In this age of financial austerity, an increasing number of U.S. and European companies are seeking financial backing from and alliances with cash-rich Chinese companies. Those same Chinese investors however, are keen to snap up assets at what are sometimes bargain basement prices.

Chinese outbound investment is definitely on the rise: the Chinese Ministry of Commerce predicted in January that Chinese outbound investment will reach $560 billion annually by 2016, up from a record $60.1 billion in 2011. The Heritage Foundation’s China Investment Tracker shows that China invested $34.7 billion in the U.S. in the seven-year period from 2005 to 2011 and $52.1 billion in Europe in the seven-year period from 2005 to 2011, accounting for about 28 percent of the country’s total accumulated overseas investments, excluding bond purchases.

During these years, the bulk of China’s outbound investment has been aimed at enhancing China’s presence in key countries within Latin America, Africa and South East Asia, while developing a global platform for China that ensures competitive advantage in the long term (energy, logistics and infrastructure). Outbound investment has been characterized by high profile and politically motivated investments by Central Government State Conglomerates—mostly the “Big 100,” other Central Government State Owned Enterprises (SOEs) and Chinese sovereign wealth funds.

Although all experts agree that from a macro economic and high-level perspective, outbound investment growth trends will continue over the next decade, we see a very differentiated reality from a micro perspective.

I remember clearly a conversation I had recently with a senior director involved in outbound investment at a Chinese financial institution. “People expect large and politically powerful SOEs to lead Chinese outbound investment, but this will be a challenging task. Most of these state companies are not ready for outbound investment,” he said. “The managers of those SOE’s are pure politicians, not businessmen; they do not know what they want, have no strategy and change their ideas all the time. The decision-making process is unclear and there are new people emerging in the decision process all the time.”

Moreover, he added, “Very few SOEs have structures or formal processes for international investment, a fact that ends sometimes in total improvisation with sudden changes. These companies rarely recognize the need for help and support. They have unrealistic expectations: at the beginning they are very aggressive, but in the end they want guarantees, and no down-side risk. The SOE system does not reward success, but punishes mistakes very aggressively.”

I agree. These large players will find it difficult to successfully acquire foreign companies. Based on my experience, success with these players requires an understanding of their real underlying motivations. One must have a sound business and political end-game in mind and deftly handle the complexities of the internal and administrative project approval processes.

My belief is that the future of Chinese outbound opportunity lies in a different arena, with different players that will bring new dynamics.

A New Playing Field: Private Enterprises and Provincial SOEs

Many new groups of players are emerging in the Chinese outbound M&A arena, bringing a new level of dynamism and growth prospects to this market.

The first group includes listed public and private companies that are already leaders in China. They are increasingly motivated to expand globally to enhance their competitive advantage within China and position themselves for growth in global markets. Hangzhou Wahaha Group is a good example. This is a privately owned and listed corporation with total assets of $40 billion. It is seeking M&A in the food and beverage sector in Japan and Australia as part of its quest to become a global brand and to diversify into other sectors, such as mining.

Another newly emerging group involves medium-sized private players, recently listed corporations and smaller corporations that have traditionally focused on domestic sales growth, or those with revenues above $300 million that have recently gone public raising considerable amounts of cash. For example, privately owned Suzhou Dongshan Precision Manufacturing Co. Ltd, a sheet metal making, die-casting and surface treating manufacturer, has become a major global supplier of sheet metal components for telecom base stations and is currently seeking a compatible overseas target that would have synergy with its core business.

Finally, a major emerging sector includes provincial, state-owned corporate leaders from rich provinces such as Beijing, Shanghai, Jiangsu, Guangdong and Shandong. There are numerous examples, such as Shanghai Pharmaceuticals Holdings Co. Ltd, a state-owned regional player and China’s third-largest pharmaceutical company.

This company is searching for new pipelines in Europe and the U.S. for generic antibiotics, cardiovascular and oncology drugs. It plans to use 30 percent of the proceeds from its May 2011, Hong Kong IPO, to fund global M&A. Another example would be YAPP Automotive Parts Co. Ltd., a state-owned player that specializes in the development, manufacture and sale of automotive fuel tanks. Yapp is looking for equity investments in Europe, the U.S. or emerging markets such as Brazil to expand its international business.

We also see opportunities in the services sector, with companies like Beijing Capital Airports Holding Co. (BCAH). Through its various operations, BCAH has become the number two player in China’s airport management sector, reporting throughput of 143 million passengers in 2010. It is seeking majority or minority investments in airports in both North and South America and in Southeast Asia to expand its airport management business overseas.

These newly emerging groups of companies often have huge cash reserves and are looking for new types of projects, quite different from the past. InterChina suggests these companies often prefer to invest in or buy industrial companies with “good enough” synergies that can be used in China to enhance their competitive advantage. They will look for smaller, non-political transactions “below the radar,” that will be easier to acquire, integrate and manage.

These companies will buy majority stakes and be open to strategic acquisitions abroad (involving minority stakes), linked to JVs in China in which they hold controlling stakes.

