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If Fujian Grand Chip Investment Fund (FGC) abandons its agreed EUR 670m acquisition of Aixtron [ETR:AIXA] following the German economy ministry’s withdrawal of its approval it will result in a much tougher future regulatory environment for Chinese buyers who are already struggling to acquire and integrate state-of-art technology assets, said a senior executive at an industry association.

“If the deal fails it’s definitely bad news for other Chinese IC buyers,” said the executive who acknowledged outbound M&A is key to China’s goal to build a semiconductor industry. “Aixtron has solid strength in essential MOCVD [metal-organic chemical vapour deposition technologies] which would greatly boost China’s growth in this field if the ongoing takeover offer can be successfully completed,” said the executive.

Shares in Aixtron have fallen 13% since 25 October when it said the German ministry’s u-turn was due to it becoming aware that the company’s technological know-how extended into the defence sector. One report said US intelligence had tipped off its German counterparts that the deal could give Beijing access to technology that could be used for military purposes. The deal is also undergoing a review from the Committee on Foreign Investment in the United States (CFIUS).

The executive said the US always holds sway over such deals that involve cutting-edge assets essential to maintain its own competence in areas such as defense and aeronautics. Its scrutiny is less strict in sectors like consumer electronics, the executive added. The Aixtron setback further highlights the extent to which CFIUS’ tentacles stretch beyond US shores and comes nine months after the US agency effectively blocked a Chinese private equity consortium’s bid for an 80% stake in Dutch company Philips’[AMS:PHIA] lighting businesses for similar reasons. The perception of CFIUS risk played a key role in derailing Chinese bids for numerous US semiconductor companies, namely Pericom Semiconductor, Fairchild Semiconductor and Affymetrix. CFIUS was also prominent in thwarting an agreed USD 3.8bn equity investment byUnisplendor Corporation [SHE:000938], a business unit of Tsinghua Holdings, in Western Digital [NASDAQ:WDC], a US manufacturer of computer and information storage solutions, as reported.

Notably, these failed Chinese bid attempts were largely led by Chinese private equity players or state affiliated investors. Indeed, eight of the last ten Chinese outbound semiconductor deals above USD 300m in value have been led by private equity investors with the two exceptions including the troubled STATS ChipPAC sale to China’s Jiangsu Changjiang Electronics Technology (JCET) [SHE:600584], according to Mergermarket records. STATS ChipPAC is suffering from considerable losses and there is still some way to go before the expected synergies can be realized, according to a recent JCET announcement.

PE dominance in M&A bids reflects trade players’ weakness

The dominance of private equity bidders and lack of strategic acquirers for overseas semiconductor assets is causing two key problems for China, said industry sources.

Firstly, large Chinese companies with international reputations would have more chances in winning national security clearances than those bidders that have opaque backgrounds such as FGC, said the executive.

The extent to which the first part of this statement is true is debatable as regulatory opposition to most of China’s failed semiconductor deals does not appear to have been linked to the particular nature or identity of the Chinese buyer. But certainly, the background and motives of FGC, a Chinese investment fund, has come under scrutiny due to suspicion, as first reported by this news service, that it is linked to San’an Optoelectronics [SHA:600703] - a Xiamen-based customer of Aixtron that sent the German company’s shares into free fall by cancelling an MOCVD order in December. San’an has not responded to this suspicion, which has since been reported elsewhere.

Secondly, the dominance of private equity acquirers over strategic buyers is hampering integration and synergy extraction efforts, said industry sources speaking at the recent 2016 China IC Industry Development Forum in Xiamen.

Wenwu Ding, president of China Integrated Circuit Industry Investment Fund (CICF) said that although China is becoming more experienced in outbound deal-making, its semiconductor industry is still lacking Chinese bidders with strong financial resources, technologies and global operational capability. Chinese outbound buyers need to focus on achieving reasonable valuations, effective control, and integrating targets with China’s own industry to realize concrete synergies from China’s outbound M&A deals, he added.

