China Newcomer Opportunities

The Dbriefs China Issues series presents:

Doing business in China:
opportunities for newcomers

Clarence Kwan, Managing Partner, U.S. Chinese Services Group, Deloitte LLP
Warren Clark, Partner, Deloitte & Touche LLP
Shelley Chia, Partner, Deloitte & Touche LLP

October 14, 2010

Agenda
• Emerging market opportunities
• Key success factors for doing business in today’s
China
• Case studies of typical market entry pitfalls in China

Copyright © 2010 Deloitte Development LLC. All rights reserved.

Poll question #1
What is your company’s China investment plan over the
next 6 to12 months?
• Pursue new investments in China
• No new investments in China
• Scale-back investments in China
• Pull out of China
• Don’t know/not applicable


Emerging market
opportunities: new
industries and services

China’s rapid economic ascent
China’s nominal GDP growth
(1978-2009)
$5
$1,200
Exports (US$B)
$1,000
(1980–2009)
$4 $800
China joins
$600
WTO
$400
US$ trillions

$3 $200
Deng Xiaoping’s
$0
―Journey South‖
$2
Launch of China’s
Open Door Policy
$1

$0

From 1978 through 2009, China’s average annual GDP growth
rate was 9.8% - 3x the global average
Sources: PRC National Bureau of Statistics, IMF, U.S. Bureau of Economic Analysis
1

U.S. investors have grown with China
After investing US$64 billion through 2008 (7.5% of China’s cumulative total
FDI) U.S. investors continued to favor China in 2009

Flow of U.S. FDI in China
U.S.$ billion
(2000–2009)
6 5.4
4.9
5 4.4
4.2
3.9
4 3.6
3.1 3 2.9
3 2.6

2

1

0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

U.S. FDI into China last year was US$3.6 billion — a 24% increase
over 2008 despite the economic crisis and the best showing since 2004
Sources: PRC Ministry of Commerce
2 Copyright © 2010 Deloitte Development LLC. All rights reserved.

U.S. SMEs are finding success
Despite less time on the ground than larger U.S. investors, many U.S. SMEs
reported profitable China operations during 2009.
Length of time in China Profitability of China operations (2009)

> 20 yrs.
Large loss
10-20 yrs.
6-9 yrs. Break even,
2-5 yrs. small loss
Profitable
< 2 yrs.
Very
profitable
SMEs Large companies SMEs Large companies

How can this success be replicated, especially with more uncertainty ahead?
Source: American Chamber of Commerce 2010 White Paper – survey of 388 U.S. companies with investments in China
SMEs = Small and medium-sized businesses, defined as those with fewer than 500 employees

Navigating risk in a land of opportunity

To create (and preserve) value in China, successful foreign
investors:

1. Seek to understand China’s business environment and anticipate
the direction of change
2. Adapt their strategy, structure, people and processes to the China
environment

4

What does China’s leadership want for China?
• A shift to a more sustainable development model
– Lessen dependence on exports by spurring domestic demand
– Promote service sector as an engine for job creation alongside
manufacturing
– Strive for “inclusive growth” (包容性增长) – spreading benefits more
evenly across urban-rural, provincial and regional divides
– Green, green, green
• Respond to the Chinese people’s desire to see China
achieve global standing commensurate with its growing
economic leadership

5

How will Chinese leaders try to get there?
A few examples
• Consensus-building – Harness the Five-Year Planning (FYP)
Cycle to build consensus around a sustainable growth path
• Targeted industrial policy – Revitalize old strategic sectors
while spurring the competitiveness of Chinese enterprises in
new ones
• Accelerated urbanization – Shift residential patterns to
improve access to employment and social services
• Recalibrated role in the global economy – Inbound FDI more
carefully vetted for alignment with balanced growth goals;
outbound FDI encouraged

6

Consensus - building
China’s 12th Five Year Plan takes form
Research

Drafting

Review & approval
Implementation
2009 2010 2011

October November 2009 March 2010 March 2011
2008 NDRC announced Premier Wen Final approval at 4th
2nd National that drafting of the submitted guidelines Plenary session of 11th
Economic 12th FYP is under to 3rd Plenary NPC
Census way, drawing on input Session of the 11th
launched from across China NPC for approval,
allowing drafting to
move to next phase
November 2008 Early 2010
Planning division of NDRC NDRC submitted
released draft outline of 12th guidelines for October 15-18, 2010
FYP State Council Review and approval of draft at 5th
approval Plenary Session of 17th the CCP
Central Committee
7

