As multinationals grapple with numerous global challenges they are still showing significant commitment to their medium- to long-term China investment plans. While the volume of Foreign Direct Investment (FDI) will increase, driven by demand and policy improvements, we are starting to see the early signs of a notable shift in approach. Groups will aim to balance their China exposure to global HQ by committing more resources from local operations, using creative deal structuring, and financing China for China, says Eduardo Morcillo.

• Investment projects in China (both organic and inorganic) by multinationals are not being affected by the international geopolitical situation. Quite the opposite, we see multinationals doubling down with their M&A transactions at pace.

• Such a high level of commitment is linked to China’s medium- to long-term drivers. Specifically, most international corporations expect China to become the first or second global market for them within this decade, and they feel comfortable about the predictability of the policy goals and the continuous deregulation trends in most industries.

• In the short-run the recent Covid situation in China is perceived by many international acquirers as an opportunity, due to an expected dip in China asset valuations. This is triggering a doubling down in some groups that are aiming to close their deals within the incoming low valuation cycle.

• In the medium-term, 80% of multinationals are planning to commit increasing levels of FDI into China in the next five years, making it one of their top three destinations of capital. 

• However there is growing concern at global multinational HQ about an overexposed China factor in their global balance sheets. InterChina thinks that during the next three to five years we will witness a shift in how international groups engage and invest in the country, with a notable shift in approach.

• Reduction of exposure will likely imply a move towards more local financing, the use of new deal structuring mechanisms, and the re-emergence of Joint Ventures (JVs) and move away from a single source of supply at a global level.

Our age of huge geopolitical, social, economic and environmental change comes with great unpredictability. For individuals and businesses alike it attacks the fundamental pillars that we all reckon with.

In terms of the Chinese market today, three current and very live challenges serve to highlight this new norm. Namely the ongoing geopolitical tensions between the US and China, the Ukrainian conflict and possible implications for China, and the upscale of Covid-19 cases in China. Many executives at multinationals are, unsurprisingly, thinking about how they should respond to these specific challenges. In short, should they be de-risking and scaling back their Chinese investments, reducing their exposure and operations in the country?

At the moment they might be thinking about it but they are certainly not scaling back their operations on the ground. Quite the opposite. Based on our own corporate finance practice M&A pipeline and most recent inbound FDI reports – as well as on our most recent survey of 290 China CEOs of global groups - it is clear that multinationals are in fact doubling down with their M&A transactions at pace. As one APAC President of a global chemical multinational said to us:

“China will be the largest growth opportunity at scale in the world in the next decade…looking at some of our business units the Chinese market will grow at twice the rate of any other part of the world. We cannot afford not to be committed to this market.”

The reason behind this statement is clear, namely the long-term direction of China as a market. One which will create more than 100 million new middle class consumers this decade. And one which will eventually have more than 600 million middle class consumers, more than the US and EU combined.  

This simple but powerful principle is pushing 85% of our clients to say that China will be their first or second global market by the end of this decade. Almost two thirds said they were aggressively pushing to achieve scale and market relevance, while three quarters were looking to become “more Chinese” in a China for China approach in order to retain competitiveness. Some 73% where looking to do this via acquisitions and JVs to ensure enhanced speed and flexibility.

Little disruption to our own ongoing M&A Pipeline

Despite the negative effects of Covid and other tensions, we are not seeing a big impact - for the time being at least - on the commitment of corporates to their wider inorganic growth strategies. Checking all of our current pipeline of 30 plus M&A projects, none of them are currently being cancelled by the current global dynamics. As the CEO of one US listed company put it to me a few weeks ago:

“We do not let international geopolitics affect our China investments anymore. If we had to wait to have a predictable, global US-China ecosystem then we would lose completely our competitive advantage in this country.”

As for the Covid situation it is true that many M&A projects are suffering some temporary delays in terms of factory visits or due diligence implementation, but this is not stopping clients’ plans. So far, in the first three months of this year, we have closed one transaction per month. In fact, international companies are doubling down on buy-side transactions. They regard the impact of the latest Covid outbreak on the Chinese stock market (and reduced GDP growth) as a potentially good moment to acquire companies at a better price.

