After a long lead-up over the last few blog entries, we now turn at last to a discussion of the legal services market for Chinese outbound investment, including outbound M&A.
This is the market that everyone is angling to capture a piece of, but as hinted at in my prior blog entries, this market segment is still in the early stage of development, and as such workflows can be hit or miss and charging and collecting international-standard fees can be challenging.
Let’s return to the overview of Chinese outbound M&A presented at our London office launch event early in May. The slides are still available here.
It is useful first to consider the levels and types of outbound M&A activity that are coming out of China. According to statistics published by Thomson Reuters and PricewaterhouseCoopers (PwC), in 2011 there were a total of 207 outbound M&A deals, up 10 per cent from 2010. Of these, 42 per cent were in the energy/natural resources area, compared to 35 per cent in the industrials/consumer-related sectors. If you add high-tech deals (9 per cent) to the totals for industrials and consumer-related deals, then these achieve relative parity with the energy/natural resources deals at 44 per cent and 42 per cent, respectively.
This industry breakdown represents a significant shift from a few years ago, when according to other reports energy and natural resource investments comprised more than 90 per cent of all outbound Chinese investment activity. The current breakdown aligns closely with conventional wisdom, which holds that Chinese outbound investment tends to focus on two main categories: access to resources to fuel the economy, and brands, technology and channels to market for Chinese goods. In the past, access to resources dominated the China outbound investment scene, but now the non-resource side appears to have pulled even.
But there is an even more interesting statistic from the same Thomson Reuters-PwC report on deal sizes. Of the 207 outbound deals in 2011, only 16 had a deal value of more than $1bn, up from 12 in 2010. That is fewer than 8 per cent of the deals. Looking at it from the flip side, more than 92 per cent of the outbound deals can be classified as mid-cap deals. As it turns out, the small number of big-ticket deals, both in absolute terms and as a percentage of the total number of outbound deals, as well as the relatively small overall number of outbound deals, has a profound impact on the legal services market for outbound transactions.
To put it simply, there are more people chasing these outbound deals than there are deals. Almost all of the top New York/US firms are here, as are the magic circle and silver circle firms, together with another 50 or so of the ’aspirational class’ of international firms. In an outbound market dominated by mid-cap deals, which any one of a hundred or so firms could do, it is tough to find a differentiator, and a crowded market tends to drive down prices as each firm competes to buy-in some deals for its outbound CV.
Case in point: I am aware of one outbound deal for a top Chinese state-owned enterprise (SOE) that was put out to bid to four top London firms a few years back. The target had operations in half a dozen European countries plus a small US piece. The projected deal value would have put it near the top of the mid-cap range, at roughly several hundred million US dollars. An objective assessment would have suggested a total fee in the range of $1.5m under normal conditions. However, these were not normal conditions – it was in the immediate aftermath of the financial crisis and, just as importantly, it was a competitive bid that would be decided solely on price since it was abundantly clear that all four firms on the short list were more than capable of running the deal.
The winning bid came in at just above $700,000, with astonishingly low internal caps on due diligence and other early-stage work segments. The SOE general counsel, who is a friend of mine, knew that the winning magic circle firm could not make money on the terms offered, but that was not his problem. He knew the winning firm could and would do an excellent job, and as a relatively sophisticated consumer of high-end legal services he was not going to open up the cap unless the agreed scope of work in fact had been exceeded as an objective matter. In other words, it was not possible for the winning bidder to bid low, insert itself into the deal and then negotiate the price up later. It turned out that the deal in fact cratered after the due diligence stage and the ’winning’ firm probably ended up eating more than a hundred thousand US dollars in time costs, which is probably a conservative estimate.
Even more remarkably, this ’winning’ firm’s bid was not an outlier. The next bids were $800,000 and $900,000, respectively. Only one of the four bidders came in with a full-price bid. You can well imagine the internal discussions in each of these firms in respect of such a bid process. How much red ink is one willing to bleed now in hopes of developing a longer-term relationship with a top Chinese SOE that demonstrates no loyalty but will put every deal out to bid on a similar competitive basis? At what point in this ’relationship’ will you stop bleeding red ink and start to achieve more reasonable returns? But when you are bidding only on price against equally qualified competitors, what choice is there but to bid the price down? It is a very tough call.
With so few deals to chase, there is not the same market segmentation as in more developed markets. The aspirational class of international firms is, as a practical matter, boxed out of the super-premium deals such the Lenovo acquisition of the IBM PC business, but the top New York/US and magic/silver circle firms are all willing to move down market to pick up what would be considered mid-cap deals anywhere else.
In such a crowded market, everyone uses whatever edge they can find, and often that is ’guanxi’ or personal relationships. That is where the local Chinese lawyers at the top international firms have a real advantage over ’lao wai’ (foreigners) such as myself – they have a natural network of classmates, friends and friends of friends that they can mine to sniff out and chase down deal opportunities. Moreover, they can reach beyond the in-house law department, which does not have the final say in selection of outside counsel, to the senior management, which does. In some cases, these Chinese rainmakers are also solid deal lawyers, but in other cases they can simply hand the deal over to their more experienced colleagues and manage the relationship. In either case, this is a critical edge, the importance of which should not be underestimated. But by the same token, the network of contacts of any one individual has natural limits. China is a big place and no one knows all the key players.
