Foreign direct investment (FDI) in China has seen a decline throughout 2012, and while Chinese investment overseas is growing, it remains cautious, and in some cases, not always welcome. In this piece, Jack Perkowski looks at investment, both in China and Chinese investments abroad, to give us a better picture of where the money is.
When I was in the auto business, the statistics published by the Chinese Government said that there were approximately 2,500 components companies in the country. Those of us in the industry, though, knew that this number only counted the firms that were registered with the government and vastly underestimated the number of companies actually making auto parts. We referenced a number more like 20,000 when thinking about the competitive landscape, but knew that this also was most likely a vast underestimation. Taizhou, a small city in ZhejiangProvince, once ran an advertisement in the local newspaper saying that there were more than 8,000 auto components companies operating there alone!
Every industry in China is similar in that way: the number of companies competing vastly exceeds the official figures provided by the government and also the number of firms that one might expect to find in the same industry in a more developed economy. Estimates of the business population are all over the map, but Ted Fishman, author of China, Inc., once told me that there are over 85 million private companies in China. That means that every industry in China is extremely fragmented. The sheer number of companies that operate in any industry is one of the reasons why the China market is so competitive.
The venture capital and private equity industry in China is no exception. China had more than 10,000 venture capital and private equity firms at the end of 2011, according to Liu Jianjun, an official in the department of fiscal and financial affairs at the National Development and Reform Commission (NDRC). Those companies managed nearly RMB 2 trillion (USD 313.9 billion) in assets according to Liu.
Officially, however, the NDRC reported recently that there were 882 venture capital and private equity firms registered with the NDRC at the end of 2011, a 34.3 per cent increase compared to 2010. The NDRC also reported that the value of assets managed by these 882 firms had increased by 41.5 per cent to RMB 220.7 billion (USD 34.6 billion) at the end of last year. In other words, the number of officially registered venture capital and private equity firms in China, and the amounts that they manage, are most likely less than 10 per cent of the actual business that is being done in this space today.
Whatever the numbers, the private equity business in China is already large and is growing rapidly. Size and rate of growth are not the problems. The biggest problem by far is that there is too much money chasing too few deals. Every major private equity firm around the world wants to invest more capital in China, while China’s strong economic growth means that more and more capital is being accumulated in the country. With China’s stock exchanges in Shanghai and Shenzhen still in an early stage of development, private equity and venture capital are natural outlets for the growing pools of capital that are springing up all over. A shortage of good deals, not a shortage of capital, is the key issue.
In the competition for deals, international firms like The Blackstone Group LP that have active programs in China have an advantage due to their global networks and reputations. The local firms, however, can act faster and have more exits available to them in China.
Both types of firms are disadvantaged by the fact that debt financing is hard to come by in China. Therefore, deals have to be financed with all equity, lowering returns in the process, and narrowing the list of potential investments to companies that are growing fast enough to generate the returns required by private equity investors.
Who’s winning the private equity battle in China?
In the opinion of many, homegrown firms such as Beijing-based Hony Capital Ltd investments are gaining market share at the expense of their international rivals. According to the Asian Venture Capital Journal, investment by Chinese firms rose to USD 7.8 billion in 2011, exceeding for the first time the USD 7.4 billion invested by US and other foreign funds.
Moreover, RMB-denominated, private-equity funds have raised USD 41 billion in the past two years, more than double the US dollar amount in China. The shift to investors using Chinese currency has resulted in a 45 per cent drop in investments by foreign funds in 2011, even though the value of private-equity deals has doubled since 2009.
While China poses many challenges for firms trying to make investments in the country, the development of the venture capital and private equity industry bodes well for China’s small and medium-sized enterprises (SMEs). For years, SMEs have been deprived of capital by China’s financing infrastructure, which has mainly consisted of a handful of large, state-owned banks that only knew how to make loans to other state-owned enterprises. With so many international and Chinese investors now looking for good companies in which to invest, the availability of capital for SMEs will only increase in the years ahead.
At the same time that good money is looking for better deals in China, China is finding that even the money it can offer to ailing businesses in struggling economies is not always welcome. Opposition to Chinese ownership of raw material or energy businesses has occurred in several countries, scuttling deals that may have gone forward with different potential buyers. However, one bid made earlier this year could provide a working formula for such deals in the future.
Earlier this year, CNOOC Ltd, China’s largest offshore oil and natural gas explorer, announced that it had agreed to pay USD 15.1 billion in cash to acquire Canada’s Nexen Inc in the biggest overseas takeover by a Chinese company. The price tag that CNOOC put on Nexen represented a 61 per cent premium over the company’s stock market value the day before the offer. Nexen’s board recommended the deal to its shareholders, but the deal is still subject to regulatory approval.
