DON’T BE OVERSHADOWED
How Asia’s CFOs can extract the most value from a minority stake.
By Don Durfee

Last summer, as San Francisco-based UCBH Holdings looked for ways to raise capital, Chairman Tommy Wu received an intriguing suggestion from his bankers. Instead of raising money through the debt or equity markets, would he be interested in teaming up with a strategic investor from China?

The idea appealed to the bank’s management, which had recently bought a small Chinese bank in Shanghai (the first acquisition of a Chinese bank by a foreign buyer) and needed money to cover those costs. UCBH owns United Commercial Bank, a Chinese-focused bank that is interested in expanding its ties with the Middle Kingdom.

Merrill Lynch, UCBH’s advisor, brokered a meeting between Wu and the chairman of Minsheng Bank, a private-sector bank based in Beijing. The meeting was a success. “They hit it off immediately,” says Richard Gibb, the Hong Kong-based Merrill Lynch banker who oversaw the deal. “There was very good chemistry between both chairmen, which was crucial to the transaction. They literally had the terms of the deal cut within three weeks.” Securing regulators’ approval required another several months.

Wu had intended to sell only 5 percent of the company, just enough to satisfy his immediate funding needs. But inspired by the prospect of ties to a larger Chinese bank that could help UCBH with its U.S.-China trade finance business, he agreed to a bigger deal. To start, Minsheng will buy 4.9 percent of UCBH, and then increase that stake to 9.9 percent, with the option of eventually owning 20 percent, subject to UCBH’s consent and regulatory approval.

“Minsheng has a very bright, aggressive management,” says Jonathan Downing, UCBH’s EVP and director of corporate development and investor relations. “We could not be more thrilled. The opportunities are too many to be imagined.”

Downing says the banks are discussing joint loans, ATM sharing, and the use of Minsheng’s distribution network so that UCBH customers can wire money to relatives within China. During the first phase of investment, a Minsheng appointee will join UCBH’s board and during the second, Tommy Wu will become a Minsheng director. The Chinese bank will also send some executives to join UCBH’s management team to learn about how the American bank does business.

Tying the Knot, Sort of

The Minsheng-UCBH tie up is just one example of an accelerating trend: Asian companies buying minority stakes overseas. Over the past six months, ICBC has bought 20 percent of Standard Bank in South Africa, China Development bank bought 3.1 percent of Barclays, and CITIC and Bear Stearns have bought stakes in each other, just to name a few. It’s happening in other industries too: aluminum producer Chinalco, for instance, recently teamed up with Alcoa to buy 9 percent of mining multinational Rio Tinto for US$14 billion (the purchase comes as rival BHP Billiton is battling for control of Rio Tinto). Japanese and Indian companies have also been pursuing minority stakes in overseas companies.

Is the optimism accompanying the deals justified? Minority stakes have certain advantages. They are less controversial, easier to put together, and arguably less risky than a full acquisition, since the comparatively small sums involved mean less damage should the deal unravel.

But there are shortcomings. By being easier to put together, it’s more likely for a buyer to step into an arrangement without fully thinking through the strategy. A minority shareholder may be just one quiet voice among many, with little influence. Partnerships such as those envisioned by UCBH and Minsheng are notoriously hard to pull off.

“Minority stakes are often a second-best solution,” says Holger Michaelis, a partner with the Boston Consulting Group in Beijing. “It’s no different for Chinese companies.”
Second-best or not, it’s a strategy that isn’t going away—indeed, bankers say it will be the preferred form of Chinese cross-border M&A, at least for now. How can companies make the most of it?

One Tactic, Many Goals

The minority deals are Chinese companies’ acquisition style de jour, despite their formidable war chests and ability to buy companies whole cloth. The three biggest Chinese banks alone have US$60 billion available from their IPOs. And companies in many overseas markets are cheap, at least in relative terms. That’s especially true in financial services, where the subprime crisis has pushed the index of U.S. financial services companies downward 30 percent in only six months.

But recent history has made would-be predators tentative. Chinese and other foreign buyers attempting deals in the United States and Europe have faced fierce opposition. The most prominent case was the 2005 attempt by CNOOC to take over American oil giant Unocal, a deal that fell apart after a dust-up in the U.S. Congress. Minority investments are less likely to stir up a political firestorm. (It’s no guarantee, however: Witness the current political battle over Huawei’s minority investment in 3Com.) They may also help calm nerves in target companies. “Often, Chinese buyers aren’t seen as transparent, their strategic goals are not clear and the capabilities they bring aren’t clear,” says one China-based consultant. “A minority stake may not raise so many concerns among the staff of the target. You can first let the waves settle and then maybe later increase your stake to increase influence.”

The desire to avoid regulatory hurdles is another incentive. In the United States, for example, regulators are required to review any purchase of over 10 percent in a financial institution. Bankers say that it’s unlikely that U.S. federal regulators will let a Chinese bank control an American depositary any time soon, given their concerns about China’s banking system. And in China, regulatory authorities have told banks that they aren’t ready yet to manage the integration of a global financial services institution.