What we expect to see emerge this week
Consideration of the 12th FYP is the sole agenda item for this week’s four-
day annual meeting of China’s party leadership (Oct. 15-18)

12th FYP Policy Thrust Potential 12th FYP Targets

Accelerated urbanization Increase national urbanization rate from 47% to 52%
by 2015
Create an energy-efficient, low-carbon society 2015 interim goal to China’s public pledge to reduce
carbon intensity by 40-45% from 2005 levels by 2020
Reduce income disparities through regional Increase urbanization rate of Central China from
integration & specialization 40% to 48%; reduce energy intensity of Central
China’s economy by 25% from 2008 levels by 2015

Extend social safety net Universal basic healthcare coverage by 2020

Lessen reliance on global markets for growth; Increase domestic consumption to 50% of GDP from
achieve economic rebalancing 36% now

Source: State Council, NDRC, Chinese media, ACMR
8

Targeted industrial policy
Seven new strategic sectors unveiled in September 2010

• Alternative Energy
• Biotechnology
• Information Technology
• High-end Equipment Manufacturing
• Advanced Materials
• Alternative Fuel Cars
• Environmental Protection

Detailed industry support plans - similar to the 2009 revitalization
plans for 10 old strategic sectors - are expected before January 1st

Meeting the challenge of faster urbanization

100
Urbanization rates (1975-2030)
90 82%
80
Percentage Urban (%)

70
51%
60
50
47%
40
30
20
10
0
1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 2030
Year U.S. China Global Average

• Although cities account for just 3% of global surface area and 51% of the world’s
population, they consume 75% of energy and emit 80% of greenhouse gases
• China has 622 million urban residents today but is still just 47% urban - plans to
urbanize an additional 280 million Chinese by 2030 will place tremendous strains
on sustainability
Sources: Population Division of the Department of Economic and Social Affairs of the United Nations Secretariat, World Population Prospects: The 2009 Revision
and World Urbanization Prospects: The 2009 Revision, Chinese Academy of Social Sciences, China Daily

“Inclusive growth” – narrowing regional disparities

Heilongjiang
―Rejuvenate the Northeast‖
(October 2003)
Jilin

Xinjiang Liaoning
Inner
Gansu Mongolia Beijing
Hebei Tianjin ―Open Up and Reform‖
Shanxi (December 1978)
Ningxia Shandong
Qinghai
Shaanxi Jiangsu
Henan
Shanghai
Tibet Anhui 2008 East Northeast Central West
Hubei
Sichuan
Chongqing Zhejiang Population (m) and 480 109 355 365
Jiangxi as % of total (37%) (8%) (27%) (28%)
Hunan
Guizhou Fujian GDP (US$B) (% of 2,555 406 909 838
―Go West‖ Yunnan
total) (54%) (9%) (19%) (18%)
Guangxi Guangdong
(September 1999)
Average Per 5,908 3,665 2,551 2,405
Capita GDP (US$)
FDI inflows 86.2 12.0 16.5 7.9
―Go Inland‖ Hainan (US$B), and as % (70%) (10%) (13%) (6%)
(September 2006) of total*

The 12th FYP is expected to strongly emphasize regional development
Sources: National Bureau of Statistics, MOFCOM and local trade & investment promotion agencies


Poll question #2
Has your company begun to look at the implications of
the 12th Five Year Plan for its future plans to invest in
China?
• Yes
• No
• No, but we intend to
• Not applicable


Recalibrated role in the global economy
China as a major source of capital

Chinese outbound US$60 billion
US$ billions projected
FDI flows
60
(2002-2010)
50

40

30

20

10

0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
(Jan.-May)

Overseas FDI in financial sector Overseas FDI in non-financial sectors

By the end of 2009, China's cumulative overseas investment had exceeded
US$230 billion, up from just US$28 billion at the end of 2000
Sources: PRC Ministry of Commerce (MOFCOM), NBS, State Administration of Foreign Exchange (SAFE)


Align China’s objectives with yours
Share the same bed, and the same dreams
How will you leverage China’s future development
to achieve your business objectives?