CNOOC’s announcement immediately brought to mind the company’s failed USD 19 billion bid for Unocal Corp in 2005 that was blocked by strong political opposition in the United States, as well as the more recent failure of a USD 40 billion hostile takeover bid by Australia’s BHP Billiton Ltd for control of Potash Corp of Saskatchewan Inc. In 2010, Canada’s Prime Minister, Stephen Harper, rejected BHP’s bid saying it didn’t provide a net benefit to the country. It was only the second rejection of a foreign takeover in Canada in 25 years.
Clearly CNOOC has learned a great deal since Unocal. In the Unocal transaction, CNOOC was competing with Chevron Corporation, a US company, for control of Unocal, while the bid for Nexen is a negotiated deal that is uncontested and has the full support of the company’s board of directors. Also, CNOOC has gone out of its way to reassure management, and the Canadian government, that Nexen will remain a Canadian company. CNOOC said it will list its stock in Toronto, keep Nexen’s employees and make Calgary its North American headquarters. The latter should help deal with the wild card of provincial politics in Canada.
Apart from these rather significant differences with the Unocal transaction, though, CNOOC’s bid for Nexen has a more fundamental difference that also distinguishes it from the proposed takeover of Potash. The Nexen transaction involves a company from a ‘consuming’ country (China), purchasing a company from a ‘supplier’ country (Canada). By way of contrast, Unocal involved a company from a consuming country (China), purchasing a company in another consuming country, in this case the United States. Similarly, the Potash transaction involved a company from a supplier country (Australia) trying to take over a company from another supplier country (Canada).
In Nexen, the interests of the two countries involved can easily be seen to be aligned, while it’s much more difficult to see alignment in either Unocal or Potash. In Unocal, the countries represented by the companies involved are in head to head competition for oil, while in Potash, the countries involved are competing for markets.
The respective leaders of large consuming nations such as the United States and China are understandably concerned about their country’s ability to have continued access to the natural resources needed to keep their economies growing. That’s why America’s dependence on imported oil is a constant theme in political campaigns.
It’s also why China, as the biggest energy consumer in the world and the second-biggest consumer of oil, has been snapping up resource assets across the globe.
However, supplier countries like Canada and Australia that have large stores of natural resources, but relatively smaller populations and economies, are most concerned about finding long-term, stable markets for their products. Developing and selling more of their natural resources is their path to prosperity.
Canada has the world’s third-largest oil reserves—more than 170 billion barrels—after Saudi Arabia and Venezuela. Daily production of 1.5 million barrels from the country’s oil sands is expected to increase to 3.7 million by 2025. Finding a reliable market for this output is one of Canada’s key concerns, and developing China as a long-term customer is a prime objective.
Moreover, CNOOC has an incentive, as well as the financial wherewithal, to accelerate development of the oil sands as well as Nexen’s Canadian shale gas prospects, boosting investment and tax revenues in the country. In this context, it’s easy to understand why the Nexen deal is likely to receive regulatory approval.
Canada’s essential problem is that the United States market currently absorbs approximately 97 per cent of the country’s oil exports. As any businessman will agree, having one large, important customer can be a big asset for any company. It also represents a key vulnerability, as Canada saw first-hand when the Obama Administration rejected the Keystone XL pipeline, which would have taken oil from Alberta to the TexasGulfCoast. Harper remains determined to build a pipeline to Canada’s PacificCoast where tankers can then be filled to supply needs in China and Asia.
It’s no coincidence, therefore, that Harper visited China to discuss oil sales and other economic ties shortly after US rejection of the Keystone pipeline. In February, Harper headed a delegation of 40 Canadian business leaders to China. While in Beijing he met with President Hu Jintao, Premier Wen Jiabao and other top Chinese officials.
Harper’s visit to China highlighted Canada’s determination to diversify its energy sales. Chinese, state-owned companies have invested more than USD 16 billion in Canadian energy over the past two years, and Chinese state-controlled Sinopec has a stake in a proposed Canadian pipeline to the Pacific Ocean that would substantially boost Chinese investment in Alberta oil sands. Overall, trade between China and Canada surged to almost USD 50 billion in 2011.
If anything, the failed bid for Unocal in 2005 taught CNOOC not to ‘fight the tape’. Deals for critical natural resources such as oil will come much easier if they are done with companies in countries whose interests are more naturally aligned with those of China.
Read Jack Perkowski’s blog at www.managingthedragon.com.