China dealmakers gear up for M&A recovery in 2H23 as border reopens – sources say

News Analysis 22 February

China dealmakers gear up for M&A recovery in 2H23 as border reopens – sources say

The China M&A market will likely see a recovery in deal activity in the second half of the year as the reopening boom unleashes pent-up investment demand amid Beijing signalling easing control over the private sector, according to sources polled by this news service.

As the country quickly moved past its first wave of Covid infections and private spending began to slowly bounce back, China’s consumer sector might see a spontaneous recovery this year, the sources said.

“We’ve seen a moving pipeline of on-hold deals coming back,” according to a Hong Kong-based financial advisor.

With the increasing market penetration and application, 2023 will be a big year for renewable energy investments and initial public offerings, said Jing Zhao, managing director at Cathay Capital.

In the face of macroeconomic uncertainty and regulatory risks, China 2022 M&A volume slumped to a 15-year low, as reported by this newswire. Bridging the valuation gap between buyers and sellers remains the key challenge for dealmaking in the first half of this year, the sources said. 

With the increasingly higher financing cost, it will take time to shore up foreign investors’ confidence after the economic scarring from the three-year Covid restrictions and “heavy-handed regulatory scrutiny” on several private industries including the internet sector, the Hong Kong-based banker pointed out.

Beijing’s efforts to win back foreign investors is in full swing. It rolled out the welcome mat with a range of easing rules for foreign investors and promoted direct investments in the high-tech, manufacturing, and healthcare sectors.

Last December, China’s National Development and Reform Commission and Ministry of Commerce jointly issued the Catalogue of Encouraged Industries for Foreign Investment (2022 Edition) which came into effect in January this year.

The updated catalogue continues to encourage foreign investments in advanced manufacturing industries and modern service industries. It also expanded the investment scope to direct more foreign capital to invest in Central and Western China for clean technology, key components for consumer electronics.

Liu He, China’s Vice Premier promised that China’s door to foreign investment “will only open wider” at the World Economic Forum in Davos last month.

The remark was reassuring for foreign investors, yet “demystifying the policy priority among mixed signals remains the most challenging task,” according to a Shanghai-based MNC executive.

Valuation slumps to a decade low

The valuation for China-based targets in 2022 slumped to a decade low at an EV/ Ebitda of 16.89x, down 33.4% compared to 2021, and only half the valuation of 33.96x in 2014, according to Dealogic data. Food and beverage dropped to 9.48x last year, almost half the valuation in 2021 at 17.08x. Technology fell by 62.8% to 11.87x in 2022 compared to 31.89x in 2021, the data shows.

The markdown and moderated valuation across industries has attracted investors seeking strategic acquisitions at discounts in China.

In February, American alternative investment manager Hamilton Lane (NASDAQ: HLNE) announced the official opening of its Shanghai office. As the first institution in Shanghai to establish a secondary fund through a Qualified Foreign Limited Partnership (QFLP) structure, it began actively sourcing investment opportunities in the CNY market, according to its official announcement.

However, some investors are mindful of the higher cost of financing and volatility in the secondary market. Primary market valuation is still under pressure, and valuations of private companies will likely become more polarized, Zhao noted. Valuations will remain high for growth-stage companies with clear competitive advantages, but companies will face increasing pressures when it comes to pre-IPO fundraising. Meanwhile, early-stage companies will see their valuations return to a relatively reasonable range, he said.

Even as private companies began to digest their valuations in the second half of 2022, it might take some time before their valuations return to a point that is attractive to investors, a Beijing-based PE investor said.

To address buyers’ concerns on valuation, earnout has become a common tool which requires sellers to meet specific financial metrics to obtain additional contingent payments, according to a Hong Kong-based financial advisor. Sellers are more acceptive of an earnout option to negotiate against an undervaluation in exchange for a future improved performance on the back of a reviving economic environment. 

Domestic deals centered around policy-led sectors

In the domestic market, investments in semiconductors, automation, AI, IoT, big data, clean energy, new materials would lead the M&A activity recovery, according to an investor from a state-owned fund.

China is keen to upgrade technology in various sectors. This certainly will result in explosive demand for chips and robots, hence the continued enthusiasm in such sectors. With the US tech ban expanding, China’s technology-driven companies have become even more determined about reducing import dependency, which has become a selling point for many home-grown startups, especially in the semiconductor supply chain, the investor added.

China’s long-awaited full adoption of registration-based IPO reform across A share markets (apart from STAR, ChiNext and BSE) is also indicative of Beijing’s efforts to support the nationwide economic recovery in the post-pandemic market, via widening direct financing channels, according to two Chinese financial sponsors.

Such a move comes as the country is working hard to efficiently funnel capital into less profitable but more tech-driven businesses, which is in line with the national objectives on industrial upgrades, transition to renewables and other clean techs, as well as technological breakthroughs, they said.

Investors might find hidden champions within the traditional business services segment, in areas such as maintenance, repair, and operations (MRO), as the business services segment is characterized by high customer retention and requires solid management skills on the part of the operator, according to the Beijing-based PE investor.

Domestic M&A would probably outperform cross-border M&A in 2023, given the challenging macro-economic environment as well as overseas regulatory hurdles which occur in more industries and countries, mainly due to the stiff US attitude towards Chinese buyers.

Outbound pickup driven by diversification needs

Cross-border deal opportunities is expected to increase within the renewable energy space, as there is a window of opportunity for Chinese companies to expand overseas against the backdrop of the energy crisis in Europe, according to Zhao. This is a great time for companies to enter the European and US markets through investments, mergers and acquisitions (M&A). Companies can quickly build up and localize their service capabilities, he noted.

Meanwhile, dealmakers are constantly on the lookout for cross-border investment opportunities, but this is driven by the challenges of investing and exiting in China, as well as the need for diversification, rather than the overseas assets themselves being attractive, noted the Beijing-based PE investor.

For USD funds, it is hard to compete with the CNY funds in terms of policy-centered sectors like hard technology sectors, according to a Shanghai-based investor from a USD buyout fund, shifting focus towards overseas markets for a diversified exit option.

Against the backdrop of US-China trade tensions, Chinese investors would spot more opportunities in Europe, the Middle East and South America, according to the investor from a state fund. Targets with leading technologies, especially those that have successfully employed and integrated AI, IoT, big data, automation with their existing businesses, would attract investors, in both domestic and cross-border M&A domains. 

Mergermarket reported a list of Chinese companies seeking outbound investments in the last six months.

Chengdu Hi-tech Development [Gao Xin Fa Zhan; SHE:000628], a Chinese state-owned construction service provider, stays on the look-out for global M&A targets to diversify into its newly developed power semiconductor business. Its M&A radar will cover countries and regions where the power semiconductor technologies have been well developed, such as Japan, Germany, Switzerland, and other European countries.

Zhejiang Supcon Technology [Zhong Kong Ji Shu; SHA:688777], a China-based industrial process control solutions provider, scouts for acquisition targets primarily in European countries and Japan to shore up its global presence. It is specifically looking for targets in the UK, Germany, France, the Netherlands, and the Nordic region.

Zhejiang Jiuzhou Pharmaceutical [SHA: 603456], a Chinese active pharmaceutical ingredients (API) product and CDMO service provider, is seeking bolt-on buys in Europe, the US and Canada for market expansion.

Porton Pharma Solutions [SHE:300363], a Chongqing-based Chinese medical contract research organization (CRO) and contract development and manufacturing organization (CDMO), is scouting for bolt-on acquisitions in Europe for global expansion.

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