During the initial outbreak in 2020, acquisition multiples dropped below 10x EBITDA and, for the first year in a decade, acquiring companies in China became cheaper than in the US and the EU. That year, even in the midst of the first wave of Covid, we closed seven transactions.

In 2021 valuations came back to what we would describe as ‘normal dynamics’ (namely 10-14x EBITDA levels). That year we closed 12 transactions and this year we are already seeing a deceleration of price expectations. All the indicators (stock market valuation decline, delayed IPO processes, increased level of industrial consolidation) lead towards a reduced value set for many of the deals we are handling.

This positive sentiment towards inorganic growth is supported by recent comments that have personally been made to me from APAC Presidents and China CEOs who, like myself, are suffering the current lockdown in Shanghai.

Here is an example of what three companies had to say to us.

Case study one: A retail player

This company admitted to me that it was very difficult to plan in the short-term. However the long-term drivers - market growth, a rising middle class, the upscaling of demand quality and sophistication, and urbanisation growth – were all still firmly in place.

Therefore the group’s China strategy is to manage short-term risks while continuing its strategic medium- to long-term CAPEX initiatives. Here the company is going on the offensive, using its proactive roadmap to help shape the industry built around three core pillars.

Firstly, scale is very important and remains more so than ever. Secondly, it’s driving vertical integration to ensure supply chain reliability and lower costs (and margin protection). And thirdly, it’s investing in widening the gap with local premium competitors in terms of skills and competences. This means becoming very local but being part of a global multinational remains a key differentiator.

Case study two: A B2B tech industrial player

This company told me that its long-term commitment to China was not changing at all. As a global company, it needed to have global coverage, and this was simply impossible in its industry without China as it becomes the largest economy in the world. China is already its fastest growth market and forecast to grow at twice the rate of any other part of the world. So the question is not about whether to commit or not to China, but on how to ensure it keeps its commitment at the right level.

The company’s approach is centred around three streams. Firstly, developing its own China based IP is becoming critical, and its strategy is built upon China indigenous Intellectual Property (IP). Secondly, in terms of the political ecosystem, it needs to make sure it is aligned in terms of setting and influencing standards and complying with government direction. And thirdly, it is building the right balance between more domestic talent in its top leadership team while still keeping some core expatriates to monitor the localisation process and ensure that the resulting entity keeps the group’s DNA.

Case study three: A performance materials global player

This group told me that it was incredibly committed to growth in China, regardless of global geopolitics and short-term pressures. Again, it said this was linked to demand growth as in its industry China will soon become the largest market in the world and a leading global R&D centre. It said the whole supply chain in its segment was also reinventing its China model, building scale and fully integrating supply chains with new technologies.

However, it said its key success driver was not about growth, but about how to become more relevant in China. This is connected to both scale and brand awareness. Likewise another key part of how to become relevant is to align with government policy goals. This is a two-way relationship as, like many multinationals, it has much to offer the Chinese government in terms of the green agenda, helping achieve carbon zero, and environmental governance.

However, sentiment levels at HQ are growing more perplexed

In contrast with the fact that multinational groups are still objectively very committed, we are seeing in parallel a growing level of anxiety, lack of understanding and fear that some C-suites at global HQ are feeling. As one CEO of a global industrial equipment group told us:

“I am so confused about what is happening in our China operations. It has been two years since any of us at corporate HQ have visited the country and we see so many fundamental changes happening in China and our local team telling us we need to make big changes to remain competitive. All this in a context where everything we read in the press and we hear from our government is so negative about this country…. I just don’t know.”

This statement made just recently by a client reflects the major changes that are taking place across China, driven by both policy changes and the dramatic geopolitical shift from the west towards China since before the pandemic started. And I don’t think either of these two trends will change anytime soon.

On the one hand China will commit to its Five-Year Plan just announced in 2022. This plan is all about higher efficiency (better allocation of government funding, access to loans, more efficient stock market, and a significant push towards industrial consolidation), higher compliance (green China, carbon zero dynamics, environmental and security measures, higher taxation, etc), and corporate responsibility within a communist party model.

