, , , ,

fork in the road

Turn right for M&A?

Building a practice in China using capital markets or M&A as the base

Over the last ten years as big Wall Street law firms and their well-to-do cousins have started or expanded China practices, they’ve had to consider whether to focus on building a capital-markets practice or a mergers-and-acquisitions practice with private-equity expertise.

Most firms in emerging markets would prefer to do a M&A deal instead of a capital-markets deal, the former being more lucrative. However, after the initial decade or two when foreign investment and venture capital first flows into an emerging market – for instance, China – and companies are able to grow as a consequence, inevitably a capital markets deal-flow develops. In China during the last 7-8 years, that flow has grown to such an intensity that work overflows and trickles down from top-tier firms into those on the second and third tiers. On vanilla equity offerings, underwriters seeking to maximize revenues may be open to second- and third-tier firms so long as they offer substantial discounts. Firms beneath the top rung thus have an incentive to hire lateral talent and build capital-markets expertise, since underwriters will use them if the price is right. In other instances, sponsors doing exits may push for their own firms to do the registered offering, perhaps because those law firms have a fee arrangement with the particular sponsor. The end result is that, because of the amount of capital-markets work in Greater China, this practice area has become the low-hanging fruit available to a broad host of firms – hence an opportunity for many firms to build a practice and an office around capital markets.

Law firm management may doubt whether capital markets is the right practice area to start an emerging-markets office, since the principal marketing strategy in this domain is underpricing the competition. Measured against New York salaries and subsidies in Asia, real-estate costs and other expenses, it doesn’t sound like a winning economic model. On the other hand, most of the outbound M&A happening in China is the direct consequence of a PRC company having done an IPO and, with funds thus raised, shopping for acquisitions throughout emerging markets. So at least in theory, a PRC company looking to do an outbound M&A is likely to have the funds to pay for legal services. Again in theory, this should present a different and more attractive model: with M&A, proportionally speaking, fees are much better than capital markets. However in practice, outbound M&A hasn’t shown the vitality that capital markets has. (To focus on inbound M&A is effectively to face the same problem capital markets has, as in inbound M&A, the competition has become the  PRC law firms happy to do the work at substantially reduced fees.) The expectation had been that rapidly after doing an IPO, PRC corporates and SOEs would be looking to go outbound. However this hasn’t really happened across the board (a notable exception is the energy / natural-resources sector, and those firms doing energy-type M&A have benefited). The conventional knowledge about this surprising inactivity is that may of these deals – and Chinalco / Rio Tinto is a good illustration – have a strong political component to them, and therefore it isn’t clear if the deal will close because of factors outside the traditional spectrum of law-related hurdles.

In sum, even though capital markets has the stigma of low-hanging fruit – and it may in fact be hard to generate much of a profit doing registered offerings – nonetheless these are revenues that are more reliable and more available than pursuing M&A deals, which may or may not close. Capital markets may actually be a good place to start – though ideally it should be one of a few other practice areas, each of which contributes to the margin. The idea is that after a few years there are 4 or 5 practices in place that a firm can develop and by which sustain itself over a 10 – 15 year timeframe.

photo: Patrick Mackie