At the time of writing (Lunar New Years Day, February 7,2008), the biggest M&A deal in the world is the US$147 billion bid by BHP Billiton to take over Rio Tinto PLC, and create a US$350 billion mining and minerals behemoth. Regardless of how this deal ends, it has had the unintended consequence of undisputedly confirming China as a player in the global M&A game - especially when what is at stake are strategically necessary natural resources. BHP's original bid of US$127 billion, tendered on November 8th of last year, had to be sweetened by another US$20 billion (16% ) because China had decided to throw its chips onto the table and deal itself into this very high stakes game. And while the other players are playing with share certificates, China is the only one who has put up hard cash! US$12.8 billion of hard cash. In one hand this play dwarfs any individual foreign investment in China's outbound M&A history, and cumulatively exceeds all of the 186 ODI transactions consummated between 1986 and 2005, combined!
　　The table the game is being played on is not wood, but Australia, and the pot is not money, but iron ore. China is the world's largest importer and consumer of iron ore because it is the world's largest producer of steel because it is the world's fastest growing large economy. Rio Tinto and BHP are two of the world's largest producers of iron ore; and combined the two companies would become a colossus perhaps capable of control-ing its pricing. With the price of iron ore, an absolute strategic necessity for China's economy to continue growing apace, having doubled last year, and projected to increase again by perhaps 70% in 2008, China could not stand idly by and let its economy's fate be determined by suppliers without taking some significant defensive measure.
The matter was so patently critical to China, that rumors immediately began to circulate that some arm of the PRC would deal China into the game as soon as BHP made its original bid in November. One rumor was that China's newly formed Sovereign Wealth Fund (SWF), China Investment Corporation (CIC), flush with US$200 billion, would itself make a direct alternative offer. Another rumor was that Baosteel was putting together a syndicate with other Chinese, Japanese and South Korean steel companies to get into the fray. Japan and South Korea, also major steel producers which would be adversely affected by the ability of a Rio-BHP combo to set iron ore prices, have also formally voiced objection to the merger along with European steelmakers. In the end, it was through one of its State Owned Entities (SOE), Chinalco, that China decided to place the bet.
　　Interestingly, the SOE chosen to act as "spoiler," Chinalco, was not a steel company, the natural draft for such a sector play, but China's largest aluminum producer. It is involved with exploration, extraction and processing of not only alumina, but also several other minerals, including copper. As part of a global push by the PRC to secure strategic minerals and metals from as many sources as possible over the last few years, utilizing its US$1.5 trillion in foreign reserves, Chinalco had acquired PeruCopper last year, and had teamed up with the Aluminum Company of America, ALCOA, its JV partner in Pingguo Aluminium in Guangxi Province. It teamed again with Alcoa to jointly acquire the largest single stake in Rio Tinto (12% of the London-listed company and 9% if the Australian businesses are included) through an acquisition of shares from existing shareholders in on February 1st.
　　Chinalco and Alcoa paid a twenty-one percent premium for these shares over the closing price of Rio Tinto on the date of purchase. The payment of such a premium seems to clearly buttress the interpretation that the acquisition was not made for purely investment arbitrage because in order to make a profit on this investment it would have to sell over its acquisition cost premium. This is unlikely in the scheme of things, given that the original bid by BHP was already factored into the market price of the shares before the date of Chinalco's purchase. Also BHP's "sweetened" bid on February 6th (i.e., 3.4 BHP shares for each Rio share) represented only a 6% increase from its original offer (3 BHP shares for each Rio shares). Because Chinalco paid the equivalent of 4.1 BHP shares for each Rio share, this is the break-even threshold and a profitable sale could only be made once a future bid from BHP exceeds this ratio. Chinalco's buy-in thus is near the high end (about 95%) of where industry observers feel the maximum bid pricing of Rio could go: that is, 4.25:1. Thus, as Chinalco's acquisition price paid is still "under water," and indicates that making an arbitrage profit, or even breaking even, on this investment was not the true goal. The reason for this US$14 billion play (of which Chinalco put up 92% or US$12.8 billion) was savvy and strategic!
Of course, the fact that the impetus was primarily strategic does not mean that it can't achieve "Double Happiness" and be successful both strategically and financially. It is worth noting that the market value of Chinalco since the acquisition of the minority stake was made has increased by about 12% or US$ 6 billion. If the investment at some point goes above its basis price paid, it will enjoy having not only its market valuation increase, but the value of its investment as well. This success would certainly help assuage the backlash from the recent loss in the Blackstone investment.
