M&A: China’s world of debt

The warnings are clear for ChemChina. The company behind China Inc's biggest outward investment bid will be hoping to avoid the unhappy experiences suffered by some of the country's earlier trailblazers.

The state-owned oil company Cnooc, for example, ran into problems after it paid a record $15bn in 2013 for Nexen, one of Canada’s largest oil firms. Cnooc began with good intentions, paying a 60 per cent premium to Nexen’s share price, only to suffer from the prolonged slump in global oil prices. A huge pipeline spill and a retreat from promises to safeguard Canadian jobs – it fired senior Nexen executives and laid off hundreds of staff – have further dented goodwill around the deal. Investments by other Chinese stalwarts have also hit turbulence, falling at regulatory hurdles or unravelling for commercial reasons.

"Chinese investment overseas is a double-edged sword," says Derek Scissors, of the American Enterprise Institute. The outward embrace of China Inc raises a series of challenges for target companies and countries, he adds. Common problems arise from a mismatch of regulatory systems, a clash of corporate cultures and commercial miscalculations.

China is not alone in having deals that hit problems – it happens to US and European companies also. But increasingly the issue for Chinese deals is debt. Analysts say that a surge in the indebtedness of corporate China since 2009 has meant that many of its largest companies are looking for acquisitions abroad while dragging behind them mountains of unpaid loans and bonds.

ChemChina, which is offering $44bn for Syngenta, the Swiss agrichemical giant, is a case in point. Its total debt is 9.5 times its annual earnings before interest, tax, depreciation and amortisation (ebitda), putting it into the "highly-leveraged" category as defined by Standard & Poor's, the rating agency.

This, say analysts, highlights the nature of ChemChina's planned acquisition before even a cent has been paid. The proposed deal is not between two commercial businesses but between the Chinese state and a Swiss company.

"Bids like that by ChemChina are backed by the state," Scissors says. "There is no chance a company as heavily leveraged as this would be able to secure this level of financing on a commercial basis."

"If your financials are out of whack with every commercial company on the planet then you can call yourself commercial but you are not," he adds.

Debt is the word

The issue with debt is by no means confined to ChemChina. The median debt multiple of the 54 Chinese companies that publish financial figures and did deals overseas last year was 5.4, according to data from S&P Global Market Intelligence. Many would be regarded as "highly leveraged".

Some companies are almost off the chart. Zoomlion, a lossmaking and partially state-owned Chinese machinery company that is bidding for US rival Terex, has a debt multiple of 83; by comparison Terex's is 3.6. China Cosco, a state-owned shipping company, is seven times more indebted than Piraeus Port Authority in Greece, which it bought for euro 368.5m last month.

The state-owned Cofco Corporation, which recently reached an agreement with Noble Group, the commodities trader, under which its subsidiary Cofco International would acquire a stake in Noble Agri for $750m, has debts equivalent to 52 times its ebitda.

The debt question is becoming more pressing as China's outward investment turns from a trend into a boom. Last year, Chinese companies invested an estimated $110bn abroad, up 16 per cent in 12 months, according to data from AEI and the Heritage Foundation, two US think-tanks.

The Rhodium Group, a Hong Kong consultancy, estimates that the M&A portion of these outward investments is set to soar this year to $97bn, up from $60.8bn in 2015. Such numbers pale against Beijing's longer-term ambitions: Li Keqiang, the premier, has said that China will invest $1tn over the next five years making it the second largest outward investor after the US. It is currently fourth placed.

"If we do not see reforms in China's financial system that led to greater capital discipline among state-owned enterprises, there is a significant risk of a political backlash against Chinese overseas acquisitions," says Thilo Hanemann, head of research at Rhodium.

"Observing the situation in the Chinese market, recipient countries are rightly concerned about the misallocation of investment, the crowding out of healthy private sector companies and a distortion of asset prices. These concerns are becoming acute now that China has become one of the top global investors."

There is a lengthening list of deals that have gone wrong. They are not isolated incidents. About one quarter of all Chinese outbound deals, worth $270bn once construction contracts between 2005 and 2015 are included, have hit "trouble" – defined as deals that have hit lengthy delays, big cost overruns or outright failure – according to data from the two think-tanks. This is most pronounced in the resources and finance sectors.

The problem is stark. Many of the state-owned companies projecting Chinese corporate power overseas are so indebted that it would be difficult or impossible for them to raise a bank loan in a market economy.

"These companies are not viable without state funding," says one dealmaker in London, who asked to remain anonymous. "Can they possibly be good owners for these companies they are acquiring? I think that is something the regulators are looking at."

