Bonfires of the vanities

In recent wave of overseas acquisitions by Chinese Firms, business sense sometimes takes back seat

The recent purchase of the AMC cinema chain in the United States by Chinese movie-theater giant Wanda Group has set off a debate over the wave of outbound Chinese investments. They are being referred to as "vanity purchases", suggesting that some of these investments were driven by ego rather than economics.

According to a PwC report, outbound Chinese mergers and acquisitions reached a record high of $42.9 billion (34.7 billion euros) in 2011, a 12 percent increase over the previous year. To be fair, the largest sector attracting Chinese interests is natural resources, where the key players are the Chinese State-owned enterprises. Given the unquenchable demand for raw materials, fueled by China's unrelenting GDP growth, these acquisitions should be viewed as strategic, even if the SOEs have overpaid for them.

Some of the more notable acquisitions from the private sector, however, do raise questions. They seem the kind that could not be justified by return-on-investment analysis. Wanda's purchase of AMC is one such example. With AMC's poor financial performance and the rapidly growing Chinese film-exhibition market, one would think Wanda was better off investing that $2.6 billion in the home market.

Even the celebrated acquisition of IBM's PC division by Lenovo Group had its share of doubters. With a price tag of $1.75 billion, Lenovo, the Chinese PC manufacturer, inherited from IBM a money-losing business unit in an extremely competitive, low-margin industry. It was years before Lenovo was able to turn it around.

Vanity purchases are by no means unique to the Chinese though. Western companies too have long been plagued by poorly justified M&As that ended up losing money for shareholders. Rather than "vanity purchase", the term "empire building" is more commonly used to describe this phenomenon. The leading explanation for empire building is agency theory, which refers to the separation of ownership and management.

In a typical Western company, the people who own the company do not oversee its daily operations. For example, the Ford family owns a large chunk of the company that bears its name, but from CEO Alan Mulally downwards, the running of the company is left to professional managers. The separation of ownership and management came to be as the original founders retired, and their offspring either had no interest in joining the family business or were deemed incapable.

The Ford family was actually exceptional in this regard. For three generations after Henry Ford, the family was actively involved and represented in the company's management. Even so, management eventually became dominated by professionally trained outsiders.

Not that the separation was resented by owners, who got to enjoy the financial returns from the labor of skilled managers. The managers, in return, are rewarded if they make money for the owners.

But the interests of management and owners do not always align. By law, managers have fiduciary duty to the owners, which means that managers must act in accordance with interests of owners. In practice, however, managers are often the better informed of the two, and it is not easy to tell if they have shareholders' best interests in mind. If a company runs out of good projects to invest in, the CEO should return the excess cash to shareholders either as dividends or via stock repurchase. But the CEO has an incentive to put himself in charge of an ever-bigger organization, with an ever-bigger budget (hence the term "empire building"). The result: CEOs often find ways to justify acquisitions that end up destroying shareholder value. According to a Wharton study, more than 50 percent of M&As fail to create value for shareholders.

The conflicting interests between owners and managers are central to understanding Western management theory and practice. In China though, the market economy is at a stage where the first-generation entrepreneurs are still at the helm. In other words, the Chinese Fords are still running their companies. The agency theory fails to explain how these owner-managers would blatantly commit capital inefficiencies: it is their own money that they are throwing into poorly conceived projects. So some other force is at play here.

The more obvious explanation is that what appears to be vanity purchases are made under a false sense of value creation. The most common reason for acquisition is access: brand, technology, management expertise and distribution network.

Lenovo bought IBM PC for its premium brand, R&D team and global distribution network. Wanda bought AMC for its real-estate locations. In both cases, the thinking seemed straightforward: these are value-creating assets desirable to any ambitious companies.

Value creation through access, however, is quite often a trap. The first thing they teach in an MBA strategy class is "never make an acquisition where a contract would do". In other words, do business with them, but don't buy them. License their technology, buy their products, partner with distributors, but don't acquire them unless you are absolutely sure you can do a better job than the current owners.

The prevailing Western business theory favors specialization, where each company occupies a unique place in the value chain. The assumption is that specialization leads to greater efficiency. More likely than not, the acquirer is better off being a business partner than an owner. And if the deal does not make sense between partners, it will not between owner and subsidiary either.

Such thinking led to the specialization of Western companies. Apple does not make its phones. It leaves that to Asian manufacturers. Instead, Apple focuses on what it does best: product design and marketing.

Asian companies, in contrast, tend to grow into conglomerates - entities that hold a large variety of unrelated interests. This is most obviously manifested in the Japanese keiretsu and Korean chaebol. Hyundai, the largest South Korean chaebol, is internationally known as a car manufacturer. But it also has some 60 other subsidiaries, with interests in construction, chemicals and financial services.

The existence of such gigantic conglomerates is puzzling to Western business theorists, who argue that they cannot compete with more specialized companies. But recent research revealed some advantages of Asian conglomerates. In an environment lacking a mature capital market and contractual enforcement (as found in the early days of Japanese and Korean economies, and in present-day China), these business "empires" are able to reduce communication costs, leverage their premium brands, and withstand external shocks better. In other words, "empire building" actually makes sense in such a business context.

Given the choice between ownership and partnership, it is perhaps the Asian mentality that pushes Chinese companies to opt for the former. Perhaps what we are seeing as poorly justified outbound Chinese acquisitions are simply the Asian business practice carried overseas.

In the end though, the Chinese owner-managers are playing with their own wealth. We may criticize their financial analysis or their Asian-style empire building, but as founders of their companies, they only have to answer to themselves. If they enjoy the prestige from owning foreign subsidiaries, who are we to say they should not do it.

The prestige translates into real value too. In China, there is a considerable halo effect surrounding a global brand. A perceived global brand will have an easier time securing deals, attracting talents, even winning favors from the government, which is always looking for national champions to promote. The overseas acquisitions may be vanity purchases indeed, but the vanity comes as much from the owner-managers as from all of Chinese society.

The author is co-founder of demohour.com, China's first crowd funding website. Contract the writer at hefeng@demohour.com. The views do not necessarily reflect those of China Daily.

(China Daily 08/10/2012 page10)