• Where does your product/service fit in the 5-year
plan?
• Are you in one of the seven new strategic sectors?
– If not obvious, could you at least support these sectors?
• Will you invest in an “encouraged” region?
• Will you collaborate with a Chinese company to
expand your global footprint?
– Leverage partner’s local knowledge, financial strength, R&D
capabilities, and distribution network to expand market
coverage
– Relationship goes both ways

Success factors and
examples of typical market
entry failures into China

Poll question #3
Which of the following best describes the likely mode of
entry for your next investment in China?
• Wholly-owned greenfield/organic entry
• Minority stake acquisition
• Majority state acquisition
• Other forms of strategic alliance (joint venture etc)
• Not applicable


Deal-making in China - creating lasting value
Five Questions Companies
Should Ask

• At what point should we walk away from a deal?
• What is an acceptable price to both parties?
• How should the deal be structured?
• Does the deal present a compliance risk?
• How can the acquisition be integrated in to the global organization?


Potential deal breakers
War stories from our colleagues on the ground in China
 At what point should we
• Lack of integrity on the part of target’s walk away from a deal?
management • What is an acceptable
price to both parties?
• Disagreements over management • How should the deal be
control structured?
• Does the deal present a
• Inability to establish clear title to assets compliance risk?
• How can the acquisition
• Diverging expectations over price be integrated in to the
• Conflicting stakeholder obligations global organization?

• Case: A U.S. manufacturer acquiring an operation in Southeast
China realized that the target’s managing director had been making
large payments to a “non-existent” overseas consultant
– It was revealed that the “consultant’s” offshore account belonged to the
managing director


Pricing considerations
• At what point should we
• Availability of basic financial information walk away from a deal?
• Conflicting valuation  What is an acceptable price
to both parties?
procedures/methodologies • How should the deal be
• Contingent/hidden liabilities structured?
• Redundancies and non-core assets compliance risk?
• How can the acquisition be
• Sustainability of sales integrated in to the global
organization?

• Case: A European chemical company seeking to acquire a privately-
owned manufacturer in China found that no social security payments
had been made for its 3,000-strong sales support staff. This would
have potentially resulted in huge un-accrued liabilities for the acquirer.


Structuring and compliance considerations
Remember the “3 Cs” of Deal Structuring • At what point should we
walk away from a deal?
• What is an acceptable
Contain: Insulate the investment from hidden or price to both parties?
contingent liabilities associated with previous  How should the deal be
structured?
operations or from potential liabilities created
 Does the deal present a
during the transaction itself compliance risk?
• How can the acquisition
Comply: Ensure that the terms of the deal and be integrated in to the
global organization?
subsequent operations are in compliance with
pertinent regulations from the outset, both in China
and in the home country

Compete: Create a sustainable business model
that minimizes the net global tax position and
maximizes the flexibility of cross-border capital
deployment


Common containment mistakes

• Failure to detect legacy liabilities and adjust structuring
accordingly
• Failure to uncover improper related-party transactions
• Assuming unnecessary risk in a seller’s market
• Over-reliance on personal relationships
• Failure to assess the consequences of offshore payments
• Case: A U.S. firm purchasing a majority stake in a Chinese
consulting company was pleased with the three years of financial
data presented by the seller, but due diligence advisers found the
virtually flawless financial statements suspicious and recommended
searching further in the past
– It was revealed that the seller had enhanced the most recent accounts
and buried significant unpaid taxes in the preceding years
– The buyer avoided the tax liability by executing an asset deal rather than
an equity deal


Common compliance mistakes
• Following common business practices without a full understanding of
their legal basis
• Failure to recognize the potential for inconsistent regulatory
interpretation between local and state-level officials
• Failure to anticipate and adapt to changes in the regulatory
environment
• Ignoring industry-specific regulations
• Violation of foreign exchange rules
• Misunderstanding of circumstances under which a license can or
cannot be transferred
• Case: A Canadian enterprise sought to acquire the exploration rights
from a gold and platinum mining facility in southwest China
– After making payment, the buyer was informed by the central government that
the exploration rights were non-transferable
– The buyer was forced to invest an additional US$8 million to set up a joint
venture with the Chinese company