Dealmaking

Chinese state-owned acquirers often seem motivated by non-commercial impulses, which complicates matters. By carrying out directives to "go out and buy" businesses that fit with Beijing's industrial policy, state-owned companies and even a few of their private counterparts win kudos in the Communist party hierarchy. That helps them tap into official largesse, such as approval for expansion plans and backing from state banks and capital markets.

"State-owned enterprises have high incentives to increase their size, and they use plans outlined by [government agencies] as weapons to expand both domestically and internationally," says Victor Shih, professor at University of California San Diego. "The bigger they are, the more political weight and more room for rent-seeking can be enjoyed by senior management."

Minxin Pei, professor of government at Claremont McKenna College in California, raises a series of concerns. "People should ask whether such acquisitions are made with non-economic motives and whether China’s acquirers have the capacity to manage these large, complex and innovative firms (like Syngenta)."

With revenues of $45bn last year, ChemChina is the country's largest chemical company. Ranked 265 on the Fortune Global 500 list of the world's largest companies, it employs more than 140,000 people, two-thirds inside China and is directly administered by the State-owned Assets Supervision and Administration Commission. Sasac, however, is a relatively weak body. It plays second fiddle to the ruling Communist party's organisation department and anti-graft watchdog which both exercise more influence over hiring and firing in state enterprises. So long as executives at Sasac-administered firms help advance core national interests, they are given operational freedom.

Few have been more skilled at playing this game than ChemChina's chair, Ren Jianxin. At the other end of the SOE spectrum are smaller companies such as Zoomlion or Haier, which recently paid $5.4bn for general Electric's appliance unit. Both have strong ties to local governments but not necessarily Beijing.

The Syngenta transaction gave ChemChina and Ren a key role in the country's overseas food security strategy. Fitch upgraded ratings for one of the group's biggest units on the basis that its parent was of "great strategic importance to China". It mentioned its contribution to China's crop protection sector, leadership in chemical material supply to national aerospace projects and its championing the speciality chemical industry.

Food security

In addition to this eclectic mix, ChemChina also has a tyre division that last year paid euro 7.3bn for Italy's Pirelli. What appears to some analysts as a sprawling conglomerate without a focus is, from its creditors' perspective, a company that has established itself as a key player with a penchant for landing trophy assets in strategic sectors.

"Chinese overseas projects are meant to elevate the country's international reputation," says Gilliam Hamilton, China research analyst at NSBO. "The government, and by extension SOEs, therefore prefer large, headline-grabbing mega-projects such as rail lines in Thailand, in South America and the Syngenta deal to smaller deals."

Consequently it is not just Chinese state banks that are happy to lend to companies such as ChemChina, but large western ones too. Implicit state backing for ChemChina and other SOEs' debt, as noted by Fitch last year, reduces their perceived credit risk to lenders.

To secure its agreement with Syngenta, ChemChina received $30bn in acquisition financing from China's Citic Securities and $20bn from HSBC. It then plans to sell equity stakes in Syngenta and issue long-term debt - bankers working with the company say they are being flooded with requests to participate in the financing.

What is music to the ears of ChemChina’s creditors can sound like alarm bells in Washington.

"China has systematically blocked regulatory approvals of foreign-developed biotech seeds, resulting in billions of dollars in losses for companies like Dow, DuPont, Monsanto and Syngenta," says one US executive who tracks China deals closely. "(China) has said explicitly that foreign companies will not dominate China's seed market. Now you have a Chinese SOE acquiring one of those foreign companies."

The executive suspects that if the ChemChina deal is completed, "Syngenta's seeds will ultimately receive preferential regulatory approval by Chinese authorities, further undermining the fortunes of Dow, Dupont, Monsanto and Bayer."

In Switzerland few such concerns have been raised about China Inc snapping up a Swiss national champion. Some argue the risk of job losses and other disruption would have been a greater had the company been bought by one of its international peers, such as Monsanto.

Johann Schneider-Ammann, the Swiss president, pronounced ChemChina's offer "a good deal". Last year, Italian politicians and workers broadly welcomed Ren’s purchase of Pirelli for the same reason.

Still, Chinese bidders have miscalculated. Last month, the Committee on Foreign Investment in the US blocked a seemingly innocuous $3.1bn sale of a lighting unit from Philips, the Dutch conglomerate, to a Chinese consortium. The US body has the power to review and potentially block transactions that might harm the country's national security. A planned $23bn bid for chipmaker Micron by Tsinghua Unigroup, the Chinese state-owned semiconductor business, never got off the ground last year, in part because it was believed the deal would hit a regulatory brick wall. With that in mind, ChemChina has said it will voluntarily submit its deal for Syngenta to Cfius for review.

"No one is going to ask many questions (about Chinese outbound deals) unless they are clearly a security risk or could be construed as such," says one veteran China dealmaker. "Otherwise anybody should be able to buy anything they want as long as they are paying over the odds."

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