(The following is the second part of a two-part essay on post-merger integration of Chinese cross-border acquisitions, co-authored with David Cogman, a Partner in McKinsey's Hong Kong office and leader of their China Globalization service line. Read the first part here.)
Selective integration
In recent years there are an increasing number of deals where the acquirers have attempted to selectively integrate one or two business areas, while managing the overall relationship with the target through a board. Under the right circumstances, this can be effective. A few examples illustrate common features of this model.
Petrochina – Ion: combining technology with market presence
When a subsidiary of Petrochina acquired geophysical survey technology company Ion in 2010, Petrochina was already one of the world’s largest contract explorers for hydrocarbons. Ion had arguably the best 3D seismic imaging equipment in the industry. The industrial logic of combining the two was compelling. However Ion was a relatively flat, informal and entrepreneurial Houston-based company and Petrochina remains a large and complex SOE.
What Petrochina had, however, was a small group of managers who had accumulated many years’ experience running exploration operations outside China. These managers shared a common technical language and frame of reference with Ion’s management. Hence they became the ‘bridge team’ between the two companies. Management of Ion was done primarily through the board, but there was extensive and close collaboration on how to rapidly deploy Ion’s technology and expertise into Petrochina’s exploration operations. Other functional areas were left largely untouched.
CSR – Dynex: accelerating scale-up of R&D
In 2008 Dynex, a mid-sized UK based semiconductor company focused on selling modules into the railroad sector was 75% acquired by China state owned CSR (one of China’s largest railroad equipment producers who at the time were ramping up their high speed rail capabilities). CSR provided Dynex with new capital to scale up their R&D and to expand their sales force into new geographic markets. CSR brought the Dynex products to market in China through their own products and channels. Dynex management now includes several executives from CSR, including the head of R&D and of sales and the board has four Chinese members out of a total board of nine.
Making selective integration work
This approach is appealing, though it is not easy to execute. Making selective integration work requires a few key skills that not all companies possess.
First, the acquirer needs the ability to manage an asset through the board. This is not as simple as it sounds. Boards are cultural phenomena; their authority and role varies significantly across countries. The legal role of a board in China is quite different from the US, Germany or the UK. Some companies and individuals are notably skilled at doing this – for instance, this is the standard operating model for Hong Kong conglomerates such as Swire and Jardine Matheson – but many are not, and view the board as little more than a legal formality.
Second, the acquirer needs bench strength in the specific integration areas. The acquirer needs a cadre of people – maybe as few as a dozen – which can interact at a working level with the target, and have credibility with the target’s managers.
Third, the acquirer needs a deal team capable of negotiating the right kind of arrangements prior to deal closing. Negotiating in this context doesn’t mean writing it into the legal agreements, but rather reaching a practical mutual understanding with the other side, with no confusion or ambiguity. This is harder than it sounds. In some situations, notably tightly controlled auctions where access to the target is restricted by the sale process rules, it may be outright impossible – one of many reasons why Chinese aquirers still do not like competitive public sale processes.
Progressive integration
Geely’s acquisition of Volvo in 2010 was a milestone in the global auto industry: it was the point where many in the MNC auto community woke up and realized that domestic Chinese auto makers were serious in their international ambition. Domestic brands had not, at that point, achieved notable success in the domestic market relative to Sino-foreign JV brands.
None of them had meaningful presence outside China, and none had integrated foreign operations into their business: in the case of the Sinoforeign JVs, it was domestic operations that integrated into the global product platforms.
Auto integrations pose unique challenges. Value lies primarily in achieving scale through consolidating product platforms and procurement. This is hard to do without doing a full-on integration of the two companies, hence most post-merger integrations in auto are very hands-on and involve extensive restructuring of one or both sides.
Geely’s management were aware of the risks involved. Having bought Volvo out of financial distress in 2010 at a relatively attractive price, they had more time on their side than most acquirers. They decided, sensibly, to walk first before running. The easiest and highest-value part of the integration was sharing R&D and manufacturing expertise from Volvo into Geely, and this was the first area of focus. The next area was a significant step-up: finding operational synergies across production platforms in procurement and product roadmap. This was a multi-year effort. The next step was to look at the marketing and distribution footprint, and find areas that could be consolidated.
The pace of integration has been slower than was anticipated at the outset. Yet the company has defied the skeptics who predicted culture clash and financial underperformance. Geely traded off returns against risk in this approach, and having avoided the short-term danger of becoming another SAIC-Ssanyong, it had time on its side to achieve its strategic goals with the business.
Working with partners: can co-investors help?
The problems we have discussed include a mismatch between management systems, and lack of experience operating in a foreign environment. Can these be addressed by involving a financial investor as partner? Numerous co-investors, primarily buyout funds, actively seek opportunities to partner with Chinese acquirers in these situations. Their greatest value is in the pre-deal stage. They can be very helpful postdeal; however they create one significant additional problem, which is orchestrating their exit from the investment.