　　However, I don't think Chinalco will flip the investment. The move was fundamentally strategic, and not arbitrageurial, nor even economic or financial, in nature. The combination of Rio Tinto with BHP's natural resource assets, particularly iron ore, would mean the surviving entity could have a dangerous choke hold on China's access to the sine qua non of the PRC's continued unprecedented economic expansion: steel. The central government is concerned, and appropriately so, that the combine could, and would, be able to control and set prices for not only iron ore, but also other commodities that are necessary for China to sustain its planned economic trajectory. As it is, both BHP and Rio Tinto already earn a significant portion of their revenue from sales to China. More germane is the fact that the fear on the part of the Chinese has already become reality in that BHP advised the Chinese in December that it intends to raise the price of iron ore to Chinese steel foundries in 2008 by half. Such a verified intent on the part of BHP strikes terror in the hearts of China because such a pricing hike would be the pricing strategy of the combined BHP-Rio Tinto merger which would control over a third of the world's iron ore, as well as other necessary metals and commodities as copper, natural gas, diamonds, uranium, gold, nickel and silver.
　　It is important to follow the money. Late last year CIC had earmarked a third, or about US$67 Billion of its SWF to go to the China Development Bank (CDB) is at the heart of this and other defensive acquisitions of critical resources. CDB not only financed Chinalco's stake in Rio Tinto, but has also expressed an interest to acquire a 35% stake in Xstrata mining company, located of course, on the green felt playing table of Australia. Additionally, there has been recent speculation that CIC is teaming up and backing China Shenhua Group, the SOE that is the largest coal miner in China, to buy a stake in Fortescue Metals, the third largest iron ore producer in Australia, after Rio Tinto and BHP. Is all this the same "coincidence" that Mr. Xang said characterized Chinalco's buy-in of Rio Tinto? I doubt it is coincidence.
　　The intriguing, but to my mind rhetorical, question is whether or not CIC, through the Chinalco-Alcoa JV, will mount a competitive bid for the whole deal. The possibility makes for dramatic headlines but is not realistic. It is unlikely for at least two reasons. First, the magnitude of the transaction is far too large. Despite holding US$1.5 trillion in foreign reserves, US$ 200 billion of which have been allocated to its SWF (CIC), China will not wager so much of its wealth on a single bet, no matter how strategic. It would not be prudent. Besides, the regulatory approval process might make CHINALCO look like a pleasant event. The outcome would likely be unfavorable and very time consuming. However, as food for thought, there is the possible, but probably improbable, hook-up with other SWFs, which have the money to back an alternative play. Such possibility is an indicator of just how much these new mega-entities could change the global M&A scene.
　　Secondly, both the alignment with Alcoa and the joint purchase of the Rio Tinto interest was defensive in nature, and probably designed not to block the BHP deal, but rather, exact benefits to get its support for the deal. However, this leverage would only be valuable in the event that the vote of Rio Tinto shareholders was close enough to give the Chinalco-Alcoa a "swing vote." But Rio Tinto and BHP have an uncommon commonality: they are to an unusually large extent owned by the same shareholders. Perhaps not a legally affiliates, but arguably technically. There is some dispute about the extent of this shareholder overlap, but it apparently is at least 50% and by some accounts as high as 70%! Thus the "take-over" may be less of a hostile tender than a restatement of asset ownership in the two pockets of the same investors. This augers it unlikely that there would be a real contest between the parties respective shareholders; either the vote will be overwhelming for, or overwhelmingly against, the BHP take-over. Of these two alternatives it probably will be overwhelmingly in favor of the deal and therefore make Chinalco's toe-hold not all that meaningful to closing the deal.
　　However, Chinalco's subtle strategy might be that after a take-over, there would necessarily have to be a shedding of assets and businesses, as there normally is. Credible speculation is that Chinalco-Alcoa slug would be in a preferred position to pick up the most strategic pieces of Rio Tinto in the event of its possible break-up and streamlining of non-core assets (i.e, other than iron-ore) post take-over.
Now matter how the drama winds up, one thing has become abundantly clear: China can, and will, be a factor in major cross-border M&A transactions. However, whether it or not it will elect to ante up and play with respect to any given transaction, will still depend to a significant extent on whether or not the pot is composed of assets which are strategic, not simply a money-equivalents like chips.