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Huawei and 3Leaf: What went wrong? Chinese telecoms set sights on strategic foreign assets

by CKGSB Knowledge

March 3, 2011

Chinese Direct Investments on the Rise despite Obstruction

Recent years have seen a surge in Chinese direct investment in the US. From 2003 to 2010, Chinese businesses established operations and created jobs in at least 35 of the 50 states in the US. During these eight years, there have been a total of 244 Chinese direct investment deals in the US valued at USD $11.6 billion.

In 2010 alone, investment exceeded $5 billion. Among 230 deals, 74% involved private companies while investment by state-owned enterprises accounted for 65% of all Chinese direct investment by dollar amount.

However, China’s outward direct investment in the US has faced many obstacles and this has damaged the reputations of some companies.

Recently, Shen Danyang, spokeswoman for the PRC Ministry of Commerce said that a total investment of $20 billion in Chinese outward direct investment in the US have been impeded or rejected.

Huawei’s failure in 3Leaf acquisition 

Huawei, one of the largest telecommunication manufacturers in the world, has recently failed to close several deals related to investments in US.

In February 2011, Huawei announced that it would back away from its plan to acquire US server technology owned by 3Leaf due to pressure from the US government. The Committee on Foreign Investment in the US (CFIUS) urged President Barack Obama to veto the purchase on concerns of “US national security”.

The US government has long been concerned about Huawei’s relationship with the Chinese government. It is long-known that the founder of Huawei was formerly a People’s Liberation Army soldier, though Huawei denies ties with China’s security services.

“I think that the American government’s concerns are unnecessary but understandable. They’ve been very open about why they see Huawei as a potential threat to American security. From the outside, Huawei may look like a black box and is run like a close-knit fraternity,” commented Teng Bingsheng, CKGSB Professor of Strategy.

According to Teng, with 3Leaf, Huawei overlooked the necessity to seek initial American government approval.

“I don’t think that the issue for the American government was the actual content of the deal between Huawei and 3Leaf. The technology that Huawei wanted to buy wasn’t particularly sensitive. For the United States, it was about making the point that if Huawei wants to operate in the American market, it has to play by the rules. This was a small deal, but it was a way to teach Huawei a big lesson,” Teng added.

Other obstacles for Huawei in the US

In 2005, China Development Bank issued a credit line of $10 billion to finance Huawei’s overseas expansion. Subsequently, Huawei has sought out opportunities in both developed countries like the US and developing countries like India. It has penetrated markets in Africa, the Middle East, Latin America and Europe, but it has often met unexpected difficulties in American acquisitions.

Since 2008, Huawei’s three proposed deals in the US have been rejected by the US government.

In early 2008, Huawei, acted as a junior partner in a deal led by Bain Capital to take over 3Com in a proposed $2.2 billion deal. The company gave up finally due to stated security concerns.

In July 2010, Huawei lost a bid to take over 2Wire, an American broadband Internet software producer, although Huawei’s offer exceeded its rivals by $100 million. The company also failed in a bid for Motorola’s mobile network infrastructure unit, which was bought by Nokia Siemens Networks.

In 2010, a group of US Republican lawmakers raised national security concerns about Huawei’s bid to supply mobile telecommunications equipment to Sprint Nextel Corp.

“For Huawei, it’s a necessary step to acquire strategic targets in the United States and other developed countries. Huawei is already the world’s second-largest telecoms manufacturer, and for it to continue to expand into a truly global force, it needs to find and integrate the latest technologies it needs from around the world,” Teng said.

Teng suggested that for the long term, Huawei needs to increase its transparent as a company. In fact, Huawei has an advantage as compared to many Chinese firms in this regard; it publishes financial reports, for one thing, which is somewhat unusual in China.

“But making corporate governance more open and visible will go a long way toward making them more trustworthy in the eyes of foreign governments. Another helpful step might be moving toward a public listing, especially outside of mainland China, since this will also open a window into how the company is managed,” Teng said.

Adapting to the Current Overseas Investment Environment 

In a broader context, there is a growing willingness in China to display and exert its power on a global level.

