New Mode of M&A Investment -- Consolidation-oriented M&A Investment
HE Qiang, CEO of JD Capital.
This article is an excerpt from his speech delivered on JD Capital 2016 Annual Meeting on May 26, 2016.
Ⅰ. Two Major Trends of Chinese Economy
Currently, the Chinese economy has entered new normal as the economic environment both home and abroad has changed greatly. However, I believe, for we investment institutions, the two major trends still remain the same.
1. Trend of securitization to continue.
The first trend is securitization. The launch of SME board in 2004, share-splitting reform in 2005 and the NEEQ in 2013 are all evidences to the rapid growth of China’s securities market over the past decade. It has also brought great benefits to all the listed companies, investors as well as JD Capital.
I expect securitization to continue. Judging by the ratio between total market cap and GDP, the securitization level in China is still low. In 2014, the ratio stood at 59% in China, 151% in the US and 108% in Japan. Moreover, direct financing accounts for more than 40% of the total social financing in China, far lower than that in developed countries (60%~70%) and even in India. Therefore, China’s securitization will continue.
2. Industrial concentration to further strengthen
The second trend is the industrial concentration, which can be seen from the global economic development, in particular, the development of the American economy. After five M&A booms (including horizontal, vertical, leveraged, diversified and cross-border M&As), many sectors are now highly concentrated in the US. For example, the top 20 US pharmaceutical companies own 70% share of the market while their counterparts in China only have 11%. The combined share of top 20 players in some sub-sectors like tourism, logistics, food & beverage and apparel is even lower.
The sector dispersion gave rise to increased M&A deals. In recent years, China’s M&A volume has been constantly breaking last year’s record. Last year, over 9000 M&A dealers happened in China, worth over USD 700 billion. Additionally, Chinese companies are now targeting overseas market. In 2015/1Q16, Chinese companies spent over USD 20 billion/USD 10 billion in overseas M&As. All the data above reflects the boom in M&A.
Ⅱ. Problems for Equity Investment
1. Fewer underlying quality assets
Along with the M&A boom come problems for the investment sector. A big problem is fewer quality projects and more investment institutions. This phenomenon can be compared to “wheat-cutting”. Between 2009 and 2012, PE investment in China was like cutting wheat throughout the country before they were ready. Just alike, many institutions aiming the same project usually drove the price to sky high level, leaving little room for profit. Besides, institutions back then found it hard to exit after they finally acquired the project due to on-and-off IPOs and the absence of registration system.
2. Poor liquidity in the NEEQ
Though it is relatively easy to get listed on the NEEQ, the liquidity is still insufficient. Currently, the average daily turnover is only around RMB 1 billion. Of course there are companies actively traded. JD was actively traded before its suspension of trading. Now there are more than 7,000 companies of different quality mixed in the market and the top 50 take up 34% of the total profit generated by NEEQ-listed companies. In the past month, the average daily turnover of these 50 companies accounted for 11% of the total on the NEEQ, which indicated that the large-size companies with high profit have attracted great attention from investors and are actively traded.
The same principle also applies to mature markets. For example, the top 50 companies with the highest market value only account for less than 3% of the total market value in the Hong Kong market, but their average daily turnover is 50% of the total. Additionally, less than 10% of NASDAQ-listed companies together contribute half of total turnover. A huge number of companies are not actively involved in the trading. This is the status quo of mature markets, which is likely to be the situation on the A-share market after the implementation of the registration system. As a result, only large-scale profitable companies can attract high attention and be actively traded.
Ⅲ. Strategy of the consolidation-oriented M&A investment
Under such circumstances, JD Capital has made some changes to its investment strategy.
1. Shift from equity investment to M&A
In the past, we adopted a 2*2 mode, in which both the profit and P/E ratio double, the valuation being turned from 1 to 4. Because of the economic downturn and the slowing growth of the profit, it is hard to find a company with an annual profit growth rate of 30% and 2x profit growth, but it is relatively easier to find companies with growth rates of 15% and 1.5x profit growth.
After the implementation of the registration system, the price spread between the primary and secondary market will narrow. It is possible to turn the P/E ratio from 10 to 15, but this can only make the profit double within three years, which is not appealing enough to investors. Therefore, our investment cannot merely rely on the development of companies themselves and the price spread between the primary and secondary market. We also need to push up the valuation by enhancing profit via external M&As.
