billion in foreign oil and gas assets in the 2005-20 period. The China Petroleum and Chemical Corporation (Sinopec) also acquired, in June 2006, a 97% stake in Udmurtneft, a medium-sized unit of BP’s Russian vehicle, for US$3.5 billion. Under pressure from WTO and environmental commitments, the oil and petrochemical industries are also undergoing large-scale restructuring, with foreign investors encouraged to participate in exploration, large domestic infrastructure projects and downstream activities. Foreign companies too are eyeing up a share of China’s huge retail petrol market.

At the same time, China is seeking to make more use of natural gas, by tapping domestic reserves and boosting imports, with the focus on major oil and gas basins, including those of Bohai Bay, Songliao, Tarim and Ordos. We expect to see increasing emphasis on nuclear and hydroelectricity over the next two decades. Renewable energies are also starting to be exploited more widely in rural areas. As well as in the primary energy sources, we anticipate the emergence of deal opportunities in power transmission and distribution. According to Asia Times, China’s investment in the power industry may amount to RMB1.2 trillion (US$169 billion) in the 2006-10 period, averaging RMB240 billion (US$33 billion) annually, 70% more than in 2005.

Real estate

The underpinnings remain strong in the Chinese real estate market: the housing market is growing as a result of increasing and continuing urbanization, and the demand for commercial property of all kinds is continuing to expand along with the economy. Foreign investment in China has grown substantially in recent years. According to Latitude Capital Group, the announced foreign investment (including Hong Kong investments) totaled US$18 bilion in 2006. In the first half of 2007, investment reached US$11.3 billion.

According to DTZ, the percentage of investments from the US dropped to 46% in 2006, from 68% in 2005, while the proportion of European and Asia Pacific investments increased to 16% and 33% from 12% and 20%, respectively, from a year earlier. Beijing and Shanghai are still the major cities for foreign investment, and the proportion of non-US investors has increased. However, foreign investors are now searching for higher returns in secondary cities, such as Chongqing, Tianjin, Nanjing, Chengdu and Wuhan.

Foreign investors are adopting diverse approaches for entering the Chinese market. Besides purchasing building and projects directly or developing sites directly, they are also acquiring stakes in, or participating in ventures with, Chinese real estate companies.

Given the strong growth in the market, many Chinese companies have sought to raise funds from the market or invest directly in the real estate market. For example, Country Garden, a Guangdong-based property developer, went public in Hong Kong in April 2007, raising US$1.7 billion (it was the largest ever IPO by a Chinese developer); while Ping An Insurance’s move to acquire Mei Bang International Centre in Beijing may indicate a shift toward greater involvement by insurers in the real estate market.

Despite the increased control initiatives, such as Circular 171 and the enforcement of Land Appreciation Tax, the opportunities are real in China’s real estate market, and the outlook is promising.


The development of the Chinese telecommunications industry is primarily led by the four major telecommunications operators in an environment consisting of equipment vendors, device manufacturers and a vast network of value-added service and content providers. These players, both domestic and international, are focusing on different segments in the telecommunications value chain, which has contributed significantly to China's GDP in the past few years. The telecommunications service sector alone is estimated to have contributed 3% to 6% to gross domestic product directly and indirectly in 2007.

In terms of both total market capitalization and number of subscribers, the Chinese telecommunications operators have already become giants in the global telecommunications arena. China Mobile, the leading mobile operator in China, has surpassed Vodafone and AT&T to become the largest telecommunications operator in the world. In 2007, the total number of mobile subscribers in China reached 531.8 million, (369 million from China Mobile). The usage of voice services saw double-digit growth for the major operators: the minutes of use of the two mobile operators, namely China Mobile and China Unicom, increased by 19.4% and 14.8%, respectively. In addition, data services generated new sources of revenue for both mobile and fixed line operators. In 2007, income from value-added services increased by 29.3%, and the number of broadband subscribers by 7% to 10%.

The Chinese market for telecommunications services is expected to continue to grow rapidly, although a range of opinions exists as to the actual rate and nature of the growth. However, undoubtedly, the Chinese telecommunications industry is now one of the top markets globally.

The key drivers behind the growth in the Chinese telecommunications industry are predominantly the changes in customer needs or demands linked to advances in technoligy. Convergence of fixed and mobile networks, as well as with IT and media industries, will likely create new revenue streams for operators. Also, the mobile phone penetration rate in China is relatively low, currently at around 35% to 40% with a total population of about 1.3 billion, when compared with a penetration rate of 75% to 80% in developed markets such as Japan and South Korea. Rural area penetration is expected to be another key fpcus in the coming three to five years. Lower-cost wireless and broadband technologies will enable operators to tap the new markets beyond the urban areas. The major challenge for the operators is, however, to boost average revenue per unit, and profitability, while growing the number of subscribers. In addition, the Chinese government has committed hundreds of millions of renminbi to fuel industry growth through R&D investments, e.g., the Time Division-Synchronous Code Division Multiple Access (TD-SCDMA) services recently piloted in Beijing.

On the other hand, the long-awaited restructuring of the telecommunications industry with the potential consolidation of the operators has been more controversial, especially among the investor community. Most investors are concerned about the costs associated with both the transaction as well as the integration of operations. It is also uncertain whether the restructuring will bring more balanced competition to the market. Despite the skepticism, the telecommunications market outlook is still promising given its size, and the pressure for liberalization as part of the Chinese government’s commitment to the WTO is opening up the telecommunications industry to foreign investment.