Common competitive positioning mistakes
• Failure to use an offshore intermediate holding company or
forming one in a sub-optimal jurisdiction
• Giving insufficient consideration to exit strategies
• Using legal entities that are incompatible with the business model
• Failure to capture specific tax incentives
• Failure to correctly estimate the long-term capital needs of the
China operation
• Inability to repatriate cash in excess of dividend capacity
Case: A U.S. firm acquired a contract manufacturing facility in Shenzhen to
do final product assembly for export
– The company’s structure was intended to minimize the Chinese tax burden but
they were precluded from selling directly in to the Chinese market
– As local demand products grew, the firm sought to sell domestically but to do so
they had to export and re-import its products, incurring customs and shipping
costs, thus making their prices uncompetitive vis-à-vis local Chinese competitors

Poll question #4
Which of the following issues strikes you as the most
significant challenge to pursuing a deal in China?
• Lack of transparency
• Legacy liabilities
• Management/Control issues
• Difficulty agreeing on price, including the valuation
method
• Regulatory/licensing issues


Deal-making in China - creating lasting value
People issues dominate the list of transaction headaches

Potential deal-breakers
• Lack of integrity on the part of target’s management
• Disagreements over management control
• Inability to establish clear title to assets
• Diverging expectations over price
• Conflicting stakeholder obligations

Pricing considerations
• Availability of basic financial information
• Conflicting valuation procedures/methodologies
• Contingent/hidden liabilities
• Redundancies and non-core assets
• Sustainability of sales


Putting people first - before the deal
Understand the stakeholder environment

1. Find out not only In China, these 跨  At what point should we
walk away from a deal?
who can make the individuals can be both
deal but who can inside and outside the 国  What is an acceptable price
to both parties?
break it. company. • How should the deal be
经 structured?
2. Learn everything Lack of management
you can about the integrity is one of the 营 compliance risk?
stakeholders in most frequent deal- • How can the acquisition be
advance. breakers in China. integrated in to the global
organization?
3. Secure a firm
mandate from your
This will help you to
negotiate with
以
top management, confidence in China’s 人
including clear unpredictable and less
“go/no go” decision than transparent M&A 为
points. environment.
本


Putting people first - during the deal
Establish trusting relationships

4. Negotiating in China Strong-arm tactics can • At what point should we

is not just about be effective but should
跨 walk away from a deal?
• What is an acceptable price
getting the best deal
possible but also
be applied judiciously.
国 to both parties?
 How should the deal be
building lasting 经 structured?
 Does the deal present a
relationships.
5. Trust takes time but If they trust you, you will 营 compliance risk?
• How can the acquisition be
once you have it, get the information integrated in to the global
organization?
nothing moves a needed to support your
deal forward faster. decisions.
以
6. You do not need to Be creative – Look for
be Chinese to get occasions where acting 人
what you want in like an American
China. advances your cause. 为
0
7. Better to
communicate too
But more importantly,
make sure you can trust
本
much than too little. your translator.


Putting people first after the deal
Transform relationships into lasting China value

• At what point should we
8.Signing the Use the relationships 跨 walk away from a deal?
contract is often you have established to • What is an acceptable price
just the beginning protect your China 国 to both parties?
of real negotiations value. • How should the deal be
in China. 经 structured?

9.Loyalties in China The best way to retain 营 compliance risk?
 How can the acquisition be
are more often to critical employees, integrated in to the global
individuals than to customers and organization?
companies. suppliers is to retain
key leaders. 以
10.Anything is Without the right
人
possible in China,
but nothing is easy.
people, nothing is
possible.
为
本


Join us on November 11 at
11 AM ET as our China Issues
series presents:

China Tax and
Regulatory Update

Contact info
Shelley Chia
shelleychia@deloitte.com.
+1 213 688 3232

Warren Clark
warclark@deloitte.com
+1 215 246 2503

Clarence Kwan
clkwan@deloitte.com
+1 212 436 5470


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