Principles of Management

China Corporation

Chinese firms have traditionally been reticent to invest overseas. There has traditionally been resistance to such activities, and Chinese managers knew little about competitive markets. Moreover, Chinese firms have long had fantastic opportunities for both growth an M&A in their own country. The merger between Lenovo and IBM in 2004 marked the beginning of a new era in Chinese external direct investment. This paper examines the issue, with respect to both the opportunities and the challenges in Chinese direct investment abroad.

When Chinese computer maker Lenovo acquired IBM's personal computer business in 2004, the transaction sent shockwaves through the West (Hamm, 2005). It had long been identified that Chinese firms had competitive advantages in the production of electronics, being able to combine modern technology with low costs of labor and land, but until that point Chinese firms were not viewed as viable global entities. Indeed, Chinese crossborder M&A activity had been small scale, averaging just $3 million per venture (Taylor, 2002). The Lenovo move was one of the first instances of a Chinese firm acting like a player on the global business stage. Merger and acquisition activity for Chinese firms had been held primarily to the domestic markets, and smaller markets throughout the ASEAN region.

This paper addresses some of the issues with regards to Chinese firms engaging in such activity, using the case of Lenovo's takeover of IBM's personal computer unit to illustrate key points. For all of the opportunities that Chinese firms have as they increase their size and scope, there are considerable problems as well. These include issues of management talent and of the use of equity in M&A transactions. These issues have so far stunted the growth of the M&A market, with firms both internal and external placing emphasis instead on strategic alliances (Xu, Bower and Smith, 2004). Recent figures indicate that Chinese firms are investing overseas at a much more rapid pace in the past couple of years.

Chapter 1: Opportunities and Problems

With the rapid growth of some of China's major industrial concerns, the time has come for these firms to expand overseas. The natural first step is to begin selling overseas, then to perhaps set up subsidiaries. However, it is inevitable that Chinese firms will need to expand via mergers and acquisitions.

China has become a capital surplus country (Wong & Chan, 2003) and as such, has looked to find places to invest its capital. The nation's foreign direct investment still outweighs its outward flows dramatically, but for the largest Chinese firms, there are significant opportunities throughout Asia and even around the world. China moved into the top five home nations for foreign direct investment in 2004-2005, replacing Japan (Schuller & Turner, 2005).

As China's firms stockpile capital, opportunities abound. Indeed, outward direct investment on the part of Chinese firms would be beneficial to the global economy, restoring balance by reducing savings rates.

There are three main problems with regards to outward M&A activity in China. The first is size and structure of the Chinese domestic market. Chinese industry is generally fragmented, with competition in any given sector conducted among dozens if not hundreds of small and medium sized enterprises (SMEs). The Chinese market, therefore, is ripe for consolidation, which has been identified as the number on trend in the Chinese M&A industry going forward (Fuhrman, 2009). If Chinese firms are focused on domestic consolidation, that will leave little money for external direct investment.

The second main problem with regards to outward M&A activity in China is the level of management talent. This was a concern among observers in the Lenovo-IBM deal, for example. While IBM had previously outsourced its production to Lenovo, the latter had outsourced management and marketing to IBM. Now Lenovo executives were being asked to manage a vast multinational empire, and had to commit themselves to bringing on IBM talent in order to ensure success of the venture (Hamm, 2005). Lenovo was a unique case, too. Few Chinese firms have had the access to Western-caliber managerial talent, and have had to rely on talent from Hong Kong, Taiwan and other overseas sources. The Chinese education system has simply not been able to keep up with the demands of its rapidly growing economy (Ma & Trigo, 2008). As such, Chinese firms are in a poor position to expand internationally, in particular to the West, as there will naturally be questions with regards to the ability of domestic Chinese management to add value to a Western-fun firm and its shareholders.

China's cash surplus, in particular that of foreign capital, has allowed those Chinese firms wishing to engage in overseas M&A activity using primarily cash. This helps Chinese firms overcome the difficulties associated with using Chinese equities to conduct deals. Chinese companies trade in a two-tiered system of domestic stock markets ('A' Class) and international class ('B' Class). In 2002, foreign investors were allowed to trade A shares, improving the liquidity of Chinese equity considerably. However, Chinese stock markets are hampered by a number of factors -- poor regulation, lack of IPOs, high barriers to entry, governance issues, and lack of liquidity (Green, 2003). Although Chinese stock markets have made strides towards improvement, they are inferior in many respects to Western markets. In addition to $650 million in cash and payments for $500 million in liabilities, Lenovo also financed the IBM deal with $600 million in equity (Jennings, 2004), but this was only made possible because Lenovo was listed on the Hong Kong exchange at the time, not Shanghai. Listing on developed, liquid exchanges is vital to the use of equity in M&A activity outside of the domestic Chinese market, until the Chinese equity market is fully modernized and becomes more liquid.

