Editor: Tell us a little bit about your professional background.
Bernstein: I spent most of my professional life in international business, the first 20 years principally in Europe, commuting back and forth, with a few years each in the Czech Republic and in Israel. One of my real estate clients, a war refugee who spoke 11 languages, became my mentor. In 2001, I took my first trip to China, and today I commute monthly. I’ve visited about 125 cities across China, and my wife is Chinese. My partner, Neil Pinchuk, and I joined Marcum three years ago. We basically run the China practice, one of the largest in the country, with offices in New York, Beijing, Shanghai, Guangzhou and Hangzhou, and 75 bilingual (or better) professionals in China. We represent almost 40 companies. Most people would agree it’s exciting work, but the 15-hour flights, 12-hour time difference and Chinese-language documents are not for everyone.
Editor: Where does outbound M&A stand in China today?
Bernstein: Overall, 2013 may be a record year for outbound acquisitions by Chinese companies, with over $43 billion of deals announced so far this year. This is being driven by a unique constellation of circumstances. Obviously, the Chinese have accumulated a significant amount of foreign reserves, and the government is encouraging investors to move beyond holding U.S. treasuries and to begin taking bites of real assets. You also have a select group composed of the so-called state-owned enterprises, or SOEs, which are well-connected companies with access to very low-cost, long-term financing. And you have domestic uncertainty with overcapacity already at very high levels in many industries and a shortage of large-scale, traditional investment projects.
Editor: I understand Marcum recently held an investor conference in Beijing in September. Any key takeaways?
Bernstein: We had more than 400 people from over 60 companies (including 17 of the largest companies in China) and over 125 investment firms. There is a lot of interest in China right now. It is the second-largest economy in the world, poised to be number one.
There were two very interesting takeaways from our conference. First, Chinese stocks are at their lowest levels right now – undervalued by 60 to 80 percent relative to international comparable companies – generating a lot of interest for investors. The interest level is high, but so is the level of scrutiny. Of course, from an IPO standpoint, the last two years have been dismal. But that now appears to be turning around: recently, very strong IPO performances by Qunar and 58.com suggest that investors will step up if the company has the right credentials.
Second, cross-border business is very high on everybody’s list, but it continues to be difficult to define. In China, our firm has broadened in many ways to accommodate its complexities. We represent companies in the United States that are looking at making Chinese acquisitions; we work with wealthy Chinese who participate in EB-5 investment programs (the Chinese account for over 40 percent of all EB-5 visas); and we are becoming heavily involved in bankruptcies, somewhat surprisingly. Every time a U.S. company in certain sectors – apparel, technology, manufacturing, toys – goes bankrupt, Chinese creditors are involved. They have acquired some very well-known brands and interesting assets through these liquidations.
Editor: Are there particular sectors that are of interest to Chinese acquirers?
Bernstein: Until a few years ago, we saw deals focused largely on natural resources, which made sense given the high demand for raw materials in China and the low execution risk involved. But the deals we are seeing today have a very different character. They include very high-profile real deals, for example, Fosun’s agreement to buy Chase Manhattan Plaza for $750 million and Shuanghui International’s $4.7 billion purchase of Smithfield Foods. Evidently, some of the stronger players are looking to step up. And they are being smarter about avoiding deals that will meet with significant national security hurdles.
What’s getting much less attention but is potentially more interesting is that recently some of the very large, successful tech companies, especially Tencent and Baidu, are openly and actively looking to take strategic stakes in tech companies in the United States. The Chinese are making a number of acquisitions in Silicon Valley right now; they seem to be recognizing China’s need to move beyond its highly successful, essentially copycat business model.
Editor: Is stronger IP protection an incentive here?
Bernstein: I think IP is part of it, but it is also about the Chinese trying to tap into a very well-established innovation ecosystem. It is about moving their engineering capabilities higher up the value chain. The Chinese are taking steps to be truly creative on all levels, which will be transformative for them.
Editor: What are the most common pitfalls for Chinese companies when acquiring (or seeking to acquire) companies in the U.S.?
Bernstein: In many cases, the synergies are quite obvious. The Chinese bring tremendous scale and a highly entrepreneurial culture to the table. Meanwhile, they are decades away from developing the desirable brands and high quality that will make them global players – assets that American companies already possess. While the financials need to make sense, the ultimate determination of the success is going to be the resultant business culture. Can you meld the two organizations and create something greater than the sum of its parts?
For its part, Lenovo made a very serious and conscientious effort to do this, and it worked well. The Chinese used to come in with their own management and their own mentality, but they’ve learned since and are now players everywhere. Today, they are the second-largest purchaser of real estate in the United States behind Canada.
Editor: Aside from language challenges, what are some of the due diligence challenges for foreign companies coming into China?
