Latitude Capital Finds the Sweet Spot in China M&A
M&A Asia
2004-08-20

Latitude Capital's Focused Approach to China's M&A Middle Market Begins to Pay Off

Though obviously any large-scale transaction in China grabs the headlines, such deals are only the tip of the iceberg viewed from an overall activity standpoint.

The largest share of the total deals done are domestic intra-China M&A. But all of the players M&A Asia has talked to agree that there is little or no room for foreign firms to get involved in this area – at least at present. Pricing issues, for instance, remain a formidable barrier to entry.

On the other hand Hong Kong-based Latitude Capital Group, which offers boutique M&A services in the China market, sees increasingly promising prospects in the middle tier of the cross-border market, and for a variety of reasons.

The caveat would seem to be that it's important to be tightly focused. And that means being intimate with the PRC's rapidly-changing market segments, which in turn means being seriously experienced. And flexibly creative.

Broadly, the firm targets the technology, healthcare, consumer and manufacturing sectors. But that alone doesn't say much because, China being China, there are many peculiarities that have to be addressed before even an obvious opportunity can become a profitable reality.

Managing Director Frank Au says that two types of acquisitions are prominent at present.

Now that the country is well-developed in terms of export manufacturing, almost anyone overseas looking to move their manufacturing operations to a PRC platform can now be assured that pockets of South China and the area around Shanghai offer a ripe and ready ecosystem with good logistics and all the component supply levels needed to make an acquisition viable and fairly straightforward.

"Within that, what people really have their eyes on now is the PRC domestic consumer market, meaning they're targeting not only companies that have an established export manufacturing business, which gives international companies a certain level of comfort in terms of the work and product quality, but companies with an established China sales and distribution channel into the burgeoning domestic market," Au told M&A Asia.

Among the obstacles, regulatory issues rule. These include the substantial protectionism still in place in various industries, and therefore how much foreign ownership is allowed.

There are also legal question marks that overseas companies need to get comfortable with, centered principally on their inability to get 100% control in most cases.

"It's a level of operating risk because the rule of law is still not completely clear in China and is not as well defined as it is the international market," he says.

MO and Woofees
The offshore/onshore stratagem has become the preferred modus operandi in dealing with these considerations: the investor buys an offshore company which, in turn, owns what is called a WOFE (pronounced "woofee" in the trade; a Wholly-Owned Foreign Enterprise) which operates the business day-by-day.

The key to success here is a well-experienced international law firm. Their skills in creative structuring are key.

The classic case study occurred some years back when Sina went public. Because Sina was in the content provision business in China, an Internet Content Provider (ICP) license was required. The catch was that that could only be held by a domestic company. And while ongoing liberalization of such regulations is a fact, the structure created in Sina's case to overcome this hurdle is still valid; direct foreign control remains rare.

"The VC investors would typically invest offshore," he explains. "The WOFE ran the business, while the license was held by an affiliated PRC company (typically owned by the founder). The WOFE was then positioned to capture value from the PRC company via a series of management contracts and service contracts."

The bottom line is that the foreign company gets to work in the China market in an industry that, under the rules and regulations is supposed to be protected.

The advent of CEPA in Hong Kong has added an enticing new option to this formula.

This grew out of newly promulgated rules and regulations in the SAR, principally aimed at fostering closer relations and business ties with the mainland. What makes them valuable to offshore investors, especially in regulated industries, is that in buying a Hong Kong holding company, it becomes easier to eventually migrate and get all the necessary licenses, paving the way for full de facto foreign ownership and control.

"CEPA offers a level of accelerated development towards 100% direct ownership in China compared to other foreign/foreign jurisdictions," Au says. In other words, the investor is speeded to his destination on a more favorable political wind.

Another level of opportunity that Latitude Capital finds even more exciting is centered on Chinese returnees.