Chinese managers may share that opinion. “Almost all Chinese companies lack prior overseas M&A experience,” says Qiao Liu, a professor at the University of Hong Kong and a specialist in M&A. “They know there’s a danger in attempting a whole takeover. It is safer to use small stakes to get some experience with overseas transactions and learn about overseas markets.”

In their public and private statements, the Chinese buyers also stress that these investments are a way of learning how to do their business better. It’s a major goal for CITIC Securities, which swapped US$1 billion stakes with Bear Stearns in October. “We want to enhance our ability in product innovation, as we see growing demand from our customers for wealth management,” says one CITIC executive who asked not to be identified. Other areas of focus for the Chinese banks include risk management, IPO support, and specialty and project finance.

There is also the hope that investments can help lay the foundation for collaborations of the type UCBH and Minsheng are discussing. Other goals can include preempting competitors who may be looking to acquire a target and paving the way for a company’s own eventual acquisition of a target.

A Minor Key

These aren’t simple goals. Not surprisingly, companies have historically had trouble achieving them. In the 1980s and ‘90s, for example, several European banks bought minority stakes in each other in hopes of creating a platform for collaboration in anticipation of a single European banking market. For example, in 1996 Banque Nationale de Paris and Germany’s Dresdner Bank swapped small stakes and mapped out plans for a joint business in Eastern Europe, among other places. Credit Lyonnais and Commerzbank attempted something similar.

At the time, the deals were hailed as visionary. Before long, however, they had fizzled and the partners had agreed to terminate the collaborations. “It never turned out to be a competitive advantage on a European scale for the banks,” says BCG’s Michaelis. “It’s hard to get things like this to come to fruition.”

Some avoid minority deals as a rule. One is Karsten Eller, the China-based vice president of M&A for BASF. The German chemicals maker has no minority investments in China, although it does have a number of majority-owned joint ventures, which are mostly legacies from a time when Chinese regulations required a JV for foreign operators.

Minority investments, particularly in the context of a JV, are something to avoid, says Eller. “I’ve spoken with colleagues who have only a 20 percent stake in a company and who aren’t represented on the board for some reason,” he says. “They have no practical influence on the day-to-day goings on at the company or on the strategy. You have to ask what the benefit is.”

But many have succeeded with minority stakes. This is true in high-tech and pharmaceuticals, where minority stakes have long been an accepted way of placing bets on technologies and scoping out possible takeover targets.

Consider the example of Ranbaxy Laboratories, the US$1.4 billion Indian pharmaceutical company. Since 2006, the company has taken minority positions in three Indian medical technology companies. In some cases, the goal was to take a step into a business area that’s just outside of Ranbaxy’s core focus. The first of these was a US$4.3 million investment in Zenotech Laboratories, which specializes in oncology medications, an area where Ranbaxy doesn’t yet have a strong presence. In October, the company announced that it would boost its stake in Zenotech from 7 percent to 45 percent.

“That one-year period was like a courtship,” says Amitabh Gupta, Ranbaxy’s vice president of M&A. “It helped us understand the competencies of that company and grow comfortable with its management.” Ranbaxy will market Zenotech’s oncology drugs overseas.

A separate investment in Krebs Biochemicals & Industries is intended to cement an operational agreement. Krebs had excess fermentation capacity and was losing money because of it. “Their capacity fit exactly where we needed capacity, so instead of spending US$15 million building it ourselves, we spent US$2 million on a small stake. Now we are using them as a contract manufacturer,” says Gupta. Ranbaxy could have signed a contract without the investment, but the 15 percent stake entitles it to a board seat. “This makes us more comfortable when we deploy proprietary technology in their facilities.”

Beyond the strategic attractions, there are other reasons this strategy makes sense for Ranbaxy. Minority investments require little senior management time. The business development team tracks down possible investments, handles the negotiation (with top management approval), and takes care of the relationships until the business decides it’s something it wants to focus on. The investments are also low risk, since the sums are small and the stakes are easy to exit. The three companies Ranbaxy has invested in are publicly listed—if Gupta wants to sell out at any point, he can.

It’s a delicate process, though. A single board seat allows little control. “We are just relying on one vote in a six-member board to help us in corporate governance, for example, or to get the information we need,” says Gupta. And without full control, partner relations require some finesse. “Generally speaking, these entrepreneurs don’t want to sell out. So it’s important to give them a feeling of comfort that you aren’t going to take over the company. So we don’t ask for too much.”

Furthermore, to the extent that such deals are strategic, a dealmaker has to think about them strategically. “You should be absolutely clear as to what you are doing and why, and what the long-term road map is,” comments Gupta. “The road may have forks—at some point you can go left or right or straight. But the option of roads in front should be very clear.”

The Search for Clarity

The complexities of a small stake in a biotechnology firm are compounded for a multibillion dollar chunk of a global bank. Do the big Chinese acquirers possess this degree of clarity?

