An Analysis of the M&A Market in Mainland China

Master Thesis at
HfB – Business School of Finance & Management,
Frankfurt am Main, Germany

submitted by

Tim Brückner

Frankfurt am Main, 15 March 2005

Table of Contents

List of Figures ... iv
List of Tables  ... v
List of Abbreviations  ... vi

I Introduction  ... 1
I.I Research Problem  ... 1
I.II Methodology  ... 1

II Definition of M&A  ... 3

III Rationale for M&A in Mainland China  ... 5
III.I Value Generation of Cross-Border Transactions  ... 5
III.II Pros and Cons for M&A in China  ... 6
III.II.I Pros  ... 6
III.II.II Cons  ... 7
III.III Summary  ... 8

IV FDI  ... 9
IV.I Inbound FDI to China  ... 9
IV.II The Importance of M&A Transactions  ... 11
IV.III Summary ...  13

V The Chinese M&A market  ... 14
V.I Numbers from Literature Review ...  14
V.II An Analysis of the Chinese M&A Market from 2000 until 2004  ... 16
V.II.I The Overall Market ...  17
V.II.II Sector Segmentation  ... 17
V.II.III Geographic Segmentation  ... 18
V.III The Future of M&A in China  ... 19
V.IV Summary  ... 20

VI Available Investment Entities for Foreign Investors ...  21
VI.I Foreign Investment Enterprises  ... 23
VI.I.I Joint Ventures  ... 24
VI.I.II Wholly Foreign Owned Enterprises  ... 25
VI.I.III Foreign Investment Companies - Limited by Shares  ... 26
VI.I.IV Shares of Chinese Listed Joint-Stock Companies  ... 27
VI.II Summary  ... 28

VII Transaction Forms  ... 29
VII.I Transaction Classes  ... 30
VII.I.I Asset Deals  ... 30
VII.I.II Share Deals  ... 32
VII.I.III Mergers  ... 37
VII.II Summary ...  39
VII.III Transaction Structures  ... 40
VII.III.I Direct Acquisitions – Onshore  ... 40
VII.III.II Direct Acquisitions – Offshore  ... 40
VII.III.III Indirect Acquisitions – Onshore  ... 41
VII.III.IV Indirect Acquisitions – Offshore  ... 41
VII.IV Summary  ... 43

VIII Legal Environment  ... 44
VIII.I Key Government Agencies  ... 44
VIII.II Recent Legislation  ... 45
VIII.III Land Use Rights  ... 47
VIII.IV Summary  ... 48

IX Peculiarities of the M&A Transactions in China ...  50
IX.I Cross-Border Issues  ... 50
IX.II Government Approvals  ... 51
IX.II.I Sector Regulation  ... 52
IX.II.II Antitrust Review  ... 54
IX.II.III Valuation Procedure  ... 55
IX.II.IV Summary  ... 57
IX.III Due Diligence  ... 57
IX.III.I Financial  ... 59
IX.III.II Legal  ... 60
IX.III.III Tax ...  61
IX.III.IV Summary  ... 63
IX.IV Documentation  ... 63
IX.IV.I Letter of Intent  ... 64
IX.IV.II Covenants  ... 64
IX.IV.III Representations and Warranties  ... 65
IX.V Other Issues  ... 66
IX.V.I Taxation  ... 66
IX.V.II Management Incentives  ... 68
IX.V.III Financing  ... 68
IX.V.IV Consideration  ... 69
IX.V.V Exit Options  ... 70
IX.VI Summary  ... 70

X Case Study  ... 72
X.I Legal Environment for M&A Transactions Involving Banks  ... 72
X.II The Acquirer and the Target Firm  ... 74
X.II.I The Acquiror  ... 74
X.II.II The Target  ... 74
X.III The Transaction  ... 75
X.IV Rationale and Analysis  ... 76

XI Evaluation of Findings  ... 78
XI.I Conclusion  ... 78

References  ... a
Sources ...  m

List of Figures
Figure 1: Types of M&A Transactions  ... 4
Figure 2: Expected Modes of Investment 2004-2005  ... 13
Figure 3: Sectoral Distribution by Value and Volume  ... 18
Figure 4: Geographic Distribution by Value and Volume  ... 19
Figure 5: The Voyage from JV to M&A in China ...  21
Figure 6: Investment Forms  ... 22
Figure 7: Available Investment Entities for Foreign Investors ... 22
Figure 8: Structure of a Merger  ... 38
Figure 9: Structure before Offshore Transaction  ... 42
Figure 10: Structure after Offshore Transaction  ... 43
Figure 11: Investment Categories  ... 53
Figure 12: Information-Economical Difficulties  ... 58
Figure 13: Shareholding Structure as of 31/12/03 and 31/08/04  ... 75

