The thinking behind HNA Group’s contentious acquisition streak

As Chinese companies’ global buying spree has chilled under the government’s tighter control of capital outflows, the HNA Group—parent company of China’s fourth biggest airline and a conglomerate with a range of businesses from hotels, tourism and logistics to finance—remains acquisitive.

In the first quarter of 2016, Chinese companies’ global mergers and acquisitions (M&A) volume hit $95.1 billion, but the number fell to $23.8 billion in the same period this year. Yet HNA Group, which recently closed a deal to buy a major stake in Deutsche Bank, shows no sign of stopping. “HNA will not stop, as international assets are better priced compared to Chinese domestic assets, and low-cost capital is still available,” said Adam Tan, HNA Group CEO, in an interview with Reuters.

But Tan admitted that its purchase pace would slow down compared to the past two years.

Since 2015, the seemingly somewhat mysterious group made its name by closing deals worth $50 billion in two and half years. Compared to 2013, the group’s assets quadrupled to RMB 1.2 trillion ($176.12 billion) at the end of 2016, from RMB 266 billion.

People wonder as much about where the money is from as they do about why this Group, with its core competency lying in air transportation and tourism, chooses to expand at such an extraordinary pace.

Looking at its deals, some are adjacent to its core business: for example, buying France’s second largest airline Aigle Azur, Hilton Worldwide Holdings and inflight food provider Gate Group Holdings. But some deals seem distant, such as the acquisition of IT hardware maker Ingram Micro, three parcels of land in Hong Kong and a range of financial institutions.

Following a deal in January to acquire UDC from Australia’s banking group ANZ, this May it became a major shareholder at Deutsche Bank, taking a 4.7% stake in the major European investment bank. Meanwhile, it has also shown interest in German shipping finance provider HSH Nordbank. In Asia, HNA is said to have bought stakes in Hong Kong fund house Value Partners, one of Asia’s largest independent asset management firms.

Since its start 24 years ago as a small local airline, HNA has expanded from being an upstart firm to a giant conglomerate with approximately $145 billion assets and $90 billion in annual revenue in 2016. Along the way, M&A-driven growth has been standard practice for the company.

To understand why it behaves the way it does on international stage, it is necessary to know how it started.

Zero to one

Chen Feng, the 63-year-old founder and now chairman of HNA, started Hainan Airlines, currently China’s fourth-largest airline, in 1993 as the only airline company in Hainan Island and with only two passenger jets. At the time, he shouldered the expectations of authorities to boost local tourism and trade, and he received RMB 10 million (then about $1.72 million) from the provincial government to start the company. Yet it was far from enough, as a Boeing 737 cost at least RMB 300 million at the time.

As a result, Chen transformed Hainan Airlines into a joint-stock company, raising about RMB 250 million. He also took advantage of the company’s airline operation license, which was extremely rare in China. With the license and the 250 million capital it had raised, the company received a RMB 600 million loan from local banks and, finally, the firm started operations with two airplanes. Today it has a fleet of 1,250.

But the company did not stop financing, and the two airplanes become collateral for further credit.

“The story of HNA Group, from the very beginning, is related to a high leverage rate,” Wen Xiaomang, a former chief economist with HNA Group, wrote in his article The Financial Management Framework of HNA Group. The company, while managing to keep a healthy cash flow, never stopped finding ways to raise finance and expand through acquisition, and then get further financing based on those acquired assets and the promise of future profit, according to Wen.

In addition to domestic funding, Chen also sought foreign funds. In 1994, Hainan Airlines reached an agreement with Hudson Capital Group to issue stocks in the US. The next year, the US hedge fund magnate George Soros invested $25 million in the company.

Too acquisitive to fail

By 2000, the Chinese aviation industry had expanded to the point where nearly every major province had its own airline company, regardless of service quality and capacity, and most airlines had a high debt ratio of 80%. To address the situation and give rise to several, more competitive state-owned airlines, the country’s top aviation regulator, the Civil Aviation Administration of China, started a round of restructuring. Within two years, most small local airlines were merged into the big three: Air China, China Eastern Airlines and China Southern Airlines.

To avoid the same fate, Hainan Airlines, whose parent company HNA Group had by this point been formed, purchased three local airlines in less than two years: Chang’an Airline, Xinhua Airline and Shanxi Airline. It also bought a controlling stake at Meilan airport in Haikou, the provincial capital of Hainan. The speed was surprising to rival Chinese aviation companies given the small size of HNA compared to the big three and the state support behind them.

“If HNA had not grown so large by purchasing assets at all costs, today there would be no HNA Group,” said Wen in his article.

To diversify and go global

Even with this survival, the drying up of cash remained a problem. With the outbreak of the SARS epidemic in 2003, Hainan Airlines reported a loss of RMB 1.47 billion, five times other airlines’ losses.

“We had been making profit for 10 years … it was the first time we had such a big loss. I realized that relying solely on an airline is not wise,” said Chen 10 years later in an interview with the Guangzhou-based Yangcheng Evening Post.

As a savvy operator in the industry, Chen was aware of the existence of a “transparent ceiling” for the development of airline companies—the Chinese government strictly controls the opening of new air routes, so the non state-owned Hainan Airlines has no priority when it comes to the opening of new routes, and the busiest, most profitable routes are usually dominated by state-owned airlines. Only by diversification could the company sustain further growth.

