At first, it's hard to make sense of the mergers and acquisitions (M&A) market in China. Some foreigners are enthusiastic while others are gloomy to the point of clinical depression. But look a little closer and a pattern emerges. The optimists tend to be the investors and high-level executives who are buying into Chinese businesses at record rates--excited about the strategic advantages and financial returns. The people gnashing their teeth are the acquisitions teams on the ground in China, the folks inside an acquiring firm who must actually do the acquisition.

We will return to these beleaguered souls in a moment, but first the good news: M&A activity in China is growing like topsy. Since 2002, every year has been a record year. In 2005, for example, there were $46 billion worth of inbound and domestic deals, according to PricewaterhouseCoopers and M&A Asia--up 34% from 2004. Outbound deals accounted for another $7 billion. Private equity money is now pouring in. The big foreign law and accounting firms in Shanghai and Beijing cannot hire M&A specialists fast enough.

The government has fed the optimism by somewhat clarifying opaque regulations. And while a jumble of government agencies continues to have jurisdiction over M&A--each with its own (sometimes contradictory) guidelines--the situation is improving. Many state-owned companies have been put under the control of the State Assets Supervision and Administration Commission (SASAC), which has done a good job of simplifying guidelines for the sale of the assets under its management.

While trying to guard against the possibility that foreigners will swoop in and buy their way to dominance in key sectors of the economy, the government has continued to expand the number of industries open to foreign M&A investment. That's because one of the government's overarching policy goals is to shunt state-owned enterprises (SOEs) into the private sector, retaining only a tiny core that the state deems crucial for national defense, energy, etc. As a result, an estimated 4,000 to 5,000 SOEs are privatized each year out of a total remaining stock of roughly 135,000. The government sees M&A activity as a key driver of this restructuring and privatization process.

Other reasons for optimism have to do with the fact that China's booming economy is overly fragmented in many sectors. Consolidation brings with it numerous M&A opportunities as firms buy up other firms in a quest for economies of scale. This is already underway in the logistics and retail sectors, among many others. Perhaps the biggest drivers--especially for foreign investors--is the ongoing lure of the China market. An acquisition is often the cheapest and fastest way to create a low-cost manufacturing base or to grab market share in China.

Despite the heartening developments, caution is warranted: It is easy to botch an acquisition. About three-quarters of the potential deals in China fall apart during the negotiating stage, that is after a letter of intent has been signed. In the U.S., by contrast, the deal success rate is well over 50%. Typical reasons include arguments about asking price, unpleasant due diligence surprises (e.g., hidden liabilities) and inability to resolve employment issues. For example, an SOE might demand that its entire workforce be guaranteed contracts for three years--an unpalatable burden for a foreign buyer that wants to wring out inefficiencies.

The deal failure rate is only half the story. The risk of post-deal failure is also significant. That's because the really tough issues only emerge after the deal has been inked, when two companies are forced to actually work together. Success is hard enough to achieve when the two companies are from the same culture and the same economic system. In the U.S., for example, well over half of all mergers destroy shareholder value, according to studies by McKinsey and Ernst & Young, among others.

Now consider the degree of difficulty involved when a foreign multinational (MNC) tries to restructure a Chinese SOE. The SOE has been operating in an environment where contracts, performance incentives and even the profit motive itself have not been regular features of commercial life. For an added touch of realism, imagine that the MNC acquisition team is overstretched because it must continue to run the MNC's China operations while simultaneously overcoming the gargantuan cultural, linguistic and operational barriers involved in a postmerger integration. No wonder those acquisition teams are often so depressed.

Can these barriers be overcome? The M&A literature on China is full of advice. Some of the better suggestions include:

Building a talented acquisitions team, with both expatriates and Chinese staff, that has enough time and resources to do the job. The team should be looking for allies inside the target who can then help drive the restructuring process during postmerger integration. This works best if buyer and seller have a preexisting commercial relationship, so that there is sufficient opportunity to assess the target's managers and build up working relationships with the best ones.

Spending extra time up-front screening acquisition targets to make sure they are good strategic fits, and again during the due diligence phase to unearth hidden surprises.

Being respectful to the people at the acquired company, especially during restructuring. Coming in barking orders doesn't work well in China. The staff may not openly resist but they will be quietly seething, and operations will suffer.

Having a restructuring plan that includes performance incentives for key managers and personnel.

But there is another option which has not, to our knowledge, been discussed in print--an option that involves privately owned enterprises (POEs). We are not suggesting that POEs make viable acquisitions in themselves--they often don't. But they can be immensely useful as partners.

The Rise of the POEs

China's private sector Internet companies (Alibaba, Joyo) have grabbed a fair amount of investor attention over the past couple of years, but most M&A deals still involve the SOEs. This is because SOEs typically dominate most sectors. They have been the best capitalized companies with the greatest scale.

That is now changing. While SOEs continue to operate sluggishly and with reduced access to capital (as the struggling state banks choke off funding), there is a new breed of private Chinese firm rising up to compete with them. It has been true for some time that China's private companies have lower average costs and higher productivity than the SOEs. But what is new is that these firms are now starting to challenge the SOEs in terms of product quality and market share. It is a pattern we have observed in numerous industries, from industrial parts to marine equipment to mining machinery.