"These are basically more or less the top grads in China who did their undergrad at, say, Beijing University or Tsinghua University and then went abroad to work, many at multinational corporations. Since perhaps 1996 they"ve been trickling back bringing Western international management training and experience with them," he explains. "Because of their backgrounds, they've been able to attract venture financing because they provide potential investors with a higher comfort level as they have typically been educated in the US and/or worked in MNCs in both the US and China. There's a successful core of these people across different industries in place now in China, and they've founded a wave of thriving private enterprises across a range of industries including sales and distribution companies, technology companies, mobile value added service companies, e-commerce companies, and the like. Collectively, they've all tapped into the burgeoning middle-class consumer market, offering a range or products and services to China's new wave of consumers, especially those in the rapidly growing urban markets. And we think that is the most exciting segment in the Chinese marketplace at the moment, and that it will continue to be for some time."

The VC Connection
Latitude works to connect these businesses with international private equity and venture capital companies; Au reckons that such activity takes up about 50% of the firm's time. Or, when such entrepreneurs have built a successful company, the firm helps them sell it.

As examples, last year Latitude advised 3721, a leading Chinese keyword and search company, on its acquisition by Yahoo!, the latter's first in the PRC. It was also a transaction ranked among the top ten M&A deals in the country in 2003.

Perhaps just as importantly, it only took them four months start to finish.

More recently, in May of this year, the firm advised Zindart, a Shenzhen-based manufacturer of a wide range of plastics and die-cast products (best known for its "Corgi Classics series of miniature cars in overseas markets) on its disposal of Hua Yang, its non-core OEM printing and packaging division.

Commented Latitude Managing Director Alfredo Lobo: "We believe a major theme going forward will be for Chinese manufacturers to move up the value chain in owning and managing branded products versus just being an OEM supplier. As such manufacturers get more successful, they are less and less willing to just be the no-name manufacturer behind the scenes. They want to acquire technology and the brands they have historically served."

Au points out that this trend of Asian/Chinese companies looking for acquisitions abroad is still at a very early stage, however. Then again, the firm itself was only launched two and a half years ago. So their success so far – even if somewhat limited in actual dollar terms – is impressive.

That doesn't mean it's easy, though. There's a lot of buzz, a lot of talk about Asian/Chinese companies looking for acquisitions abroad, he says, but still a certain resistance among such companies, even those already listed in Hong Kong, to actually pull the trigger. That will change. And the fact a growing number of such companies are willing to pay for the talk, to pay for screens and due diligence, underscores this, as does Latitude's brimming deal pipeline. Also auguring favorably is the noticeable uptick Au sees in activity, and he expects that to continue into the foreseeable future. At the same time, he doesn't anticipate seeing many deals north of the $100 million mark. "We focus on deals between $10-100 million in size; and that's proving to be a real sweet spot," he says.

"My partners and I have extensive US and Asian M&A backgrounds," he notes. "But in this market there's not really a lot of public-to-public M&A deals. That's more of a mature market characteristic. Nevertheless, smaller deals still collectively represent an exciting, even ground-breaking, opportunity. There's no shortage of up-and-coming PRC companies looking for international investors, nor of businesses that have build a decent platform and want to be bought by a bigger MNC platform. Thereafter, the owners either stay with the business and manage it or move on and do it again."

Other kinds of opportunities, such as buyouts, while likewise presenting an increasing number of possibilities, Latitude leaves to others.

"That's a long cycle business, basically taking and privatizing an arm of an SOE – the hope being that you've found a gem within the larger group. But you've got to go through a series of restructurings, and separate your target from the rest of the SOE asset, which sometimes still include the local public works-related assets such as the local school system in the municipality; separating the business asset from the public works-related assets is one of the keys to creating a new viable profitable entity," he explains.

Though he doesn't say so, taking the approach Latitude is taking also minimizes the government interface, a prominent feature in most M&A deals in the country.

"We're fascinated by the growth in the number of classic Silicon Valley-type serial entrepreneurs we're seeing in the marketplace. We think the opportunity they represent is big, and we intend to stay focused on servicing this market."