Funds bring deep experience in deal execution and in managing the stakeholder issues surrounding them. This is of significant value to Chinese companies that lack the network to generate proprietary dealflow, providing opportunities that they otherwise wouldn’t see; and it helps them navigate the deal process more efficiently. Partners are less consistently helpful in navigating government and other stakeholders, such as Huawei’s failed bid for 3com: even Bain Capital as co-investor was unable to get the deal through CFIUS review.
Zoomlion’s 2008 investment in Cifa is a good example of how the dynamic changes from pre- to post-deal. A triumvirate of financial co-investors – Hony, Goldman Sachs and Mandarin Capital Partners, a Sino-European fund with strong links to Italy – helped source and complete the deal. They provided heavy support on diligence, negotiation and funding, and setup corporate governance post-closing, without which the deal would have been considerably harder for Zoomlion to execute, perhaps even impossible.
They also helped find and install a new CEO. However post-deal the company struggled in operations and R&D – two areas where the PE investors did not bring much to the table. Revenues fell, and before too long the PE-backed CEO was replaced by one of Zoomlion’s choice. However despite poor financial performance – revenues in 2011, only three years out from the initial investment, were less than 40% of pre-deal projections – the financial investors still managed to exit with respectable returns. PE investors put considerable effort into the structuring of these deal to protect their downside, and typically the strategic investor takes greater risk. This is because the majority strategic investor has greater ability to manage the asset post-deal than minority financial investors. Nonetheless it is uncomfortable when the strategic investor does more operationally, but makes lesser returns.
In Lenovo’s first outbound deal, the acquisition of IBM’s PC business, two foreign funds – TPG, General Atlantic – invested alongside Lenovo, and brought considerable expertise in deal execution and risk mitigation as well as in providing international credibility to Lenovo, who had almost no profile outside China at the time. However their ultimate interest was in the returns they could generate, while Lenovo’s core motivation was in developing an international platform for growth over the coming decades. This initial deal perhaps needed the funds’ involvement to achieve success. In subsequent deals, Lenovo chose to be the sole investor.
In recent years a new kind of partner has emerged: local Chinese funds, some private-sector, many with some form of government funding, who help Chinese companies execute acquisitions. Staff in these funds, particularly at the junior level, are typically Chinese nationals with international experience – people who have studied and worked in investing abroad – hence they bring experience that the companies they partner with lack. The limited partners are predominantly Chinese institutions, and they often do not have the pressure of the fundraising cycle that foreign funds feel, allowing them to be more relaxed on the timing of exit for their investments.
It is too early to say whether these funds will behave differently from their foreign counterparts. However they provide a middle-ground, and the numbers of co-invest deals with them involved has grown very fast in the past few years. Take, for instance, Chinese retail operator Sanpower’s acquisition of Brookstone Holding, a US-based retail store network. They were supported in this by Sailing Capital, a Shanghai-based fund set up to assist Chinese companies acquiring overseas, relying primarily on RMB sources for funding but whose investment team has a background working for foreign investment firms such as PAG. Early results appear positive: it has opened three stores in China already, including a flagship in Shanghai, has increased the pace of format innovation and marketed more aggressively toward younger age groups.
There is clearly a role for funds to support outbound acquisition. However it’s less clear that they can play a major role post-deal in integration. In all the examples we looked through, we found few where the fund had played a meaningful role in operational improvement or restructuring.
Building the toolkit
The fundamental challenges that we have highlighted above mostly come down to three areas: the historic lack of a managerial cadre that can function in a foreign acquisition; incompatible management systems; and differences in corporate culture. Over time, it is becoming easier to address these. The pool of internationally-experienced Chinese nationals with experience in
multiple corporate cultures continues to grow, and Chinese companies’ management systems continue to become more sophisticated.
That said, there are a few necessary elements to successful deals that Chinese companies will not develop unless they make the effort to do so. The first is to develop their own ‘playbook’ for these acquisitions. As with any corporate function, you become good at M&A by codifying and standardizing how you do it – by finding out what works for you individually.
Lenovo did this after its purchase of IBM’s PC division, and it has served them well in subsequent acquisitions. The second is developing the ability to run a company in a light-touch manner primarily through the board. This is something that no company or manager has naturally, and how you do it outside China is substantially different from within China. It is a question of knowing what management information to look at, how frequently, where you need transparency into operations and how to achieve that. Most successful private equity investors acquire this skill through the course of their careers by sitting on multiple investee company boards, but it is not reasonable to expect a corporate manager to know how to do this.
As many Chinese companies have come to realize, there is no magic bullet for integration. Investing in your own skills and capabilities gives you more options to choose from, but you still have to make the right choice and execute well on it. As these companies’ deal teams mature and build experience, we are seeing more thoughtful and ambitious approaches to post-deal integration. This is good, as without raising their game on integration, they will struggle to create value from the current wave of deals.
(This article was co-authored with David Cogman, a Partner with McKinsey's Strategy & Corporate Finance Practice, and Head of their Chinese Globalization service line. This is part of a new compendium of essays on Chinese cross-border M&A: "A Pocket Guide to Chinese Cross-Border M&A". Download the PDF of this report here.)