According to an Asia Society and the Kissinger Institute Special Report on China, An American Open Door? Maximizing the Benefits of Chinese Foreign Direct Investment released this year, by 2020, China’s foreign investments will exceed $1 trillion, and most of this investment will be concentrated in the US and other developed countries.

Chinese direct investment in the US is distributed among diverse industries, including IT, electronic equipment and components, metals mining and processing, textiles, leisure and entertainment, financial service and insurance, renewable energy and warehousing and storage.

Professor Teng said that too often, Chinese companies assumed that if they have money, they should spend it, and they underestimate both the economic and the regulatory risks of overseas acquisitions. All too often, the initial steps go well, but the deal will be tripped up either by regulatory issues or by integration difficulties. As a result, the success rate of Chinese companies’ international acquisitions has remained low.

The authors of the report, Daniel H. Rosen and Thilo Hanemann of The Rhodium Group, estimate that Chinese firms in the US have created more than 10,000 American jobs. But despite an effective U.S. screening policy for inward investment, political interference threatens to divert legitimate and potentially beneficial investment deals.

Surging Chinese investment has triggered populist anxieties in the United States, just as Americans once feared economic domination by Japan. “Japanese investment in the United States during the 1980s was as controversial as China’s,” the authors say, “but in the following years, U.S. affiliates of Japanese companies invested hundreds of billions of dollars in the United States, and today employ nearly 700,000 Americans.”

“More importantly, though, Chinese companies need to understand that overseas acquisitions require a sound economic basis. Recent events will be more important as a lesson for Chinese companies that they need to be careful about the way they engage in major overseas acquisitions. Due to Huawei’s missteps, they now see where the landmines are and can get an idea of how to avoid them,” Teng said.

We spoke with CKGSB Strategy Professor and Associate Dean Teng Bingsheng to unravel the situation and learn what went wrong with both the Huawei-3Leaf and the NSN-Motorola deals, as well as what the implications will be for Chinese and foreign companies.

Q. How did Huawei stumble in its purchase of 3Leaf’s assets? What was the motive behind the acquisition, and why did the U.S. government object?

A. For Huawei, it’s a necessary step to acquire strategic targets in the United States and other developed countries. Huawei is already the world’s second-largest telecoms manufacturer, and for it to continue to expand into a truly global force, it needs to find and integrate the latest technologies it needs from around the world.
But with 3Leaf, Huawei overlooked the necessity of getting American government approval. By the time the deal came to the government’s attention, it was already rather late, and so the United States had little choice but to challenge the deal.

Actually, I don’t think that the issue for the American government was the actual contents of the deal between Huawei and 3Leaf. The technology that Huawei wanted to buy wasn’t particularly sensitive. For the United States, it was about making the point that if Huawei wants to operate in the American market, it has to play by the rules. This was a small deal, but it was a way to teach Huawei a big lesson.

Q. Looking at China, do you think that the decision to delay the NSN-Motorola deal was related to Huawei’s troubles? Might Huawei have lobbied the Chinese government to strike against foreign companies in retaliation for the problems it faced?

A. I think it was related. Particularly as Motorola has an ongoing lawsuit with Huawei on other issues, there is already an uneasy environment for foreign companies in the telecoms industry in China, and the CFIUS decision won’t have helped. But I don’t think it was necessarily caused by Huawei’s lobbying. Of course companies on both sides are regularly involved in lobbying efforts, but I think the Chinese government would have acted this way even without it. Just as the American government felt the need to make a statement by blocking the 3Leaf deal, telling Huawei that it needs to play by America’s rules, the Chinese government is making a statement by blocking the NSN-Motorola deal.

After all, the Chinese government sees Huawei as a flagship of domestic innovation and a pillar of its telecoms industry. It’s proud of Huawei. So when Huawei encounters what China perceives as unfair treatment, China naturally gets defensive.

Q. Do you see Huawei’s treatment as unfair? Is it possible that the American government is using “national security concerns” as an excuse to protect its own telecoms sector from Chinese competition?