InterChina expects middle-market investment by Chinese companies in Europe and the U.S., with deal values of $300 million or less, to increase in the next few years. These deals will most likely be concentrated in the auto, machinery, clean-tech, energy and consumer goods sectors.

How To Deal with These Investors

InterChina is a partner in IMAP, one of the leading global M&A corporations and I serve on its Board of Directors. In this role, I face an important challenge: how to explain to my colleagues from more sophisticated markets, the unique mix of factors that shape the development of relationships with Chinese corporations investing abroad.

The level of vitality, energy, drive and passion found in Chinese corporations embarking on overseas investments is unique. This is a new area for them and Chinese shareholders and managers are adamant about becoming global leaders. This is a very subjective factor, but in today´s depressed global economy, this attribute should not be disregarded as a source of global competitive advantage.

On top of this, all these corporations still are rooted in a growing economy that is increasingly being driven by domestic consumption. They are thriving in industries with growth rates in the range of 10-20 percent, in a context of great liquidity and strong government incentives. Such players can afford to bet on global expansion, and to make mistakes, since their underlying business is healthy and will remain healthy in the short to medium-term.

Apart from the vitality of domestic consumption in China and its evolving growth model, we also forecast that the Chinese yuan will appreciate an estimated 15-25 percent over this decade. This will greatly enhance Chinese corporations’ acquisition power.

Finally, China has a lot of money. This is reflected in credit lines granted by State Banks to its leading corporations. Some striking examples include a $7 billion credit line granted in 2011 by the Chinese Development Bank and Chinese Exim Bank to Sinovel Wind Group Co., the largest wind turbine company in China, to expand in the U.S. and Europe. Another example: a several billion dollar credit line to China HNA Group, a Chinese aviation, shipping and hotel industry investing group, to grow globally. Deep pockets always help to frame successful acquisition strategies.

Despite this bright scenario, there are significant challenges. Below are the most significant obstacles facing Chinese outbound investors.

1) Lack of Strategy

Many companies want and need to grow abroad, but are completely at a loss for how to do so. Many of these players know how to act in China, but are unfamiliar with the formal management tools needed to grow abroad. They mostly act opportunistically and not based on any formal strategy developed in advance. This can have a great impact, since western competitors for good M&A deals will know exactly why they want to acquire a target, enabling them to be more efficient and convincing toward the various stakeholders involved in a transaction (shareholders, workers, clients, local governments, etc).

2) Cultural Clashes

There are certain rules of conduct and accepted global styles that most Chinese investors disregard, giving priority to cash. A “Money Talks” approach and the resulting cultural clashes can be a serious handicap for Chinese investors, often leading to failure.

3) Complications and Process Issues

The global M&A market operates under a clear set of norms. There are rules for structuring nearly every step of a deal, reflecting both format and content principles that many Chinese investors, with the exception of the more sophisticated and experienced ones, do not yet grasp. Moreover, the Chinese foreign exchange regime, in which the RMB is not yet freely convertible, and the complicated and cumbersome M&A approval process (NDRC and MOFCOM driven), can make Chinese transactions exceedingly complicated. Both issues are clear disadvantages for Chinese investors seeking overseas acquisitions.

4) Lack of Knowledge

Although there is a clear flow of western and returnee talent from the M&A and investment world in the U.S., EU, Japan, etc., into China, most prospective investors lack the basic capacity to drive a global M&A process and to integrate and get value from those acquisitions.

Western companies need to be aware of the potential pitfalls of dealing with Chinese companies that are still finding their footing as overseas investors. Both sides need to seek a common understanding on what to expect and how to best ensure that deals will succeed.

Although InterChina has been an active player in China’s M&A arena since 1994, we only began our outbound M&A practice in the mid 2000s. Over these years, we have made many mistakes and have learned how to adapt global practices to the realities of the Chinese market.

Key Success Factors

In our view, the key success factors for working with Chinese corporations are twofold. First, prior to initiating conversations and formal negotiations, apply the “Motivation & Capacity Acid Test.” If a Chinese corporation or investor is not able to explain the business case or rationale behind the deal, or cannot prove a basic alignment of internal resources to support the transaction, the opportunity cost of getting involved may be too high.

Secondly, once a transaction process has been initiated, it is essential to engage a Chinese team in order to enhance communication channels. Flexibility also is essential, as well as a willingness to adapt western and global M&A approaches to Chinese realities, while helping Chinese management understand the norms of global M&A transactions.

Chinese-based companies completed a record 207 deals valued at $42.9 billion in 2011, up 10 percent from the prior year. We expect deals to continue to increase as Chinese companies take advantage of the ongoing economic downturn and crisis in Europe and the United States to carry out even more mergers and investments in western companies over the next 5 years.

The race to tackle the immense opportunities for outbound M&A from China has begun. Understanding the complexities of this developing opportunity is only the start. Adapting to them and developing appropriate methods to engage Chinese enterprises will yield competitive advantages that will maximize the chances for success for enterprises that are able to adapt.

About The Author Eduardo Morcillo

Eduardo Morcillo, a Spanish national, is Managing Partner of InterChina Consulting. He has vast experience in investment banking and China-specific transactions.