China has always been a challenging place to do business, and this is just as true for the process of rightsizing operations as it is for building a presence in the market. Brent Carlson, Director, Hong Kong, AlixPartners, offers guidance for companies looking to cull non-core and/or under-performing assets to fit Chinas changing business and economic environment.
Asubtle yet substantial shift is occurring in the foreign invested landscape in China. After two decades of a rush to invest into the country, foreign multinationals are now re-evaluating and rightsizing their China operations portfolios.
Several underlying factors underlie this emerging trend: the chronic slowdown of Chinas economy, overinvestment and overcapacity, an increasingly harsh business environment, and increased compliance and financial integrity challenges. In a boom period a rising tide lifts all boats; however, once the tide peaks, the receding waters expose the rust in the hull. Likewise, during the peak time of Chinas inward foreign investment boom (in the 2000s right after China acceded to the World Trade Organisation (WTO)) the challenges of doing business in China were outweighed by the strategic imperative and prospective opportunities offered by the booming China market. Now the tide has turned, and these strategic imperatives have largely eroded away.
Nevertheless, China remains the worlds second largest economy and will retain its position as an important global market; however, the key issue revolves around rightsizing to the current opportunities rather than making a complete exit. Operations and investments which may have made economic sense in the past no longer do so. Savvy management teams at leading foreign multinationals are increasingly looking to prune the corporate tree in China, which will become a key aspect of M&A activity in China over the next few years. Furthermore, pruning the corporate tree successfully will take smart planning and execution as the intricacies of business in China make the process of business exits challenging as well. Chartered Secretaries can play a key role in this process to help guide a companys overall strategy in this regard, as well as to help avoid potential pitfalls and effect a smooth corporate pruning process.
The China market still compelling, but no longer what it once was
The spectre of a financial (and subsequently) economic crisis in China has loomed and then faded repeatedly over the past few years. The bears point to Chinas unsustainably high levels of debt which in historical perspective have always preceded a crash, whereas the bulls point to Chinas continued high level of economic growth rate as proof that a crisis will be avoided. Although the debate continues as to whether or not a crash will ensue (its too early to tell), perhaps the larger issue which gets missed (the elephant in the room) is that Chinas economic growth rate has slowed dramatically in recent years and inevitably will continue to do so. Chinas annual GDP growth rate has dropped from double-digits 10 years ago (around 12%-13%) to around half that level this year. The decrease has come in the form of a slow, steady decline since 2010.
However, at the same time China has been pumping credit into its economy to sustain growth, with annual credit growth levels approximately double the GDP growth rate. In doing so China has propped up growth with credit. This represents a sound short-term strategy but remains fundamentally unsustainable over time. In a recent report by the International Monetary Fund (IMF), Chinas credit efficiency has eroded considerably over the past decade, resulting in the need for ever larger amounts of credit to generate the same amount of growth. The IMF noted that in 2008 new credit of approximately RMB 6.5 trillion was needed to increase nominal GDP by RMB 5 trillion; by 2016 it took RMB 20 trillion to generate the same amount of increase.
What this means is that Chinas current growth trajectory both in terms of credit and the economy as a whole must decrease in the years to come. If China fails to de-lever its economy and wean itself from credit-driven growth, then the risk of a financial crisis becomes greater with even worse consequences. Policy makers in Beijing realise this, as exemplified by the recent crackdown on debt-fueled acquisitions and shadow banking. De-leveraging may be and likely will be a long, drawn-out process. Under any scenario the slowdown in Chinas growth will continue. The boom time is over.
