Issues CFOs should consider before launching a JV

Back in 2001 when China joined the World Trade Organization, foreign direct investment (FDI) poured into China's first-tier cities such as Beijing and Shanghai with frenzied anticipation that China would be the biggest growth market of the century. In the winter of that year, I took a position as finance manager in China for a business unit of a foreign public-listed company. The company provided public transport, including operating taxis and commuter trains.

Despite China's rapid urbanisation and its global ambition, many sectors in those days were closed to 100% foreign ownership. The only way for any foreign enterprise to get a foot in the door to China's vast and profitable market was to form a joint venture (JV) with a local partner in China.

The company I worked for decided to structure the JV as an equity joint venture — a limited liability company where both parties share profits and losses according to their respective equity holdings — essentially what you will find in most parts of the world. In this article, I share how my experience on the project gave me some excellent insights into what finance departments should consider before launching a JV in any market, not just China.

Getting started

My team met with many potential equity JV partners across many cities in China in search of the right match. We used three criteria to evaluate prospective partners:

• Chemistry. Assess the feel-good factor about the partner — something that makes you trust the other party and want to work with them. This is the most important factor when choosing an equity JV partner, especially establishing chemistry with the senior management team.
• Strategic fit. The parties' mid- to long-term goals should be similar enough that each party can envision how the partnership will help each of them achieve their own strategic goals.
• Deal structure. Will the parties be able to agree on the structure of the deal at an entry price that makes sense for both parties?

Evaluating partners was a difficult process. Many deals fell through due to a lack of chemistry, a mismatch with the general direction of the potential partner, or a failure to agree on an entry price for a mutually beneficial equity JV. (Even a JV that begins well may someday outlive its usefulness and need to be ended, as discussed in "How to Shut Down an Unprofitable JV".)

I finally came across a businessman who owned one of the largest taxi fleets in Beijing who was interested in partnering with us. We took time to get to know each other, cultivated the relationship, and understood each other's vision before eventually forming an equity JV.

Based on these experiences, I developed three simple tips for finance leaders to improve the success of any JV.

Choose the right partner

Many organisations have dedicated in-house business development teams or mergers-and-acquisitions teams that go to the ground to look for potential deals. Organisations sometimes use outside parties to help broker a deal. These include consultants from investment banks and private-equity funds, or boutique firms that specialise in brokering or introducing deals to potential buyers or sellers. The options also include government departments or private individuals with contacts in the market.

But these sourcing avenues are only the beginning of the JV formation process. Building relationships and chemistry with the potential partner's senior management team is the most crucial factor in a JV's success.

When searching for the right partner, both parties of a potential JV are faced with immense internal and external pressures to make things work. Many have to show results for a successful acquisition or JV to their internal management and external shareholders. In my case, it was having the company undertake a strategic initiative to achieve more than 50% of total annual revenue from its international markets within the next five years.

Furthermore, some potential partners may only reveal the "positive" side of their business — especially if they are the keener party to form the JV. For example, one potential JV partner we came across was expanding so rapidly that it could not increase its credit limit with any bank. We later realised that banks were going to recall its loans and put it under a liquidity crunch. Our alert team spotted this red flag and took appropriate actions to further evaluate whether this JV partner was the "right" fit for us.

Before signing the JV contract, both parties should pause and re-evaluate their counterpart holistically. A useful question to keep asking is: "What is the most compelling reason the potential JV partner has to want to form a JV with us?" Continually asking this question will enable you and your organisation to evaluate the partner strategically.

Consider ROI from your perspective, not the JV partner's perspective

When exploring the feasibility of a JV, we dived deep into the financial and operational numbers of the potential JV vis-à-vis its revenue and market potentials from our perspective. The potential JV partner — or deal brokers such as investment bankers — may produce a set of numbers from their perspective that can assist our assessment of the return on investment (ROI).

It is vital to have someone with deep industry and business knowledge of the financial and operational numbers evaluate the JV from your own organisation's perspective. Having a "gut feeling" on the feasibility of the potential JV is important because I've learned from my past experiences that the usual due-diligence process will not uncover all uncertainties surrounding the ROI evaluation.

In the Beijing JV case, the number of licences available to operate taxis was capped at 60,000 by the Beijing city government. In order to cover our large fixed costs and invest in modern technology such as installing a GPS on each taxi, a minimal economy of scale had to be present to generate positive ROI. Looking only at the financial and operational figures of the potential JV partner was insufficient to consider ROI from our perspective.

Other considerations include looking at the market segment and its growth potential in the mid- to long-term, as well as the strength of competitors. You should also consider the supply chain — including fixed assets purchases, spare parts, and human capital — when assessing the ROI.

Questions we asked ourselves were: If competitors were to make a strategic move to acquire other players in the market rapidly, would our ROI still make sense? And what is the likelihood of such forces affecting the feasibility of the JV? What happens if there are prolonged delays in getting a taxi due to a restriction on the use of diesel engines? We also recognized that even if the potential partner was purchasing taxis at $5,000 per vehicle, that didn't mean the new JV company could purchase taxis at that price.

My recommendation is to perform various forms of due diligence on major operational purchases.

Because uncertainties are risks to the business, I would recommend that the JV contract include certain built-in warranties from the local JV partner. These warranties could protect the foreign investors in the event of incomplete or inaccurate "confidential information" that was fraudulently provided. For example, a warranty could state that the foreign investor will not incur any liability arising from the use of such fraudulent "confidential information".

Choose the 'right' person to manage and engage the JV company

I have witnessed many JVs in China fail due to a lack of trust and communication between JV partners. This is further complicated if a JV has many parties representing the interests of its individual shareholders, which is likely to happen.

To compensate, companies should form a team to manage the JV from the beginning. This team should stay involved when the negotiation moves into more advanced stages with an eye towards both evaluating the project and building trust with the JV partners.

While it's vital to have the right people working on the project, I have seen too many organisations fail to send their best employees to a JV. Companies also should be aware that many employees are reluctant to work in a JV as they fear it might hurt their career advancement compared with employees who stay at the "head office".

It's important to develop a strategy to address those concerns so that you can build a JV management team that will cultivate trust with JV partners. The best leader for such a team will have key character attributes including high emotional intelligence, strong communication skills, and the ability to build win-win solutions when conflicting ideas present themselves.

Resources

Reports

• Management Controls in Automotive International Joint Ventures Involving Chinese Parent Companies
• Building a Better Business, Together: Welcome to Finance Business Partnering

C.F. Wong, ACMA, CGMA, is a member of the Association of International Certified Professional Accountants' North Asia regional advisory panel and head of finance at a company with manufacturing and sales operations in China. He has more than 20 years of experience in finance, including strategy planning and execution, strategic finance business partnering, operational management and improvements, mergers and acquisitions, and automation. To comment on this article or to suggest an idea for another article, contact Alexis See Tho, an FM magazine associate editor, at Alexis.SeeTho@aicpa-cima.com.