List of Tables
Table 1: Real GDP Growth in China  ... 6
Table 2: Utilised FDI to and from China  ... 9
Table 3: Favoured Countries for FDI  ... 11
Table 4: Cross-Border M&A in China between year 1985 and 2006  ... 15
Table 5: Source of Funds per Country ...  15
Table 6: Cross-Border M&A in China between year 1988 and 2003  ... 16
Table 7: M&A in China between year 2000 and 2004  ... 17
Table 8: Foundation Requirements for FIE  ... 23
Table 9: Advantages and Disadvantages of a JV  ... 25
Table 10: Advantages and Disadvantages of a WFOE  ... 26
Table 11: Classes of Shares and Exchanges  ... 27
Table 12: Acquisition Targets ...  29
Table 13: Advantages and Disadvantages of Asset Deals  ... 31
Table 14: Advantages and Disadvantages of Acquisitions  ... 36
Table 15: Advantages and Disadvantages of Mergers  ... 39
Table 16: Overview about Legal Regulations  ... 45
Table 17: Sector Regulation Overview  ... 53
Table 18: Enforceable non-compete clauses  ... 64
Table 19: Liability for Severance Payments  ... 65

List of Abbreviations

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I Introduction

The Master Thesis An Analysis of the M&A Market in Mainland China gives an introduction into the Mergers & Acquisitions (M&A) business and analyses the M&A market in the Mainland of the People’s Republic of China (China). Thereby the Thesis focuses on the development of cross-border transactions within recent years and the relevant intra and extra Chinese influence factors.

I.I Research Problem

After the publication of recent M&A transactions data in October 2004 it is clear that the M&A market in China gains importance in a rapid manner. Within the first nine month of 2004 the Chinese market triplicated from about 10 USDbn in the previous year’s period to 35 USDbn. With a total of 695 announced domestic and cross-border transactions – in comparison to 730 transaction with a value of 52 USDbn in Germany (cp. w/o author, 2004b and w/o author, 2004a) – China comes close to the sixth position of Germany in worldwide M&A volume.

This rapid growth supports the common acceptation in the Investment Banking environment that China will be one of the most attractive markets for Corporate Finance services in the following years. Therefore the Master-Thesis should give an insight into the historic development of M&A transactions with Chinese involvement and the current market situation. Thereby the paper will focus on country specific influence factors that have significant importance to M&A transactions.

I.II Methodology

To better understand the problem set firstly a brief insight into the M&A business will provide definitions and define the relevant transactions which should be analysed in this paper. Following that the rationale for M&A transactions involving Chinese businesses and the Pros and Cons of such investments will be described. Thereby general aspects of the Chinese economy will not be discussed in detail as related information is already available in other sources. 

The Thesis will then present Foreign Direct Investment (FDI) data of the last two decades to show the development of FDI and the changes in the investment modes. After clarifying global FDI trends the evolution of the Chinese M&A market will be analysed using external sources and conducting an own study using standard databases relevant to the sector.

In the following factors specific to the Chinese M&A market will be described. Those are qualified in respect of the particular legal form of the Chinese target firm and focussed on the most relevant influence factors concerning Chinese market regulation.

Peculiarities during the due diligence process, issues in respect of documentation and a set of other issues are described to illustrate most important pitfalls of M&A transactions in China.

This knowledge will then be applied to a case study covering the Chinese banking sector, which is one of the business sectors facing strongest regulation. The acquisition of a minority stake in Bank of Communications (BoCom) from HSBC Holdings plc (HSBC) in 2004 will be used to illustrate this. Further on the rationale for the transaction will be discussed, referring back to the earlier chapter about Pros and Cons of investments in China via M&A.

Finally the previous findings will be analysed and the perspectives of the Chinese M&A market will be qualified, concluding with a statement whether the optimism of the market is legitimate or not.

II Definition of M&A

The term Mergers & Acquisitions generically refers to any combination of two or more enterprises. Mergers and acquisitions are two different legal transactions in many jurisdictions, including the Chinese legal environment.

Thereby a merger is defined as the legal combination of two independent economic entities where the target company is dissolved into the acquiring company. By legal classification the acquirer assumes all the assets and liabilities of both entities. The procedures for executing a merger transaction tend to be fairly straightforward (cp. Marren, 1993). On the downside, mergers often require the approval of both the acquiring and target firm′s shareholders and the acquiring firm assumes all of the target′s liabilities (cp. Milman, 1999). An acquisition is defined as the purchase of all or part of the assets or shares of an economic entity by another entity. As result of this both entities survive after the transaction.

The acquisition of equity interests of another firm can also lead to the creation of a Joint Venture (JV), in this case an Equity Joint Venture (EJV). Under the umbrella of M&A transactions also JV in the form of Contractual Joint Ventures (CJV) can be summarised as drafting of the JV contract may require the same expertise as a conventional M&A transaction.

The table below illustrates the different forms of M&A transactions and classifies them according to the Intensity of Relationship and the distinction between a “Make or Buy” decision.

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