The challenges of China business as always and even greater
China has always been a challenging place to do business, from the travails documented in the early days of Beijing Jeep to today. However, during the peak boom period for foreign investment in China (the 2000s) such challenges were overlooked, ignored and brushed aside in favour of the vision of participating in Chinas monumental growth story. Indeed, in the 2000s after China acceded to the WTO, every multinational CEO had to have a China strategy to convey to investors. Throughout this period the challenges of doing business in China were always hard. Every year the American Chamber of Commerce in China conducts a member survey which includes top business challenges. Over the years these challenges have largely remained the same, with only slight variations in ranking from year to year. These challenges include rising labour costs (and unrest), inconsistent regulatory interpretation and unclear laws, intellectual property rights issues, and increasing domestic competition. In addition, one big difference over time in the annual survey has been the outlook on profitability for the companies China operations. Over the past several years these have shown a steady deterioration. In a booming economy, such challenges can be set aside; however, in Chinas current economic and business environment they only accentuate the necessity of re-evaluating China operations and culling under-performing and/or non-core assets.
Pruning the tree in China issues and approaches
From a broad strategic perspective, determining whether an entity has become non-core or under-performing largely depends upon the strategic imperatives of the group company and key performance indicator benchmarks most appropriate to the business. Ultimately, beauty is largely in the eyes of the beholder. In terms of determining the level of under-performance, this is in essence an arbitrary benchmark driven by opportunity costs to the overall organisation combined with a projected cost/benefit analysis. Nevertheless, in any case if an entity has been operating at a loss or hovering around the break-even levels, its fair to place it in the under-performing bucket.
Once the decision has been made to cull non-core and/or under-performing assets, an initial assessment needs to be made upfront as to the available options and to highlight any issues which may hinder a smooth exit. The first obvious option is to explore sale of the business. Commonly this involves retaining an investment bank to guide the process and help find a buyer. However, for non-core or under-performing assets this may prove more difficult than expected for a couple of key reasons. First, many non-core operational assets may be too small to generate interest from the larger investment banks. In many cases foreign multinationals have subsidiaries in Mainland China which fall below the materiality threshold for the parent or group companys consolidated financials. Subsidiary entities such as these tend to lack the size and scale necessary to generate much interest on the part of prospective buyers and consequently on the part of the prospective sell-side investment bank. In addition, if the operational asset is obviously under-performing (as defined above), the very nature of the troubled asset also results in a damping of interest on the part of prospective buyers. For under-performing assets the field of potential buyers narrows to those tending to specialise in special situations, as well as restructurings and turnarounds.
There has been an increase in such specialised financial investors in Asia Pacific over the last couple of years, and these will likely provide the most attractive expanding base of potential buy-side prospects. Other buy-side options for assets in Mainland China have also included domestic Chinese companies. Choosing the right buy-side partner is key to a smooth disposal and exit. Although domestic Chinese buyers will continue to play a large role in buying up assets, the recent scrutiny by Chinese regulatory authorities on the M&A activities by Chinese multinationals indicates that doing deals may be more difficult for domestic Chinese buyers in the future, especially if they need to raise debt for the deal.
Besides an outright sale of the non-core asset, the other main strategic option for a parent/group company to deal with a non-core and/or under-performing asset consists of winding-down the operations and deregistering the business. This option is usually considered after attempting to shop the asset to a prospective buyer, but without success. Like many things in China, wind-downs are possible but often not easy or at least may take longer than expected. Labour issues in particular, specifically negotiating severance with staff, can prove more difficult than initially foreseen. In addition, local districts typically can view de-registrations with a lukewarm welcome at best as decreases in investment reflect negatively upon the locality. Nevertheless, the concept of restructuring in general is re-entering the business vocabulary in China. When placed in the context of pruning, of cutting certain pieces to save the whole, then acceptance of the situation becomes somewhat easier. During the wind-down process its also important to appoint trusted interim managers as care-takers of the operations to guide the overall process, preserve what value remains in the entity, and facilitate an orderly wind-down.
More deals to follow
As the nature of Chinas business and economic environment continues to change and as multinationals in China re-assess their investment and operational footprints there, more pruning in the form of business exits will follow. Corporate secretaries are well-placed to assist their companies to execute the companys overall strategy in China as multinational companies increasingly enact their own version of the hold on to the big, let go of the small (婁댕렴鬼) policy.
Brent Carlson, Director, Hong Kong