Bernstein: We’ve seen that even some huge players – Caterpillar, for instance – can make major stumbles. You learn quickly in China that due diligence goes far beyond jetting in and checking the box. Our team realized early on that we needed to invest in a local team and to develop local sources of knowledge. Having been inside over a hundred Chinese companies, we’ve learned to triangulate sources of information; we’ve found you must always drill down one more level; and, most importantly, we’ve developed an understanding of the entire ecosystem between companies, local government and banks.
Editor: How does Marcum compare with other accounting firms in China?
Bernstein: Certainly, the Big Four have a presence, but there are very few middle-market firms other than Marcum truly practicing full-time in China. We think we have built something relatively unique – a local team that is highly trained in the norms of SEC and PCAOB accounting and that is well integrated with the U.S. parent, with full access to its resources. Meanwhile, other U.S. firms practicing in China ship people over for periods of time, or else contract their fieldwork to Hong Kong firms and then sign off on it.
I mentioned the language challenges earlier. In China, everybody reads and writes in the same language, and in the first-tier cities, most people speak Mandarin or Cantonese. But once you get south of Shanghai, the country breaks up into many different dialects, which is why we have offices across China. Keep in mind that, especially in China, anytime an outside company or government audits you it’s rarely good news. We’ve found that sending in auditors who live locally – people who speak the region’s dialects and understand its customs – makes all the difference.
Editor: Drew, in recent years the market has lost confidence in Chinese companies listed on U.S. exchanges, resulting in a near-freeze in Chinese IPOs. How does the future look?
Bernstein: My view is that the market lost confidence not just in Chinese companies but also in the entire system that deals with them – including the accounting firms, many of which failed to detect fraud. Unscrupulous investment bankers took many Chinese companies public when they had no business doing so; even worse, they failed to give them the proper follow-up and support they needed afterward.
I once chaired an audit committee for an NYSE-listed Chinese company and ended up running one of the largest investigations in China. While I may have been a fool for taking this on, the company was ultimately cleared of the allegations, and it was probably the best education I ever had. Marcum has become known as the “go-to” resource for accounting support when your company is under some kind of cloud and you need to get to the bottom of what happened with the financials. In every case, we have been able to reach a resolution. I couldn’t have led these efforts without that experience.
There have been only four IPOs for Chinese companies this year, one of which – China Commercial Credit – Marcum served as the auditor for. It was a remarkable deal because, at the time, the thinking in China was that in such a difficult market, any viable IPO would have to be a sizable company with blue-chip credentials. Then along comes the relatively small micro-lending company China Commercial Credit (NASDAQ:CCCR), which shares a business model with over 5,000 other companies in China. It then proceeds to launch a successful IPO. This renewed a lot of interest by demonstrating that small IPOs are possible. We believe that Marcum’s reputation for providing accurate financial information was part of its success.
This is significant for China because Chinese companies divide into two groups. Those in the A group are the SOEs, which I mentioned earlier. The B companies are what I consider the mid-cap to micro-cap companies, and they lack access to power or money. They have been relegated more or less to what’s known as the shadow banking business. This informal system has become so huge that the Chinese government has actually stepped in to try and regulate it. Meanwhile, foreign capital, which has been a principal source to these companies, has all dried up. So something has to change.
The two recent successful IPOs I mentioned earlier may indicate good things to come.
Editor: I’ve read that many of China’s most talented youth continue to leave the country in search of better opportunities. Is anything being done about this?
Bernstein: What are those people looking for? Air you can breathe. Access to quality education. And the confidence that talent and hard work will be rewarded. Every country, including China, understands that the development of a country depends upon the retention of talented, creative individuals. In order to achieve this, laws protecting patents and intellectual property must be established and enforced so that people can make money from their ideas.
China has taken aim at the problem, but it has far to go. The way it is now, many of the best and brightest leave China and go to Europe or the United States and send money home from there. We’ve seen IP enforcement at times in places like Beijing and Shanghai, but in the third- and fourth-tier cities, there is almost none.
The reality is that much of China is run by businesses, small and large, which through their political connections operate what are essentially monopolies within their own provinces and communities. Without opportunities to succeed, China’s best and brightest will continue to leave.
Interestingly, today, much of the pressure to reform is coming from academics – college professors who are on the front line, witnessing the brain drain. They know it’s critical that this problem be addressed for the economy to transition from a copycat model to an innovative one.
The Chinese have made amazing progress in the last 40 years. That said, the last 10 have been pretty disappointing. Socially, many challenging issues persist. Economically, in the early ’90s, the idea was to dismantle the SOEs and promote small business and entrepreneurship. In the last 10 years, this has actually regressed somewhat. The SOEs have become more powerful, and well-connected private companies have grown tremendously. So that is probably a more accurate way to understand the country.
The people who have run China are not its most educated people, but their children are. I believe that, as time passes, we will see more and more educated people take positions in the government. Education continues to be a high priority for Chinese families, rich or poor. Things will improve, but it will take time. It is a massive country.
Published November 7, 2013.