The pattern works like this: A longtime SOE employee leaves to found his own company, often setting up shop in the same city or region as his former SOE. From there, he begins to attract former colleagues, including operations and sales personnel. The operations staff replicates SOE production techniques while the sales staff brings with it some of the SOE's customers. The private entrepreneur skimps on social obligations payments (e.g., worker retirement benefits, etc) and rigorously cuts costs, including the cost of compliance with tax regulations. Unlike at an SOE, the workers know they must produce or face the owner's wrath. At first, the POE is a parasite on the SOE, picking off its most cost-sensitive customers. Then, with its lower cost base, it eventually generates enough cash to make major improvements to the plant. Quality rises. Before long, the POE is out-producing the SOE and challenging its market dominance.

Perhaps the most spectacular example is Mengniu Dairy Group, which rocketed out of Inner Mongolia to become China's second largest producer of milk, yogurt and ice cream. Niu Gensheng founded Mengniu in 1999, after he was kicked out of the state-owned Yili Dairy in a bitter power struggle. Mr. Niu, then a vice president at Yili, took a few key people with him when he left, borrowed $1 million from family and friends, and set out to take on his former employer, China's largest dairy group. With a combination of bold marketing and incremental technical innovation, Mengniu is rapidly closing in on Yili after just seven years in business. Annual revenues last year were approximately $1.3 billion, versus Yili's $1.5 billion. Mr. Niu himself is already a legend.

The emergence of such POEs--almost certainly just beginning--carries some interesting implications for those thinking about M&A in China.

Thus far, POEs have not made for very approachable acquisition targets. The main reason is that owners don't generally want to cash out or relinquish control. They are empire builders who seek to pass their companies to their sons and daughters. In addition, the POEs are, at present, generally imitators rather than innovators--making products that are copies of the SOEs'. This also means they are not yet head-to-head competitors with MNCs--except in the most basic and low-tech of products and industries. But if the POEs are not competing with the MNCs and don't make viable acquisition targets, why talk about them?

The answer is two-fold. First, they are growing so fast that they can make for attractive investment targets. These companies are often capital-starved (though low in debt) and would welcome cash in exchange for a minority equity stake. Investors would not have control, but they would likely have some influence (in the form of a board seat, for example). A strategic investor might buy a stake in a POE supplier to ensure access to a key input. Or the POE might be a local competitor with a strong distribution network and customer base. It might, with additional investment capital and technology, serve as a China manufacturing base for a multinational. The advantages are that these companies are low-cost, nonbureaucratic and know how to operate in China. The main drawbacks for the investor are the lack of control and the difficulty of exiting the investment.

Secondly, as mentioned above, POEs can make for good acquisition partners for foreign buyers looking to restructure an SOE--especially if it is the SOE that the private company came out of. They will have a large network of contacts within the SOE. This means they will know what is going on inside the company during negotiations. Not only that, POEs can knowledgably assess the value of the SOE's assets and can find hidden liabilities. They will also likely have good relationships with local government--greatly easing the M&A approvals process. All of this helps a deal get done.

More importantly, the POE will be instrumental in restructuring the SOE. The POE will speak the same language and know how to avoid many of the common cross-cultural pitfalls. From personal knowledge, they will be able to identify the most talented managers as well as the slackers and obstructionists. And they will know how to strip out costs, as they are already experts on that front. What's in it for them? Growth, mainly.

Of course, working out a viable three-way deal structure is complicated. There are not many established models. One option is to pull the assets of all three parties into a single new company. Another possibility is that the foreign company and the POE take equity stakes in the SOE in proportion to their investment amounts. Each deal will need to be worked out case by case.

And, of course, anything that is new in China is likely to face heightened regulatory scrutiny--though we have, in our own practice, not found these regulatory barriers to be insurmountable. Indeed, many government officials see the inherent appeal of MNCs teaming with POEs to tackle a restructuring. The multinationals can provide the capital, the technology and the international sales channels while the private Chinese enterprises provide the local knowledge and connections, as well as the rigorous cost control. By working together, the odds improve that a lumbering, somnolent SOE can be whipped into shape.

Besides the rise of the POEs, what's next in China M&A?

First, M&A activity will surely continue to grow, but perhaps at a slower rate. Certainly, in terms of deal value, 2005 will be hard to match, at least this year: Excluding the $12 billion in (one-time) deals related to the sale of strategic stakes in China's big banks, M&A was flat (though the total number of deals rose 15%).

Nevertheless, activity should continue to grow as foreign private equity money floods in, as the regulatory situation improves, and as more sectors, including the service sector, are further opened to foreign investment. The underlying rationales driving M&A in China--the chance to acquire low-cost manufacturing capacity and market share, the quest for scale in fragmented industries, the potential investment returns from buying strategic assets and fast-rising Chinese firms--are too compelling to ignore. Looks like those internal acquisition teams are going to be suffering for a while yet.

Mr. Levine is a project manager and Mr. Woodard is CEO at Javelin Investments, a Beijing- and Shanghai-based investment consulting firm with a specialty practice in M&A.

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