Here’s an example of how this works in practice. While at Lovells I had built up some good will with the law department of a particular SOE, which put us on the short-list of three firms to pitch for a particular outbound deal. We thought we were in a very good position as we knew that one of the other two firms in fact had a conflict of interest and was going through the beauty parade simply to build relationships for potential future projects. The remaining competitor was a US firm with a smaller presence in a relatively newly established Beijing office. We had what we thought was a very strong and competitive bid in terms of price, experience and geographical coverage, but when the results were announced the deal went to the US firm. When we later enquired of our close contacts in the law department of the SOE client as to what tipped the balance in favour of the other firm, we were told that it was because the US firm “was such a famous law firm”! Obviously, this was a subjective judgment (with which we, of course, did not agree at the time), but it reflected the fact that the other firm had a senior Chinese lawyer leading the pitch who had developed ’guanxi’ at the management level of the company and not just at the law department level, and that proved to be the winning combination. (Epilogue: the US firm that won that particular bid was Hogan & Hartson, so if this bid had come up a few years later it would have been a Hogan Lovells bid rather than a Hogan versus Lovells bid)
The above examples reflect the practical realities in only one segment of the market. In both of the above cases the Chinese client was a relatively sophisticated China top-50 company, the target had its principal assets in North American and/or Europe and the deal value was in the upper end of the mid-cap range. This represents the sweet spot for the top international law firms: top-tier Chinese companies are more inclined to consider hiring a foreign law firm, particularly when the deal value is relatively high, and a northern hemisphere deal lines up more neatly with the existing geographical coverage of the vast majority of the top international firms. However, this in itself illustrates the two-fold challenge for outbound investment deals: for the deals falling within this three-pronged sweet spot, there are 50-plus firms with offices in China that will all be happy to pile on to chase the price down, but if you change any one of the above three prongs, which may be the case in two-thirds or more of all outbound investments from China, the competitive positioning of international law firms is subject to other market pressures and challenges.
Let’s consider each of the three prongs in order:
· Chinese companies outside the top 50. First the good news for international law firms: these target clients don’t get as much attention from international law firms so the competition is not as fierce. The bad news: they tend to be less sophisticated consumers of legal services and more cautious about fees. In fact, in some cases you need to spend so much time negotiating the fee arrangements that you are already in the red before you start the actual work.
· Lower end of the mid-cap deal value range. Price sensitivities increase as the deal value decreases, opening the door for top lawyers in leading Chinese domestic firms to take a lead transaction counsel role working with local counsel in the target jurisdiction on many mid-cap deals, thus introducing another competitive factor for international law firms in this outbound sector.
· Southern hemisphere deals (we should include Central Asia, Eastern Europe and Central America in this grouping as well as this applies to all developing countries). Even for top-50 Chinese companies, if the international law firm does not have an office in the target jurisdiction, it most likely will not be short listed, even if it has a 10-page deal list in the target market. Chinese companies typically have zero appreciation for the value of the transaction management role in an outbound investment/M&A deal, and see it as merely a post-box (or in Chinese, ’qiaoliang’ or ’bridging’) function for which they are not willing to pay international rates. The general rule is that if the international firm does not have an office in the target jurisdiction it cannot play (energy deals are the exception to this rule for the top international energy firms with offices in China – they can and do chase energy deals around the world for Chinese companies). This again creates an opening for top lawyers in leading Chinese domestic firms to take a lead transaction counsel role working with local counsel in the target jurisdiction on these deals.
Obviously, when you have a Chinese company outside the top 50 doing a low-end mid-cap deal in a developing country, it is very hard for the international firms to get a piece of the action, and the Chinese firms are rushing in. Just take a look at the representative outbound deal list for Zhong Lun shown on slides 16-18 of the China outbound investment presentation.
My partner Cheng Jun, who is dual-qualified in France and China, has a dominant market position in outbound Chinese investment in Africa, mostly in natural resources and infrastructure, and he and his team are now following many of these same clients to do deals not only in other developing countries but also in Australia, Canada and South America. Many of these deals are in the high end of the mid-cap deal range.
Another Zhong Lun partner, Simon Cheong, who is Australian-Chinese educated and qualified in Australia and who previously worked at Freshfields Bruckhaus Deringer and the International Finance Corporation, is working with Chinese-sponsored investment funds on a range of acquisitions in South-east Asia. Some of my Zhong Lun partners in Shanghai are outside counsel to a newly formed Shanghai-based sovereign wealth fund looking to make substantial investments around the world. A partner in our Shenzhen office is working with a leading Canadian law firm on an acquisition of a Canadian target in the solar energy space. I am working on both buy-side and sell-side on outbound deals as well as advising various Chinese clients on a range of cross-border commercial transactions. And there is a lot more outbound work that others in the firm are doing.
