The rising uncertainties in international and domestic markets due to the COVID-19 pandemic, inflation, and supply chain disruptions, have cooled down the mergers and acquisitions (M&A) in China, after a record year in 2021. This situation could represent an opportunity for small and medium sized enterprises (SMEs) to survive and thrive in the post-pandemic era.
The limited scale of SMEs, which reduces their ability to overcome challenges in the financing and management of larger projects, is the main reason for the relatively low participation of SMEs in mergers and acquisitions (M&A).
However, SMEs should reconsider M&A as a strategy to successfully face the global economic changes affecting the business world.
In the past year, Chinese investors have become more cautious about M&A deals because of economic uncertainties, but strategic and private-equity firms are still deploying capital in investments with long-term returns.
In the current environment, investors are keen to invest in sectors which are more resilient.
One of the main limitations for SMEs to be able to achieve their potential is the lack of sufficient funds. In general, SMEs depend on internal resources to finance their investments.
According to the European Capital Market Institute (ECMI), SMEs in the European Union (EU) cover 60 to 70 percent of their investment needs with internal funds, while bank financing and leasing makes up the rest.
In contrast, equity financing among SMEs in the EU is basically insignificant. ECMI discovered that the only equity investments in EU SMEs are pre-IPO risk capital, which accounted for roughly 2.5 percent of total SME financing in 2020, before the pandemic.
Limited access to equity markets and high cost of debt, reduces the ability of SMEs to finance acquisitions. However, a strategic approach to M&A, including investor selection, can lessen their financial constraints.
A rigid M&A strategy can potentially limit SMEs in their flexibility and may become too costly, forcing SMEs to choose to use their funds in more immediate operational needs or research and development (R&D.)
Nevertheless, developing a M&A strategy with strong value propositions before engaging targets or investors is crucial and could save them money in the long run.
If an acquisition makes strategic sense in the near future, SMEs can prepare their management and develop relationships with potential targets. In addition, strategic restructuring and financial optimization can prepare the firm to master the operation. For some companies, an acquisition will provide a base for further acquisitions.
On the other hand, the small scale of SMEs is beneficial for strategy development. Smaller companies with reduced internal complexity can execute strategies in a simpler and faster manner without comprehensive documentation.
M&A serve as a viable strategy for SMEs to overcome financial and strategic constraints, as these two recent trends show.
The most obvious trend is succession planning. M&A as exit strategy is becoming more popular, since a growing number of SMEs – especially in developed countries – experience difficulties handing their business down to the next generation.
Another trend has emerged due to accelerating globalization. Many start-ups and mature SMEs have been founded with a “global business model”, which requires early scaling. Since selling part of their equity is common to finance early growth, these firms are more comfortable with strategic acquisitions.
SMEs should change the assumption that a M&A can only be done by a large company and consider M&A as one of the practical options that can help them reach specific goals, such as geographical market expansion or product diversification.
An acquisition might reduce competition if the market has only a few key players. This also holds true for vertical M&A throughout supply chains, which SMEs can use to secure strategic sourcing.
Using long term relationships has also its benefits. M&A with existing business partners, customers, distributors, or suppliers, may smooth the process since the parties involved are well informed about the value of the target, and facilitate the post-merger integration.
Partial acquisitions can limit the control of market penetration, but they represent an opportunity for SMEs to have less financial and managerial commitments. In addition, gradual acquisitions over a longer period provide a way to test the target for a possible integration, without exposing investors to the full risk of failure in the beginning.
M&A with business partners and partial or gradual acquisitions provide a method to manage information asymmetry, which is pervasive in SME transactions.
Nevertheless, this should not lead to a neglect of target valuation. The degree of subjective value tends to be higher for SMEs than for large corporations. This can concern companies relying on the influence of entrepreneurs or interpersonal connections with stakeholders, as well as firms with strong capabilities but weak documentation.
SME investors should perform thorough due diligence based on historical facts and future potential cash flow to determine an adequate acquisition price.
Selling part of the business to finance growth of the core business, which is the norm for scaling start-ups and large corporations, is another viable strategy for more mature SMEs. Finding a strategic investor can bring synergies beyond monetary value.
On the other hand, financing growth with equity can reduce the risk of default due to excessive debt. High levels of debt can limit SMEs from growing in the first place, which applies to SMEs with insufficient collateral as well. Selling part of their equity can provide SMEs with a valid solution for overcoming financial constraints.
China remains the world’s hottest market for several industries, with high prospects for growth, innovation, and investment. Among others, China’s ambitious decarbonation and digitalization goals are ramping up M&A activities in relevant industries.
Alongside the optimistic outlook, investors must note China’s recent regulatory moves that restrict the scope for certain types of M&A deals and increases the compliance burden on involved parties. M&A dealmakers might be faced with longer approval timelines and extensive information disclosure requirements.
To learn more about our services in China, contact our Head of Business Advisory - Ms. Kristina Koehler-Coluccia at kristina@woodburnglobal.com.
DISCLAIMER: All information in this article is verified to the best of our ability and is assumed to be correct at time of release; however, Woodburn Accountants & Advisors does not accept responsibility for any losses arising from reliance on the information provided within. The information provided is for general guidance and does not replace specialized advice.