The University of Hong Kong’s Li is doubtful, saying that many of the deals look more opportunistic than strategic. “When Chinese companies negotiate with foreign firms, they tend to bargain hard on price,” says Liu, who previously worked for McKinsey advising Chinese companies on corporate development issues. “But you have to negotiate the whole deal—if your purpose is to learn about risk management, then you have to put that into the agreement. I don’t think a lot of these companies are aware of that.”

Indeed, say bankers, compared with the financial stakes that Western banks bought in Chinese companies a few years ago, the current deals are less finely negotiated. When Spain’s BBVA invested in CITIC in 2006, says Gibb of Merrill Lynch, “they spent months negotiating and devoted reams of paper to the kinds of joint ventures they might do together. The China outbound deals are less paper intensive.” Accordingly, the contracts have also been negotiated and signed much faster.

To the extent that this reflects a determination to get on with business, that’s positive. This could be the case for Minsheng and UCBH, whose leaders share “a common vision and similar values,” as UCBH’s Downing puts it. But as the companies work through the particulars of their collaboration, certain details, such as the precise roles of the managers that Minsheng will send to its American partner, remain vague. Similarly, with other recent Chinese minority investments, a simple letter of intent is all that defines the post-investment collaboration.

Ambiguity doesn’t bode well, however. Akhil Gupta (no relation to Amitabh Gupta), joint managing director of Bharti Airtel, the Indian mobile communications company, is a veteran of many minority investments made into his company. “These deals can run into major trouble if there’s no clarity on what the nature of the investment is,” says Gupta. “You have to be clear about what rights you are getting and what role you are expected to play. Is the investor expected to play any kind of role in terms of management or supervision? Or are they only entitled to receive some reports?”

In the deals that Bharti has worked out with its investors, including SingTel and Warburg Pincus, that clarity has yielded good results, according to Gupta. “We have always insisted on this clarity on what the roles and rights are,” he says. “Once that’s done, thereafter on an informal basis they’re very willing to extend a helping hand.”

A related risk for the Chinese banks is strategic. These companies have cash to invest, but just because prices overseas are cheap doesn’t mean that the investments make sense. In particular, if those investments come at the expense of focusing on their domestic businesses, that price could be too high, says Nick Palmer, a Hong Kong-based partner with Bain & Co. “As Chinese banks think about the reasons for expansion activities, they have to balance that with the opportunities and challenges that remain at home,” he says. “There is still a lot of work the banks need to do to optimize their operations and reach the full potential of their domestic customers, particularly in the face of increasing foreign competition.”

Furthermore, there is more growth happening in China than in Western markets. “There’s a clear logic for foreign banks to invest in Chinese banks because that’s the new growth front,” says Palmer. “It’s less clear for Chinese banks investing internationally, because most international markets are growing slower than China.”

There are other reasons to invest, of course, and learning from the target company is one high priority. Knowledge transfer can be arduous and time-consuming, however. Again, the investments made by Western companies into the Chinese financial sector may be instructive. When GE Money invested in Shenzhen Development Bank, for example, one of its goals was to improve its partner’s skills in areas ranging from risk management to product development. GE sent a cross-functional team to work at the bank, organized educational sessions, and worked closely with its new partners on a handful of specific projects, such as launching a new credit card (see “Mix Masters,” April 2007).

Short of something so extensive, there are other steps Chinese companies should consider. One is to secure a seat on the board. “Once on the board, the director should get himself on strategic subcommittees, for instance, joining the risk management committee,” says Liu. “You can get hands on experience by working with the other directors.” Additionally, argues BCG’s Michaelis, being on the board can help establish the close working relationships necessary for learning. “You have a natural reason to always go back and meet and discuss strategic matters,” he says.

Such exposure may be useful for getting a picture of how companies operate at the highest level. It may be less helpful for learning operational details. But once an investor has enough of a stake to earn a board seat, says Michaelis, it’s more feasible to create some of the arrangements that will put lower-level employees in direct contact with their counterparts at the target company. “If you have an equity stake, it’s much easier to say ‘I’ll send 20 people over who will just sit behind your guys and learn how you do things,’” he says. “It’s harder if you just have a cooperation agreement without the equity.”

But be careful not to wear out your welcome. “Some minority investors, because they have a significant stake, start interfering with the working of the company,” says Gupta of Bharti Airtel. “That’s fine if you’ve already agreed to it. For example, sending three people for a few days each quarter to meet with people is manageable. But when it comes to subsequent demands, these kinds of things can be very troublesome.”

Will Asian buyers gain all they hope to from their minority investments? It’s too soon to say. “The jury is still out on many of these transactions,” says Michaelis. “If anything, it’s a practice round. It’s an opportunity to acquire M&A skills and practice thinking about corporate governance of overseas targets.”

If that’s the case, it will be an expensive lesson. But it’s cheaper than the likely alternative—full scale acquisitions that don’t quite live up to expectations.

Don Durfee is managing editor of CFO Asia. Additional reporting by Wu Chen.