The group underwent a strategic change: based on the tropical Hainan Island, it pushed into tourism, hospitality and duty free shops; meanwhile, it also targeted insurers, funds and banks—institutions and firms with good amounts of cash flow.

While the group was buying new assets, Hainan Airlines assured the group of a healthy cash flow. Luckily for Chen, Hainan did not take long to become the country’s most popular seaside resort. According to HNA, over 40% of travelers to Hainan fly with their company. In fact, even for those who do not take Hainan Airlines, HNA could still generate revenue due to its ownership of Meilan airport.“

At a time when profit margins from airline ticket sales become thinner from increasing competition, diversification is also meant to shore up future business sustainability and profitability,” says Wang Binglin, an analyst with the Shanghai-based consultancy Red Pulse.

However, some of its deals, including the highly speculative properties in Hong Kong, are not close to the neither aviation nor tourism sector.

“The many acquisitions targeting banks and other financial firms suggest [HNA] is pivoting towards being a general financial services conglomerate to support the group’s lofty visions. After its numerous acquisitions, actually half of the firm’s revenues are now derived from overseas subsidiaries, in addition to its flagship business Hainan Airlines.”

This is echoed in HNA’s Deutsche Bank deal, with the Germany-based institution now offering HNA the chance to lay a foundation for further expansion in the European market and facilitating the purchase of European assets.

There are many doubts over HNA’s deals. S&P downgraded UDC Finance, New Zealand’s largest financial firm’s rating following its sale to HNA. The rating agency also said in a report in December that HNA’s financial policy is risky and its leverage too high.

Nevertheless, the strategy of growing through acquisitions seems to be working. In 2015, HNA made its debut on the Fortune 500 list as the world’s 464th biggest firm in terms of revenue. Chen has set a new target that HNA should be in the top 10 by 2025, with a target of holding $5–6 trillion of assets—more than double of the assets held today by JPMorgan, America’s biggest bank.

Yet people remain skeptical of the deals: where is the money from?

The Financial Risk

In late June, the China Securities Regulatory Commission (CSRC), ordered loan checks for a list of Chinese companies with marquee international M&As. On the list are Wanda, Anbang, Fosun and HNA.

While HNA has been known to receive generous credit lines from major Chinese banks—almost 40% of its loans are from state-owned banks—the order to re-assess HNA’s and other acquisitive companies’ credit risk “serves as a warning that credit-fueled buying sprees will no longer be tolerated,” according to Red Pulse’s Wang.

At the end of May, HNA had around $89 billion in loans from domestic banks, as well as $10 billion worth of debt issued in onshore and offshore markets. According to HNA’s latest financial reports, among the group’s 12 listed subsidiaries, five of them have a debt ratio over 70%. The Group’s total debt to asset ratio, which had at one point hit 80%, reportedly went below 60% in December 2016, according to the CEO Adam Tan.

Explaining the continued purchase of foreign assets while subject to the capital controls of the Chinese government, Yang Guang, a chief investment officer with HNA, told the Wall Street Journal that the company “financed everything from cash flow offshore” and “we don’t have to move yuan offshore”.

In buying Ingram Micro, HNA moved $1.9 billion from its domestic entity Tianhai Investment. Another sum of money came from a group of financial institutions led by the New York branches of the Agricultural Bank of China, and the rest was from the New York branch of China Construction Bank.

Johnson Lee, vice-president of investment at London-based M&A advisory firm Deal Globe, says that in purchasing foreign assets, there are various ways of leveraging overseas markets directly, for example through banks loans, private equity funds and the issuance of corporate bonds.

“It is not a special case for HNA, because many Chinese firms, to reduce the time cost of the state capital approval procedural, would choose to borrow money outside China. HNA, as a company that started to raise finance internationally years ago, has accumulated connections and experience, plus its financial expansion could further help it to access to financial resources,” says Lee.

Wang agrees that buying stakes in financial institutions can help HNA access different forms of financing, yet it will not alleviate its degree of leverage, and more borrowing and debt rollover only “boils down to the balancing of expansion costs versus future profit-making ability.”

More than just debt concerns

“The problem with HNA Group’s deal making is its intensity in the past three years, and it was risky not only in terms of finance—it is also going to be very hard for HNA to integrate these companies,” says Edward Tse, the founder and CEO of Shanghai-based Advisory Gaofeng Capital. “There could be many problems in terms of management, personnel arrangement, corporate culture and finance,” Tse adds.

So far HNA has shown a hands-off attitude toward companies it has bought—there have been no significant changes to board members or management structure.

In announcing the deal for Carlson Hotel, members of the Carlson family said that among the bidders, HNA presented the fewest “negative consequences for our people in [terms of] job loss, and it keeps the hotels group headquartered in Minneapolis,” Star Tribune reported

As the HNA’s M&A activities have proceeded overseas, the company’s domestic firms have started to struggle. Bohai Capital, a subsidiary HNA leveraged to acquire Avolon, had RMB 232.62 billion of debt—more than 600% of net assets—in late March.

For Chinese companies that are obsessed with becoming uber-conglomerates through expansion, it is debatable whether integration can work out smoothly, and so far there is no example of success or failure.

“First you have to respect the corporate culture and establish efficient communication between the subsidiaries and parent group, then you need talent who can communicate cross-culturally. But even when you have all the conditions needed, there is still the risk of failure,” says Lee. “The bigger the company is, the harder it is to govern.”