Shanghai’s Xiang Yang fabric market is a fascinating medium in which to watch the financial equivalent of speed dating. Foreign business people and tourists flock to the market in search of a bargain. On a recent and particularly sultry autumn day, an American businessman was set to do battle against a shrewd middle-aged Chinese shopkeeper. He was negotiating a price, she was negotiating value. After five exhausting rounds, the deal was closed. He walked away satisfied with his price, a 40 per cent discount. Our veteran negotiator happily pocketed 300 per cent above her best price. Both were winners in the value game, or were they?
Like so many procurement negotiations, a focus on price ignores much of the value creation. Over the past 20 years, many companies that made their reputations and fortunes from supplying leading brand names now compete fiercely in the same market space. Think Microsoft and IBM.
China is a market in which the value game is played with abandon. Vast flows of foreign direct investment (FDI) come in search of a bargain. Agile Chinese suppliers flourish with the influx of capital. There is no doubt value is being created. Yet one report suggests that as few as 5 per cent of foreign investments are profitable accounting for their cost of capital. That is a fifth of the M&A success figure of 23 per cent reported by Forbes for US Mergers & Acquisitions in the 1990s. So who is winning the value game in China?
Motorola recently learned the IBM/Microsoft lesson from so long ago. As reported in the New York Times, Ningbo Bird Company, originally engaged by Motorola as a contract manufacturer, is now a fearsome competitor. Motorola negotiated price, Ningbo acquired the value by way of both capital and experience. Motorola joined a long long list of companies who won the price game but lost the value game.
Entrepreneurs Without Capital
To understand why such loss of value occurs, it is useful to understand the motivation of the Chinese enterprise. China has a long history of entrepreneurialism and trade. With the progressive liberalization of the economy, state owned enterprises (SOE) are highly motivated to raise foreign capital and seek international growth. But why is foreign capital so important when there are already significant levels of capital in the economy?
Simply, Chinese managers’ shareholdings are illiquid. In the migration from SOE to private enterprise, the managers were granted shareholdings. However their shareholdings are effectively useless until there is some form of foreign liquidity event (cash). And with such a liquidity event, all too frequently the cash flows directly outside the intended investment to management, related companies or ultimately to new competitors who quickly take the existing customer base. In the absence of any long-term goal, the first liquidity event is the reward that management has been waiting for. It is their exit strategy. The delivery of the promise of capitalism, so to speak. Being entrepreneurial at heart, that capital is often the foundation of a new venture where management takes their skills, key employees and customer base to execute for their own pocket. A competitor is born.
The Chinese are great entrepreneurs and executors. In a supply relationship, a different type of investment takes place. A supply contract invests both intellectual capital and economic capital. Products, processes and management are enhanced within the supplier to enhance the quality of supply. A natural and worthy goal in any strategic supply relationship. As the Chinese are masters of their own market, these improvements can provide the impetus to break through in the domestic market. Ultimately this often serves as a protected platform from which to launch into foreign markets. And thanks to brand association, quality is now associated with the product.
Both classes of investments in China are prone to leakage due to poor controls and enforceability issues. These challenges are immense: poor transparency, related companies, transfer pricing arrangements, fictional assets, innovative rental agreements, and the list goes on. Just finding out what the directors really do and which other companies they have stakes in can require the assistance of a talented private investigator. Real due diligence, even for a supply contract, really requires getting inside the Forbidden City. Focus only on price at your peril!
Battle on Foreign Soil
In China you are truly fighting a battle on foreign soil. Sun Tzu, the famous fifth century Chinese strategist articulated it succinctly. “Of all the 36 strategems – to know when to walk away is the best.” The Chinese know this well. Your challenge in China is to find a mechanism to minimize capital and value leakage yet harness the great Chinese entrepreneurial spirit. Or just take Sun Tzu’s advice and walk. With five per cent odds, you can do better in Vegas.
What we know in western markets about entrepreneurs holds true in China, we need to harness and enhance their enthusiasm to drive to a bigger goal. They definitely have the talent and capability to get there. That bigger goal must have an equally bigger reward for the entrepreneur to remain motivated and dedicated. As investors, we must recognize the limitations of the entrepreneur/company in management and accept them for the capabilities they have and build the competencies they lack.
With capital injection also comes the opportunity and responsibility of making a bigger goal achievable. Our challenge is to find the mechanisms to minimize short-term leakage of capital and direct the investment to achieving its desired outcome. This requires both an education process and a clear understanding of the objectives and values of local management.
What Motivates Chinese Managers?
So what motivates Chinese managers? Probably the same things that motivate you. They value education and have a passion for learning. They seek financial security and independence. They want to be recognized and respected by their peers and by the market. The Chinese build trusted networks of peers and employees and actively seek ways to collectively build business and value together. One mechanism to access value and motivate Chinese management is to set a goal of international IPO. If it is not on your agenda, you can be assured there is a significant chance it is on theirs. And given that your supply contract or capital investment may be a driving influence in its success, you should structure to access that value. After all, driving prices down too far will only destroy a good supplier. Collaborate and the rewards of IPO can be significant. Best yet, your cost of entry to the shareholding can be exceptionally low if you structure it correctly up front. A balance of art and science.
From Chinese management’s perspective, international IPO achieves three core goals:
- Gives great face to management.
- Provides a clear path to significant personal financial rewards.
- Ensures greater personal development opportunities.
From an early investor perspective it achieves three core goals:
- Harnesses and motivates entrepreneurial drive.
- Provides access to future value, capital growth and financial returns.
- Achieves product/production objectives.
While it is a mind-shift to move away from traditional acquisition or supply relationships, this approach acknowledges and addresses some of the control risks and accesses future value creation. And if you are a large buyer, whether you realize it or not, you are largely contributing to and controlling the valuation of the IPO. Think about it, you are building a better supplier, protecting your investment and generating an exceptional return with minimal risk.
Aligning Behind IPO
If you are looking to invest in or acquire a Chinese company, chances are your interest in the company is driven by their execution to date. Chinese management know their market and are generally great executors. However, usually management reporting and financial control is rudimentary at best. CFOs/finance managers are usually non-strategic and stick to accounting for the past rather than driving the future. If you are taking a stake in a Chinese enterprise, it pays to develop a game plan to enroll management in your vision for the company. One of the key competencies you can bring to bear is financial expertise.
In driving an IPO outcome, there are three primary drivers of valuation: return on invested capital (ROIC), growth and risk. What is critical is to educate your partner on what the benefits are of achieving your goals together. So it is incredibly important Chinese management understands how personally they will lose value from their own shareholding for every dollar that is misallocated. Success is driven by developing mutual trust and respect through action. If you can set a clear path with achievable goals and accountabilities based on competencies, chances are you will be in the successful five per cent rather than the 95 per cent of losers. You may well end up with the most mutually profitable strategic supply relationship you have ever created.