Haijun Zhao, COO of China’s largest foundry SMIC [NYSE:SMI; SEHK:981], agreed with Ding and stressed the need for Chinese industry players to take the lead in overseas deals. Private equity funds, which are currently in the driver’s seat in China’s outbound M&A activities, are at a disadvantage in achieving expected post-deal synergies when compared with strategic buyers, he said.

As part of the “Made in China 2025” plan, Beijing wants 40% of the country’s chip consumption manufactured locally by 2020, and to further increase this ratio to 70% by 2025. Last year only 27% of China’s chip consumption was made locally, according to China State Council's statistics. Some research firms consider this number is over stated and project the real number is around 20%.

While independent R&D remains the core theme of long term industry growth, M&As can fast-track China’s IC industry strategic goals and address mounting R&D and manufacturing costs in capital-intensive sectors like memories where market concentration has left only three key global players, said Xiekang Yu, deputy director and secretary general, IC Branch of China Semiconductor Industry Association (CSIA).

He added that cross-border deals would enable Chinese industry players to catch up with global giants by minimizing time to market and making strides in overall competence, while domestic deals would help create globally competitive players by streamlining local industry chain of the world’s biggest IC market, Yu said.

However, Mergermarket data shows that this domestic deal activity does not appear to be creating the powerhouses needed. While the number and combined value of agreed or completed Chinese outbound semiconductor deals has steadily climbed for the past three years - from six deals worth USD 3.1bn in 2014 to 13 deals worth USD 5.1bn in the first nine months of 2016 – domestic deal activity has, in fact, slipped. The first nine months of 2015 saw 21 domestic Chinese deals worth an average of USD 114m. The comparable period this year has seen 17 deals worth a combined USD 105m, based on Mergermarket data.

Chinese strategics need to target niche businesses

Feasible overseas targets for Chinese strategic buyers could be small-to-medium sized Integrated Device Manufacturers (IDMs) that operate in niche sectors and face succession issues. Such potential targets have proprietary technologies and manufacturing capacity, and might consider a sale to a Chinese bidder as they tend to have meager prospect of IPOs or other strategic opportunities, said Nasa Tsai, general manager of China-based IDM Changsha Innovation Semiconductor and a veteran industry executive running various large IC companies in Taiwan and mainland China since 1980s.

These IDMs could be attractive targets for higher rate of deal completion and easier post-deal integration - in certain circumstances their fabrication facilities could even be relocated to China, noted Tsai, who added that regulatory hurdles mean Chinese buyers have little chance in acquiring assets from global sector giants.

Cunzhong Jin, secretary general, China Electronic Production Equipment Industry Association (CEPEA) told this news service that the Association wants to see more M&A driven growth in China’s IC equipment sector. But he also concedes feasible overseas targets are hard to find, as IC equipment giants like ASML [AMS:ASML], LAM Research [NASDAQ:LRCX] and KLA Tencor [NASDAQ:KLAC], which have been consolidating or trying to, are unlikely to consider selling to Chinese buyers. Jin also thought it unworkable for Chinese buyers to target international component providers to meet China’s need for certain key components (the country now relies on imports) used in the country’s own IC equipment. This is because on top of the regulatory headwinds and post-deal integration difficulties such a deal would have, these providers are too big to consider interest from potential Chinese bidders.

Sevenstar Electronics [SHE:002371], a China-based IC equipment provider that recently completed its CNY 924m (USD 139m) acquisition of its Chinese peer North Microelectronics, is one strategic that does not rule out the possibility of considering more M&A opportunities, said a source familiar with the company. The source added that acquisitions are important to accelerate China’s industry growth, but successful buyers need to run the gamut of finance, technology, market, intellectual property factors to achieve significant synergies, the source acknowledged.

The executive cautioned that Chinese buyers risk creating new competitors if they fail to retain core assets of target companies.