A. I think that the American government’s concerns are unnecessary but understandable. They’ve been very open about why they see Huawei as a potential threat to American security. From the outside, Huawei may look like a black box and is run like a close-knit fraternity. Its corporate governance is opaque: according to the statistics that it issues, company president Ren Zhengfei only holds about 1.5 percent of the shares, but he seems to rule with an iron fist. Especially since Ren is a People’s Liberation Army veteran, the Americans had a knee-jerk reaction to be suspicious.

Therefore, even if the economic issue is a factor, I don’t think it’s the most important one. This was primarily a political decision.

Q: So what can Huawei do about it? Do you think that its call for the American government to do a thorough investigation of its operations and corporate structure will improve matters?

A. I don’t think there’s much Huawei can do in the short term. I’m skeptical that their recent announcement that they’re willing to be investigated will help much, since the United States would likely suspect that a cover-up operation could be carried out in advance of any investigation. Also, the Americans might not want to risk the embarrassment of actually doing a search and not turning anything up, the way they couldn’t find any WMDs in Iraq. But remember that the 3Leaf acquisition was actually quite a small deal, so its failure won’t have hurt Huawei seriously. Again, it was just a statement to Huawei that they’re on the American government’s radar screen and so need to play by the rules.

In the long term, Huawei needs to be more transparent as a company. Actually, they’re already better than many private Chinese companies in this regard; they publish financial reports, for one thing, which is fairly unusual. But making corporate governance more open and visible will go a long way toward making them trustworthy in the eyes of foreign governments. Another helpful step might be moving toward a public listing, especially outside of Mainland China, since this will also open a window into how the company is managed.

Q. Do you think this dispute will have repercussions for other Chinese companies? Will they have more difficulty expanding overseas as a result of the distrust that Huawei may have stirred up? Or will it serve as a learning experience for them?

A. I do think that it will be more difficult for some Chinese companies in the short term, particularly state-owned enterprises and other companies with significant connections to the Chinese government. But recent events will be more important as a lesson for Chinese companies that they need to be careful about the way they engage in major overseas acquisitions. Due to Huawei’s missteps, they now see where the landmines are and can get an idea of how to avoid them.

More importantly, though, Chinese companies need to understand that overseas acquisitions require a sound economic basis. Too often, Chinese companies assume that if they have money, they should spend it, and they underestimate both the economic and the regulatory risks of overseas acquisitions. All too often, the initial steps will go well, but the deal will be tripped up either by regulatory issues or by difficulties integrating the foreign target company into the Chinese buyer. As a result, the success rate of Chinese companies’ international acquisitions has been low, and even the best firms, like China Merchants Bank, have made big mistakes. Regulatory risk is one of many risks that Chinese companies face, and Huawei has shown how serious those risks can be.

Q. And what will the repercussions be for multinational companies operating in China? Do you think that this marks a new era of Chinese assertiveness on antitrust issues, particularly when its own companies are threatened? Are NSN and Motorola’s problems a sign of things to come, or just an isolated incident?

A. I think this incident was fairly isolated. China desires to play a greater role in global mergers and acquisitions. Hence, it does not want to be in a situation where its own companies are judged while it is powerless to judge others. So by delaying the Motorola deal, China was sending out a signal that it does have developed serious pieces of antitrust legislation.

More broadly, there’s been a growing trend of Chinese willingness to display and exert its power on a global level. Antitrust efforts represent one of the best and easiest ways to do this, as through them China can make itself heard without appearing overly threatening.

But I do not think this means that we’ll see China using antitrust regulation as a weapon in defense of its own companies very often, nor that there is a threat of things spiraling out of control. Huawei is an unusual case where political and economic factors both combine to raise tensions. But so far, few Chinese companies truly compete on a global scale with multinationals. Most cases of Chinese acquisitions abroad involve Chinese companies buying “losers” – cheap assets of financially strapped companies. They aren’t competing with multinationals to buy “winners,” at least not yet.

So in the short term, crises like this will probably be rare, simply because few Chinese companies pose enough of a threat to cause one. In the future, though, when the Chinese firms that engage in overseas acquisitions are seen less as “white knights” and more as serious rivals, things may get tenser.

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