The price is….. right? M&A Valuation in China

Friday, August 21, 2009 1:14

- Guest Post by Jay Boyle (Founder and Managing Director of Expat CFO)

In a New York Times DealBook article run earlier this week, “Tunneling to True Profit in China,” Mark Dixon, a founder of M&A consultancy the1.com, details some of the trials and tribulations he faced in arriving at usable accounting information on a recent trip China-side. His story would be all-too-familiar to any manager or financial professional who has tried to find a practical application for accounting data kept by private companies in almost any emerging or frontier market—or indeed, by private companies in general. Private companies keep books for tax purposes. Period. Publicly-traded companies in China are also on IFRS; non-public companies tend to keep their books in the tax GAAP described by Dixon. Some of the gems from the article that would certainly apply to any due diligence or valuation I have seen in China:

“Generally Accepted Accounting Principles are not generally accepted in China. This is partly because the Chinese have their own accounting rules and partly because rules are for breaking. And it’s not just that the companies are trying to confuse the tax authorities. It’s that, when they do so, they end up also confusing themselves.”

“Someone who behaves like a traditional, polite accountant will never find out the truth. One needs to use both carrot and stick. The stick is ‘Your business looks surprisingly unprofitable.’”

“Every stone I turned over seemed to reveal not a single spider but countless additional stones…”

Dixon also includes a formula for normalizing an income statement that is actually pretty good addition to any due diligence checklist (though I would stop short of calling it a “formula,” as I do not believe it to be anywhere near exhaustive).

The article ends, however, with the two sides reaching an impasse on price:

“Now we were ready for the hard part: the price of the business. […] Having understood the figures, I was ready with the answer. ‘We can give you 10 P/E,’ I said. ‘In other words, 10 times [normalized profit].’ […] Indeed, it turned out what he wanted was 10 times […] the actual cash they got from the business tax-free, or what could politely be called the pragmatic profit. The problem was that pragmatic profit multiplied by 10 came to almost 20 times [normalized profit]. It wasn’t even worth negotiating.”

It is possible that it was one of those deals that was never meant to be no matter what (or is still ongoing—the author never explicitly declares the deal as “dead”), but Dixon’s account of what I think is a frequent problem immediately conjures up two important points for closing deals in China—one relating to negotiating strategy and the other to the analytical tools we select for valuation in radically different markets.

FIRSTLY, the point on negotiations: the number one “soft” point for anyone involved in any aspect of communication on a deal from either side should be expectations management.

Business owners: Decide whether you want to build your business for exit or simply want it to give you a regular paycheck. If you want to sell, you need to put the infrastructure in place—if your books are a mess, you would do well to be proactive about communicating this. VCs and angels invest in family businesses with messy books all the time—indeed, good financial management is part of what their investment brings to the table. Investors can fix sloppy books (restating of financials is an integral part of any good pre-due diligence), however they shy from secrecy. Any doubts will find a way to their offer price at the negotiating table.

Buyers: Communicate early that your intention is to value the sustainable (i.e. fully compliant) company—and that this is the purpose of the normalization exercise. Before deciding whether to proceed, targets should be explicitly told that you have no intention of placing a value on special arrangements or “guanxi.”

The target should appreciate that there are very good reasons for the buyer to want this, that this is not merely a negotiating tool, nor is it a case of some paranoid foreign zeal for what is proper. It may be useful here to restate the obvious, if only to have a few talking points at the ready should the target desire explanation:

1. Different standards: Foreign firms in China are held to a higher standard by local and national authorities of all stripes. You will be under a magnifying glass.

2. Exit, exit, exit: If the target is acquired by a PE or VC firm, the books *will* be made official. No fund will accept a haircut on exit for something as silly and correctable as bad books. Nor will a corporate acquirer allow the target to continue to use its own, less accountable, accounting system merely because “it is China.”

3. Staying power: Many local companies exist purely due to some form of local protectionism or their place in a patron-client network. One example we have come across was a well-connected software company that looked great precisely because its sales were buttressed by the local government’s insistence that every company in its jurisdiction purchase the software. Guanxi is not a business model: at best, it is fleeting and, at worst, it implies substantial contingent and off-balance sheet liabilities. Any sales or exemptions that a company receives due to special relationships should be stripped and implicit liabilities should be adjusted for. This goes to the heart of normalizing financial statements: capturing what is truly reoccurring and repeatable.

SECONDLY, while *about* accounting data, the article begs the larger question of what, if anything, is different about valuing a company in China and what approaches are the most sound. Rather than “Tunneling to True Profit in China,” what most acquirers are actually after is “Tunneling to True Value in China.” Other than saying that a P/E multiple is used, the article does not go into great detail on the exact methodology applied, and I am in no position to comment on this deal in particular. I can, however, say generally that, after putting considerable time into a careful due diligence or modeling exercise, many acquirers go on to select questionable comparables and ultimately come up with a valuation that makes little sense. The best way to check this is to concurrently use intrinsic methods (such as a DCF) to value, and then cross-check—this is more labor-intensive, but ultimately can save a lot of hurt. In fact, I usually prefer to lead with my DCF number and use the multiples-based valuation as the reality check.

If one is set on relying on multiples, however, the devil is in the comparables. Many valuations conducted in China are of small- or micro-cap private companies, and the best comparables for these would be thinly-traded, small-cap (or at least not large-cap) companies with a similar product mix, selling in similar markets and based in another emerging economy with a similar credit rating and growth trajectory. A large-cap S&P-traded company from the same industry is simply too different. If the contemplated stake is not a controlling one, then, ideally, the comparable companies should also be thin floats.

Just as important is, perhaps, the basis selected: i.e. if the accounting data are in question at all, why not use a “cleaner” multiple, such as times cash or times sales? The P/E multiple is a tricky one in this case, as the “E” is still questionable (with differences in depreciation between countries and much more room for error on a normalization) and the “P” is often based on a much more liquid company, traded on a major stock exchange, so additional adjustments have to be made to account for the illiquidity discount.

In fact, although the article did not say whether or not an adjustment was made for illiquidity, for a small, private company with difficulty attracting buyers due to compliance issues (and the one in the article would seem to fit this description), an illiquidity discount might even make up most of the difference between the 10x and 20x prices.

Main article: http://dealbook.blogs.nytimes.com/2009/08/17/another-view-shanghai-ed-profits/?emc=eta1

Illiquidity discount: http://pages.stern.nyu.edu/~adamodar/pdfiles/papers/liquidity.pdf

Guanxi: http://www.allroadsleadtochina.com/2008/10/27/an-inside-look-into-bribery-in-china/

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