Most of these new plans are actually very good for China and the world. Specifically, multinationals will benefit from them since they are already global leaders on compliance and efficiency. Traditional Chinese competitors will be the ones which suffer more negative effects, since they will need to reinvent themselves at a high cost. The shift on domestic policy will create a completely new playing field where both Chinese and international groups will need to compete.

On the other hand I cannot see the US/China relationship improving any time soon. Despite the obvious economic benefits for both sides of increased trade between the West and China, geopolitical tensions – especially with the US – are casting a lengthening shadow. We have moved from President Trump’s ‘transactional negotiation’ agenda (rebalancing of trade, procurement of US goods by China, tariffs, technology and standards etc.) to a ‘values and principles’ agenda driven by President Biden which casts the debate around the Chinese political model, social order items, and national sovereignty issues.

In years to come I am betting on a ‘constructive decupling’ scenario whereby although competing geopolitical blocks generates increasing political tension, the West and China will still cooperate in terms of business, investment and joint concerns such as the green agenda and joint trade dependency areas.

A new dichotomy - very committed but increasingly worried

We are facing then a very interesting dichotomy at a corporate level. Multinational groups are clearly still very committed to China but, as the global decoupling drive evolves, they will be increasingly worried about their China exposure. From what I hear from our multinational clients they will still commit large amounts of CAPEX and investment in order to avoid losing access to the many new market opportunities in China. But they will soon start to look at exactly how they commit to the country.

It is still not exactly clear how this will take place, but here are some specific ways this can be achieved:

One: Local financing

Multinationals will increasingly try to finance themselves in RMB and position themselves in China for their China investments. Companies will try to balance out their global balance sheet exposure to China (to match their current ‘RMB asset’ exposure) by developing liabilities on the balance sheet in order to have a strategic hedge so that asset and liabilities are matched in case of a hard decoupling.

We will also see more local financing of investments either with retained dividends or local loans and bonds, while multinationals will also use local listings to raise RMB/local financing. Indeed, some of our clients are already looking at acquiring relevant minority stakes in listed entities, or at IPOs of some of their China subsidiaries on the local China stock market.

Two: Partnerships and new deal structures

Multinationals will look at doing more JVs, using partners to make sizeable investments or make a hedge on particular R&D investments. In such scenarios companies will partner with local champions and share the risk with them. It could also lead to agreements to acquire Chinese companies in stages, thereby creating a roadmap in terms of an acquisition strategy.

Multinationals and home-grown players could also work closely together on specific commercial contracts and engage in broader co-operation. And western players could also explore equity swaps with Chinese partners too.

Three: Supply chains

Multinationals will try to mitigate their dependency on China as a single source of supply. There will be a clear reconstruction of a “China for China” supply chain (much of our recent M&A is targeting this goal) while they will also have to find other global suppliers or invest closer to home to develop a second source of global supply. 

A difficult balancing act – a key success factor will be HQ and China team alignment

In summary, the onus is now on China country managers to develop China strategies that continue to demonstrate the necessary commitment to the market, while also managing the risk exposure to which HQ colleagues will be increasingly sensitive. Indeed, in our most recent survey of China based CEOs of multinationals, 80% mentioned that one of their top three challenges was to reach an improved understanding with corporate HQ. As one CEO of an electrical components multinational told us:

“None of our Chinese competitors have this problem…it is a real source of competitive disadvantage to us. Lack of alignment leads to slow response to market needs, delayed investments and, in some occasions, a complete lack of action on critical items.”

We are starting to see how international groups are gradually accepting this challenge and developing new practices. For example, InterChina has been actively involved in the creation of several China Advisory Boards, a new governance tool aimed at bridging the gap between HQ and local China operations. We have also seen a significant modification to talent recruitment and retention schemes in China, and connected to this point many groups are redefining their corporate reporting lines. As the China market demands more and more localisation, we are also seeing a resurgence of the role of a senior level expatriate.

When I look at the future for the business I lead and the companies we are advising, I keep on turning to the same fundamental principle. Put simply, everything we think we know will be different and much more dynamic in the future. We need to proactively define our own future, step into new playing fields, and reinvent how to be successful in this complex and large market.