Venture capital and private equity Private equity funds actively invested in Chinese industry in 2007. According to Zero2IPO Research Center, private equity funds invested US$12.82 billion in 177 deals. Compared with 2006, the number of deals rose by 37.2%. The prediction is that money will continue to flow into China in 2008 as the economy continues to grow.

The traditional industries outstripped other industries in terms of deals and total investment. They gained 88 deals (49.7% of the annual total), and US$8.33 billion (65% of total investment) during 2007 Compared with 2006, total investment rose by 27.9%.

Although, in general, the future for venture capital and private equity in China is bright, challenges still abound. Sourcing deals takes time and effort, and demand for experienced Chinese managers outstrips supply. While the regulatory environment has improved substantially, the infrastructure is immature and held back by intellectual property protection issues.

After a modification to a PRC law on partnership enterprises on 1 September 2007, more local funds have been established. In 2007, 12 Chinese local funds, comprising 18.8% of the entire private equity funds that invested in China, raised US$3.73 billion. Compared with 2006, the raised annual capital and newly raised funds rose by 145.9% and 100.0%, respectively.

Following in the footsteps of the first Chinese industrial fund (Bohai Industry Investment Fund, founded at the end of 2006), another five industrial funds received approval. The total value for these five funds is approximately US$8 billion.

The China Investment Corporation (CIC), China’s sovereign wealth fund, commenced operations in September 2007. CIC is responsible for managing part of China’s foreign exchange reserves with US$200 billion in assets under management. During 2007, it bought a US$3 billion stake in Blackstone Group and a 9.9% stake in Morgan Stanley worth US$5 billion.

With the promulgation and improvement of laws and regulations, Chinese private equity investments enjoy excellent opportunities for future development.

In summary

Although China remains a market unlike any other, the differences in business practices and difficulties in concluding satisfactory deals are slowly diminishing.

On the one hand, foreifn firms and advisors are more experienced at navigating the challenges; on the other, WTO commitments and the need to develop lasting trading relationships with outsiders are gradually bringing Chinese industry sectors into line with international business practices.

Some of the challenges remain: the need for regulatory approval at all stages of the transaction, differing aims across different levels of government, and the laws which are sometimes a challenge to fully understand. Even where the central government is pressing for reform, the strength of local vested interests can sometimes hold back the process. At the transaction level, deals are still timeconsuming and difficult to close, valuations are hard to agree on and foreign partners in joint ventures often encounter Chinese reluctance to cede control.

The positives are important, however. The power and consequences of economic growth, once unleashed, are almost impossible to reverse — or even rein in — although the government has so far done a reasonable job of taking the heat out of the property boom, for example. The dependence on relationships is diminishing.

Above all, having pinned its faith in economic growth, China knows that, to sustain the momentum its population expects, it has no alternative but to pursue sustained cross-border investment and alliances to modernize its state-owned firms and bring them up to world standards of efficiency and governance. China needs foreign firms for technology and know-how, just as foreign firms nees China for growth. That is not to say that foreigners will be allowed to take control and walk off with most of the rewards. Hard bargains will continue to be driven. But assuming the strategic rationale for China entry holds up, we believe the key question for most large foreign companies is no longer “if” or even “when”, but ‘how much’. That is, going into China is a matter of good advice, professional due diligence and careful negotiation.

Transaction advice in China

Following the establishment of its Hong Kong office in 1973, Ernst & Young was one of the first international professional services firms permitted by the Chinese government to open a representative office in mainland China, which it did in Beijing in 1981.

Today, Ernst & Young is one of the leading professional services firms in greater China. We have more than 9,000 professionals in Hong Kong, Beijing, Shanghai, Suzhou, Guangzhou, Shenzhen, Dalian, Wuhan, Chengdu, Macau, Tianjin, Qingdao, Hangzhou, Xiamen and Taiwan. Ernst & Young has an extensive array of audit, tax and transaction advisory professionals — and an extensive network of government contacts — to assist multinational companies with PRC laws and regulations. Ernst & Young is a leader in advising on IPOs on the Stock Exchange of Hong Kong with many clients from mainland China.

Our team has a wealth of experience in assisting private and public companies plan and execute inbound and outbound transactions, as well as serving the needs of venture capital and private equity firms in key areas:

  • Transaction support and due diligence.
  • Commercial due diligence
  • Transaction integration
  • Transaction real estate
  • Working capital management
  • Infrastructure advisory
  • Mergers & acquisitions advisory services
  • Valuations and business modeling
  • Corporate recovery (restructuring, distressed asset advisory and insolvency)
  • Venture Capital Advisory Group

Our multidisciplinary approach helps to ensure that every aspect of a transaction and its impact on the business, legal, financial and tax structure of the business is considered and effectively managed. Our Transaction Advisory Services team provides integrated services related to the acquisition, divestiture, joint venture and restructuring of companies.

Complementing our technical capabilities, and adding a valuable industry perspective to our transaction experience, is our knowledge in key sectors: automotive, financial services, pharmaceuticals, retail and consumer products, oil, gas, mining and telecommunications.

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