With M&A at the core, JD Capital’s investment strategy could be classified into two models. One is the “1+N” model which means cooperation with a leading company in the industry and assisting it to integrate multiple companies in this industry to become a company worth tens and hundreds of billions yuan, just like Beijing Utour International Travel Service Co., Ltd and Luolai Lifestyle. The other is the “N to 1” (developed by JD Capital), or the consolidation-oriented M&A investment.
Simply put, it is to find multiple qualified companies in a niche sector, integrate them into one, invest in it, and make it a leading company in this sector. Instead of looking for projects to invest in , we now can “create” projects. The advantage of this model is that some small companies previously unable to enter the capital market can now step in after being integrated into a larger scale company. For example, it is hard for a single company with RMB 10 million profit to get listed on the market, but things can be changed after it integrates 10 or 100 such companies and adds the profit to 100 million or 1 billion yuan. It will also attract more attention with higher liquidity. At the same time, after the integration, the introduction of new management team, new technology and resources could also help improve management efficiency.
2. Differences between consolidation-oriented M&A investment and ordinary investment
The consolidation-oriented M&A is an upgrading of the ordinary investment. They are different in some aspects.
First, conventional investment procedure includes four steps, namely, “fund-raising, investing, managing, and exiting”; while under the new model, it “integrates fund-raising with investing”. Moreover, the fund-raising and asset-raising are carried out simultaneously and in theory, the investment can be integrated without raising funds. The value of assets is rather low before integration, but once the integration is completed, they can have higher premium and return. Furthermore, for the investment institutions, fund-management is turned into asset-management.
Second, the traditional mode involves industry-wide integration after investing in one company in the industry while with the new model the integration of industry can be completed as the securitization goes on. This also echoes with national reform policy that calls for the integration of the supply side so as to improve social service quality and efficiency.
Ⅳ. Practice of Consolidation-oriented M&A
JD Capital has started the consolidation-oriented M&A investment in some areas.
1. Consolidation-oriented M&A investment in business management
JD has been studying the consolidation-oriented M&A in the area of the commercial property management since the second half of 2015. The cash flow of the commercial property management is stable and has a potential for further growth. This industry has a large scale, but there is regional surplus of supply and it is visibly impacted by e-commerce.
At the same time, this industry is highly fragmented. For example, Dalian Wanda Commercial Properties Co., Ltd. owns 135 shopping malls, accounting for less than 3% of the total market. Besides, there are many policy restrictions on this industry: real estate companies are not allowed to get listed; it is hard for small-scale commercial companies to get listed as well. However, consolidation-oriented M&A investment, or the “N to 1” mode, can open up for huge opportunity for such investment.
Of course, to integrate does not simply mean to put together multiple commercial management companies. Instead, we need to forge the Internet platform and set up the big data center with the assistance of new technology and business mode in order to help the company improve management efficiency and increase market value.
2. Consolidation-oriented M&A investment in the ropeway industry
The tourism industry has been booming in recent years, growing at an annual rate of around 15% when conventional industries are stagnant. One of the major sources of income of the scenic spots is the ropeway. We know that 30%-50% of the income of several listed companies comes from the ropeway operation with high gross profit margin of around 50% or above.
This industry meets our requirements for consolidation-oriented M&A investment. It is quite fragmented with regional monopoly. There are only several ropeways in one scenic spot and it is impossible to keep constructing the ropeway, so the income is relatively stable. Therefore, the “N to 1” consolidation-oriented M&A investment could work in this industry.
In addition, JD is carrying forward many other such M&A projects in areas including fuel gas, cold-chain logistics, medical segments, building material market and after-class tutorials.
Ⅴ. Target for JD’s Consolidation-oriented M&A Investment
Currently, JD Capital is seeking to integrate multiple companies with over RMB 100 million profit in some niche sectors of several “people-related” industries and bring them to the capital market. Each platform company, after the integration, is able to absorb over one billion yuan investment, which can add up to over Rmb10 billion or more investment. Such integration can bring investors with reasonable return while promoting the securitization of company assets. Meanwhile, the efficiency and quality of the social service can also be improved.
To succeed in investment, we need to systematically grasp the major trend and make nonstop efforts in innovation.