I hasten to point out that the legal services market for Chinese outbound investment is still in its infancy, and the outbound work listed above comprises only a very small percentage of our firm’s total revenue at this stage. Pricing is also a challenge for us, even with our lower cost base, so it is not all blue skies even for top local Chinese firms.
Accordingly, my intention in listing some of our outbound work is not to puff or brag but to illustrate the points outlined above and as presaged in my prior blog postings. Specifically, my intention is to underscore that given the unique characteristics of the China market, legal work for Chinese companies investing abroad is not as easy a market for international law firms to crack as many suspect and the top Chinese law firms are already competing effectively in substantial segments of the outbound market.
To answer the teasers I had raised in my prior blog entries, this is the reason I felt compelled to make the move from a major international law firm to a top Chinese law firm. With the international law firm share of the China inbound legal services market continuing to erode, and the market for domestic legal services (even for China subsidiaries of multi-national corporations) having been conceded to the domestic law firms for more than 10 years for all practical purposes, the last ’protected’ market for the international firms was expected to be outbound investment and M&A where the international firms should hold all the cards and the local Chinese firms (it was assumed) could not play.
That is not how it has played out, so I decided to rethink my approach to the market and jump sides. Carl Cheng, another senior foreign lawyer who spent more than 17 years with Freshfields in Shanghai, and who joined Zhong Lun recently, saw the market trends in the same way and made the same move. I expect there will be more to come. I know of several who are on the fence, waiting for the right time to jump.
Actually, my individual calculus in some respects mirrors that of Mallesons’ in respect of its merger with King & Wood. From what can be observed from the outside, the KWM merger was not designed to make King & Wood more competitive in China. As the managing partner of a top international law firm headquartered on the west coast of the US observed wryly, how many English-speaking Aussie lawyers does it take to do a China deal? (Answer: not 800!) It can also be assumed that the core objective of the KWM merger was not to bring King & Wood more inbound work from Australia. I have a close friend who headed the Beijing office of one of the top Aussie firms for several years who confided in me that he never got any inbound China work referred from his Aussie partners. As a practical matter, there is just not that much investment flow from Australia into China; it is all the other direction.
And that, along with the interesting combination of the KWM offices in Hong Kong, is the obvious driver for Mallesons – access to King & Wood’s Chinese company client pool for outbound investments in Australia. One can quibble about whether you need a full merger to achieve this objective, but it is an understandable rationale which in some respects parallels the drivers for my own move – ie access to the ’trusted advisor’ relationships of 150-plus Zhong Lun partners with several hundreds of top Chinese companies in all parts of China.
King & Wood and Zhong Lun present some of the more attractive platforms in China for these purposes. As previously outlined in earlier blogs, KWM, Jun He and Zhong Lun form a break away ’Big 3’ group of national domestic law firms in the China legal services market, followed by Fangda and another half dozen excellent local firms with a smaller footprint and/or more narrow practice scope focus. KWM historically has had a 60-40 split of revenues between foreign and Chinese clients, and is moving to more of a 50-50 equilibrium, while the client split for Zhong Lun has historically been more 40-60 foreign-domestic but also moving toward equal balance. By comparison, Jun He and Fangda are generally understood to be much more heavily weighted to the foreign client side than even KWM.
In the outbound legal services game, access to clients is critical, and it would be expected that KWM and Zhong Lun would have some advantages with more existing ’trusted advisor’ relationships with more Chinese clients across the entire country given the geographic reach of both firms within China and their overall positioning at the top of the market. But by no means can either of these firms dominate this outbound market segment because there are so many other domestic lawyers and law firms with similar relationships, but overall it is a significant and an important advantage at the top end of the market.
The KWM model is the one-stop shop model, at least for investment into Australia. The Zhong Lun approach is the independent law firm model with friends around the world. Both models will be effective in my view, and among the Chinese law firms more than just KWM and Zhong Lun will prosper in the outbound legal services market.
The key message is that there is an open space in the China outbound legal services market which is not occupied by the international firms, which will be filled by the top Chinese law firms working in cooperation with top local firms in the target jurisdictions. Some segments of this market (eg the top-end deals for top-tier Chinese companies) will likely be dominated by the international firms; other parts of the market (eg investments into developing countries) may be dominated by the Chinese firms; and for all other market segments there will be some overlap where we will compete head to head.
As the market matures, the market conditions will shift again, and we will all have to adapt. People regularly ask me when we can expect conditions to change, particularly in respect of improvement in the level of sophistication of Chinese clients accompanied by a significant uptick in the fee levels for outbound deals. In my view, it is a generational issue. Just as the senior partners in Zhong Lun who have a more international background and mindset are all in their mid to late 40s, so also are their counterparts on the business side in major Chinese companies.
We can expect to see dramatic changes in the management of Chinese international business transactions as this next generation of foreign-educated and foreign-trained managers takes the reigns within the top Chinese companies. This should be an evolving situation over the course of the remaining years of this decade, as deal volumes and deal values continue to march up the tables. As the levels of sophistication of the Chinese investors increase, so too will legal fees, which will benefit both international and domestic firms in China.
Robert Lewis is international managing partner at Zhong Lun Law Firm, based in Beijing