Chapter 2: The West's acceptance of Chinese capital

The Lenovo-IBM case hinted at many potential problems with respect to Western acceptance of Chinese capital. There is natural skepticism about Chinese managerial talent -- most companies simply leverage that nation's structural competitive advantages whereas Western firms have had to succeed more on the basis of managerial acumen. There was also skepticism at the time with respect to the culture gap (Hamm, 2005). Chinese business style can be vastly different than American. If M&A activity between two U.S. firms can cause serious cultural disconnect to the point that the benefits of the merger are never realized (for example, the FedEx acquisition of Kinko's) then the hurdles are inherently much greater for a Western firm about to come under Chinese management.

Westerners lack familiarity with Chinese business practices. Chinese leaders tend to have a paternalistic leadership style, in contrast to most American managers (Farh & Cheng, 2000). This and other distinct characteristics of Chinese culture and leadership style can make the prospect of Chinese management difficult not just for Western firms but for Western shareholders as well. The culture clash can provide too significant an obstacle to overcome.

In addition, the Chinese view of value in M&A activity differs significantly from the Western view. In the west, value is driven by systems, processes and synergies. In China, value is driven by relationships. Therefore, it is important to maintain those relationships post-merger, or the deal will lack value (Carpenter & Wyman, 2009). These two differing views on the rationale behind mergers are at odds with one another -- Western and Chinese understanding of this difference can make Westerners hesitant to accept Chinese overtures.

National identity is always at stake as well. In the wake of the Lenovo-IBM deal and bids for Maytag by Haier Corp. And for Chevron by Chinese oil giant CNOOC, Western media was awash in fear of a Chinese corporate takeover of the West (Business Week, 2005). These fears echoed sentiment expressed a decade or two earlier with respect to the Japanese, and also echo sentiment levied to an extent at Middle Eastern nations with a fondness for acquiring property in the West and a penchant for developing dominating airlines.

Perhaps the most important concerns for Westerners relate to structural issues within the Chinese economy. Chinese firms can finance their M&A bids with zero or low interest loans from the Chinese Central Bank, a fact that disturbs Western firms. Their argument is that if the cost of capital is zero, then how can they be sure that the deal genuinely adds value to either party? Every deal looks good when free money is being used. Moreover, there are significant concerns with China's transparency, or lack thereof. Reporting requirements are weak, and most Chinese firms have complex relationships with multiple levels of government, to an extent not seen in the West and not trusted by Western managers and shareholders (Antkiewicz & Whalley, 2006).

Chapter 3: Lenovo-IBM Case Study and Lenovo's Strategy

The Lenovo acquisition of the IBM personal computer business represents a valuable case study in Chinese M&A activity in the West. It represented the first wave of M&A activity, and today outward direct investment has increased dramatically in China. In 2008, outbound M&A activity grew 64.4% to $47.8 billion, up from $29.l billion in 2007. This growth can be seen to represent the increasing interest of Chinese firms in acquiring resources, technology and brands outside of their own country (Carpenter & Wyman, 2009).

Lenovo was able to seal the deal essentially by acting like a Western firm. It did not approach the deal from the same perspective as say, the way that CNOOC did with its unsolicited bid and ultimately failed bid for Chevron. Lenovo had a strategic alliance with IBM prior to the deal, so that the latter's management and shareholders understood the strategic value of the deal. For Lenovo, it was able to maintain relationships with IBM, including taking some of its talent back to China with it.

Lenovo traded on the Hong Kong exchange, giving it the transparency needed by Western investors. Moreover, this also lent liquidity to Lenovo shares, allowing them to be used in the deal. Furthermore, Lenovo was a large company that through its deal with IBM already had a sizeable international presence. While China's hundreds of thousands of SMEs may not be able to seek foreign M&As, Lenovo was among the handful of Chinese firms large enough, and with sufficiently significant presence in both the domestic and international markets, to execute such a deal.

Despite the differences in business cultures, Chinese firms expand overseas for the same reasons that Western firms do -- to acquire strategic capabilities, to offset competitive disadvantages and to leverage their strengths in overseas markets (Rui & Yip, 2008). The Lenovo deal was focused on resource-driven acquisition of strategic capabilities. The resource-driven perspective on Chinese M&A activity shows that Chinese firms engage in activities in part to acquire resources they lack -- in the case of Lenovo they wanted some of IBM's marketing and managerial talent, having already earned IBM's production capacity (Deng, 2009).

Lenovo's strategy was driven by the need to acquire this talent. They had already leveraged their competitive advantage in production to win IBM's business, but had prior to the merger allowed IBM to manage the Lenovo and IBM brands in the U.S. Recognizing that its future was in moving beyond low-cost production and therefore required an increase in managerial competency, Lenovo made the deal to acquire managerial talent in addition to U.S. market share. To do this, Lenovo took advantage of its prior relationship with IBM, the liquidity of its stock, and its abundant supply of cash, spending some $1.1 billion on the acquisition. The main deterrent to the deal with the lack of managerial talent at Lenovo, so the acquisition of U.S. talent not only was a strategic benefit to Lenovo but helped to assuage U.S. investors and IBM management who may have had skepticism with respect to the deal.

Chapter 5: The coming age of Chinese MNC

As reported, the cross border M&A activity of Chinese firms increased dramatically in 2008. Although the domestic market is expected to be the focus for Chinese M&A over the coming years, savvy Chinese firms are using their substantial capital bases to make an increasing number of overseas acquisitions.