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Capital Agenda Insights, March 2011 - Planning for value: getting the initial steps right - EY - Global

Capital Agenda Insights, March 2011

Planning for value:
getting the initial steps right

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The average transaction life cycle is 12 to 24 months in China, compared to around three to six months in mature markets.

Summary: Determining the strategic intent of the JV and objectives from both sides Foreign and Chinese companies come to the table with very different aspirations and perspectives on one another.

There is an old Chinese saying that aptly describes the challenges of a partnership between a Chinese company and a foreign company: "same bed, different dreams."

This highlights the often large divergence in objectives between foreign and local partners. In order to set the initial discussion on the right path, each side needs to maintain a clear view of its own objectives for the partnership and develop a realistic assessment of the likely underlying objectives of its partner.

In a rapidly changing market like China’s, partners’ objectives are likely to change as well. Therefore, it is also important for both partners to think strategically about how to preempt or influence the other when one party changes its objectives for the JV.

Thinking creatively about reshaping the JV and (or) developing robust contingency plans will be important even at this early stage.

The average transaction life cycle is 12 to 24 months in China, compared to around three to six months in mature markets. These protracted timetables for concluding deals are clearly taking a toll; in 2007, just three out of every 10 Chinese transactions were successfully completed, and those numbers have changed little in the intervening three years.

Given this longer transaction life cycle, investors need to remain patient and manage their headquarters’ expectations, while at the same setting the right expectations during initial JV discussions. We believe that foreign companies need to get several crucial steps right during the pre-deal planning stage in order to set the transaction on a reasonable path to success.

Appointing key officers

While minority shareholders’ influence over the board is likely to be limited, the ability to exercise management control of operations is important.

If the minority partner is able to name the chief financial officer, they are likely to end up with a candidate who is more attuned to Western styles of running a company and better able to fulfill compliance measures, both during the integration phase and over the longer term.

The CFO controls all financial matters, from setting the annual budget (especially important for companies with high capital spend), to finance and management reporting and internal controls.

A successful CFO will hold broader responsibility for the operational side of the business and will also have compliance officers reporting to him or her. Another key position that most foreign investors plan for is in manufacturing operations or quality control.

While local employees often have valuable know-how in this area, Western leading practices are frequently needed to bring manufacturing and quality control to the next level, especially when the JV is seeking to export its products to overseas markets.

By contrast, sales and distribution, which tend to be more localized, are better left in the hands of the local partner.

Protecting intellectual property (IP) and other rights

Foreign investors need to ensure adequate measures are put in place from Day One to protect IP rights, whether for the technology or for the management processes and know-how that Western partners are introducing.

Such measures may seem unusual, but Chinese JVs have a defined lifespan; therefore, it is incumbent upon the Western partners to ensure that their IP is not merely "transferred" to the Chinese partner’s hands, but instead reflects some of the value that the Western partner contributes to the venture.

Mapping out a clear path for the future

Finally, foreign companies will also need to anticipate the end game for the JV. Do they see an eventual increase in their equity stakes or a buy-out of the Chinese partner that will allow them to become the majority owner of the JV?

Do they anticipate listing the JV on the public market? Alternatively, do they expect to form similar JVs in other product categories or geographies?

Mapping out the potential evolution of the JV they are getting into is as important as, if not more important than, setting the right set of objectives at the onset of partnership discussions.

While it will be extremely difficult to anticipate potential end-game scenarios, foreign companies investing in China are encouraged to plan rigorously for such outcomes and for their potential triggers.

This has implications during JV negotiations, whether they involve the valuation of the business at a time of sale or non-compete clauses.

Developing and rigorously testing a set of key assumptions will help to shape decision-making and trade-offs during JV negotiations.

In a recently completed JV in a metals-processing business, the Western party’s contribution included their "know-how" around efficient processing systems deemed leading in their industry.

In forming the JV, the Western partner insisted that a portion of the final processing be completed by one of their wholly owned facilities, thereby allowing them to ensure that not all aspects of their highly valued systems were simply given to the Chinese-controlled JV.

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