M&A Strategies for SMEs in China

Sep 30, 2022 | Blog

As the limited scale of SMEs creates challenges for financing and management of larger projects, such as acquisitions, the M&A route can be used strategically to overcome such constraints and increase the value of the entity. SMEs should benchmark the costs of an M&A against the potential gains and deploy strategies that have been successfully used by industry peers.

 

By Simon Laube, China Briefing, Dezan Shira & Associates

 

The participation of small- and medium-sized enterprises (SME) in mergers and acquisitions (M&A) is relatively low, even as SMEs are highly prevalent in most markets. This is because SMEs lack the scale to cope with the financial and managerial burden of large projects.

However, with global economic headwinds, such as the COVID-19 pandemic, high inflation, and supply chain disruptions, continuously affecting the business world, SMEs are suggested to reconsider M&A as a strategy that can help them survive and thrive in the post-pandemic era.

Financial limitations

Scarce financial resources among SMEs are considered the number-one limitation to reach their full potential. Traditionally, SMEs rely on internal funds to finance their investments.

Among SMEs in the European Union (EU), internal funds cover 60-70 percent of investment needs, according to the European Capital Market Institute (ECMI), while bank financing and leasing makes up most of the remainder.

In contrast, equity financing among SMEs in the EU is basically negligible. ECMI revealed that the only significant equity investments in EU SMEs are pre-IPO risk capital, which accounted for roughly 2.5 percent of total SME financing before the global pandemic struck in 2020.

The lack of equity financing of SMEs is mainly due to high fixed costs, such as initial costs, illiquidity of assets, and ongoing compliance requirements. However, high cost pertains to bank financing as well, which is associated with the higher risk of lending to SMEs. Ultimately, limited access to equity markets and high cost of debt limit the ability of SMEs to finance acquisitions.

That said, SMEs can alleviate their financial constraints with a strategic approach to M&A. First, acquisitions may be conducted in stages or remain partial. Second, divestures can provide required cash. SMEs should consider the whole M&A spectrum while remaining firmly strategic in their target and investor selection.

Strategic limitations

One could argue that strategies may limit SMEs in their flexibility and agility if they are too rigid. Furthermore, given the cost of comprehensive strategy development, SMEs might prefer to allocate their resources to R&D or immediate operational needs.

However, M&A without a solid strategy can prove costly, as targets might be selected for the wrong reasons. SMEs should develop an M&A strategy with strong value propositions before they start to engage targets or investors and equip themselves with the managerial and financial capacities to achieve their goal.

For example, if an acquisition makes strategic sense three years in the 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 acquisition. Moreover, for some SMEs, an acquisition will provide a base for further acquisitions.

For strategy development, the small scale of SMEs is beneficial. The reduced internal complexity and less diversified products and services of SMEs mean that the required scope of strategic planning is comparatively limited. SMEs can deploy strategies in a simpler manner without comprehensive documentation.

Overcoming resource constraints

The following two trends exemplify that M&A serve as a viable strategy for SMEs to overcome financial and strategic constraints.

Succession planning

The most obvious trend is succession planning. M&A as exit strategy is gaining popularity, since a growing number of SMEs – especially in developed countries – experience difficulties handing their business down to the next generation.

A pre-pandemic survey of the German Development Bank (KfW) revealed that 42 percent of SMEs can imagine selling to an external party. Furthermore, in M&A with a German SME, acquirers are often from the same sector as their targets. Hence, M&A as exit strategy is complemented by M&A as growth strategy for corporate investors.

Global business models

Another trend has emerged during recent decades due to accelerating globalization. Many start-ups and now mature SMEs have been founded with a “global business model”, which require early scaling. Since selling part of their equity is common to finance early growth, these firms are familiar with M&A, which makes them more comfortable with strategic acquisitions.

In addition to succession planning and fast global growth, SMEs should break the stereotype that M&A is only a large company’s choice and consider M&A as one of the practical options that can help them reach various goals.

Strategies for SMEs

M&A as a fast track to achieve geographical market expansion or product diversification is a common example. The opportunity arising from speed of entry and high market penetration due to an existing customer base with direct customer touchpoints, can be realized regardless of firm size.

Moreover, 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.

Acquisitions of business partners

M&A with existing business partners, such as customers, distributors, or suppliers, offers additional advantages. If relationships have been established over a longer period, investors will be better informed about the value of the target, as well as the feasibility of post-merger integration.

Partial acquisitions

While partial and full acquisitions both leverage the speed of entry, partial acquisitions lead to less control of market penetration and customer touchpoints. However, partial acquisitions have the advantage of limited financial and managerial commitments, which is critical to SMEs. A partial acquisition may be an investment in another SME or a carve out of a business unit of the target. 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.

Valuation based on historical costs

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. Yet, these aspects can hardly be used for forward-looking valuations. In contrast, SME investors should perform thorough due diligence based on historical facts and future potential cash flow to determine an adequate acquisition price.

Strategic divestures

Mature SMEs with strong growth potential can consider selling part of their business to finance growth of their core business, which is the norm for scaling start-ups and large corporations.

On the one hand, finding a strategic investor can bring synergies beyond monetary value, since SMEs are often acquired – in full or in part – by firms from the same industry. Such investors may bring scale and market power to the business, which benefits both sides.

On the other hand, financing growth with equity can reduce the risk of default due to excessive debt. High levels of debt can also limit SMEs from growing in the first place, which also holds true for SMEs with insufficient collateral. Hence, selling part of their equity can provide SMEs with a valid solution for overcoming financial constraints and may free up resources for acquisitions of strategic importance.

 The original article can be found here: https://www.china-briefing.com/news/ma-strategies-for-smes-in-china/ 

This article was first published by China Briefing, which is published by Dezan Shira & Associates, a Partner of Sense China. The firm assists foreign investors throughout Asia and maintains offices in China, Hong Kong, Vietnam, Singapore, Indonesia, Thailand, Malaysia, Philippines, Russia and India. Please contact info@dezshira.com or visit our website at www.dezshira.com.

 

Simon Laube

Simon Laube

@Dezan Shira and Associates

 

Dezan Shira & Associates is a pan-Asia, multi-disciplinary professional services firm, providing legal, tax and operational advisory to international corporate investors.