The gap between stock market valuations in the US and China, on a price-earnings basis, are wide. The average trailing p/e in the US now is 14. On China’s Chinext board, it’s 45. For fast-growth Chinese companies, the p/e multiples can exceed 70. This will give Chinese acquirers leeway to use this “p/e arbitrage” to pay a higher price in M&A deals for a US business. In the best cases, a dollar of earnings may cost $10-$15 to acquire through purchase of a US business, but that dollar is immediately worth $50 or more to the Chinese firm’s own valuation.
Twenty years ago, similar strategy of p/e arbitrage helped fuel a temporary surge of Japanese M&A deals in the US, including Matsushita’s purchase of movie studio MCA and rival Sony’s purchase of Columbia Pictures. That activity fizzled after Japanese stock prices began to slump. At the time, a relative handful of Japanese companies scouted deals in the US. In contrast, the number of Chinese companies actively looking for M&A deals in the US will likely be much higher, and they will stay active at it for far longer.
This is equally true for Chinese companies already quoted on the Chinese stock market as well as those with that ambition. Indeed, for reasons unique to China, the incentive is stronger for private companies to engage in p/e arbitrage by buying US companies. In China, public companies generally are forbidden from doing secondary offerings, nor can they use their own shares to pay for an acquisition. When a Chinese public company consolidates a US acquisition’s profits, its overall market value will likely rise. But it has no way to capitalize by selling additional shares and replenish the corporate treasury.
For a private company, the larger the profits at IPO, the higher the IPO proceeds. An extra $1 million in profits the year before an IPO can raise the market cap by $50-70mn when the company goes public on the recently launched Chinext board of the Shenzhen Stock Exchange. Private Chinese companies, unlike those already public in China, can also use their shares to pay for acquisitions. The better private companies also often have a private equity investor involved. The PE firms can be an important source of cash to finance acquisitions, since it will juice their own returns.
In M&A, the best pricing strategy is to swap some of my overvalued paper to buy all of someone else’s undervalued paper. At the moment, some of the most overvalued paper belongs to Chinese companies on the path to IPO in China.
As a generation of financial research has shown, most M&A deals end up benefiting the selling shareholders more than the buyers. That’s because the buyers almost always fail to capture the hoped-for savings and efficiencies from combining two firms. Too often, such synergies turn out to be illusory.
For Chinese acquirers, p/e arbitrage will increase the likelihood of an M&A deal paying off – if not immediately, then when the combined company goes public.
If the target company in the US has reasonable rate of profit growth, the picture gets even rosier. The rules are, a private Chinese company will generally need to wait three years after an acquisition to go public in China. As long as the acquired US business’s profits keep growing, the Chinese companies market value at IPO will as well. Chinese acquirers should do deals like that all day long.
But, as of now, they are not. One reason, of course, is that things can and often also go wrong in M&A deals. Any acquirer can easily stumble trying to manage a new business, and to maintain its rate of growth after acquisition. It’s tougher still when it’s cross-border and cross-cultural.
Another key reason: domestic M&A activity in China is still rather scant. There isn’t a lot of experience or expertise to tap, particularly for private companies. Knowing you want to buy and knowing how to do so are very different beasts. I’ve seen that in our work. Chinese companies immediately grasp the logic and pay-off from a US acquisition. They are far less sure how to proceed.
The best deals will be Chinese acquiring profitable US companies with a large untapped market in China. This way, the Chinese company gets to consolidate the US firm’s current profits, and can then roll out the US businesses’ products in China’s fast-growing domestic market.
China business has prospered over the last 20 years by selling things US consumers want to buy. In the future, it will prosper also by buying businesses the US wants to sell.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.