Tears in the Rain – Arm and China JVs

We always warn clients that even in the best of times, Joint Ventures (JVs) in China always end in tears. And we are far from the best of times right now. There is a major example of this playing out right now with Arm China.

Arm’s China JV is, to put it simply, a bit of a mess. The Board has fired the CEO, but he has refused to leave. And owing to some peculiarities of Chinese corporate law, removing him is proving difficult.

We wanted to take a look at that as an example of the many complexities of doing business in China. We want to be clear this is not intended as a criticism of Arm. Their plight today is very much a function of the overall business climate, and there are many forces at play beyond their control.

Some quick background. Arm makes what are essentially blueprints for processors, a crucial part of many chips. Think of Arm cores as the engine of a car. Arm provides the latest designs for the engine, then the car makers put all the other pieces on top. Processors, the engine in this analogy, are expensive to design but relatively common across many part of the function sof a chip. So almost every chip which does any form of computation (as opposed to just basic sensing and reacting) uses Arm intellectual property (IP).

This role puts Arm in a central position for any semis strategy, and so it should come as no surprise that Arm started to draw a lot of scrutiny in China. As many foreign companies discovered in the early part of the 2010’s, the Chinese government was very interested in chips and looking to build its own, domestic chip companies. This led to pressure being applied to many foreign chip providers. Then the US-China Trade War hit, further ratcheting up the pressure. In the end, the Arm parent sold a 51% stake in Arm China to a consortium of Chinese investors.

Background on the deal is a bit fuzzy. There is no Arm press release on the deal, only a brief release from parent Softbank. They describe the rationale for the deal in pretty basic terms:

The Chinese market is valuable and distinctive from the rest of the world. Arm believes this joint venture, which will license Arm semiconductor technology to Chinese companies and locally develop Arm technology in China, will expand Arm’s opportunities in the Chinese market.

Source: SoftBank

This piece from Reuters says Arm sold 51% to a consortium of Chinese investors including private equity vehicle Hou An.

Backers of Hou An include sovereign wealth fund China Investment Corporation, Silk Road Fund, Singapore’s Temasek Holdings [TEM.UL], Shenzhen’s Shum Yip Group and Hopu, according to China’s Ministry of Science and Technology.

Source: Reuters

Crucially, the article points out that:
Arm will, however, continue to get a significant proportion of all license, royalty, software and services revenue earned by Arm China’s licensing of its chips, SoftBank said.

Source: Reuters

So right from the get-go. There is something odd going on here. First, Softbank’s rationale states that the China market is “distinctive”. By which they presumably mean it is distinctive in that the government has a strong, but unofficial policy to “encourage” foreign IP transfers.

Second, Arm is giving up 51% control but still hopes to get a significant portion of the JV’s revenue. One would think that for the $775 million it received and the loss of voting control would mean it no longer has a claim on the JV ‘s revenues.

We have an interpretation of all this based on our many years of working with China JVs. So allow a simple, if imprecise, description. China wants Arm to transfer IP to China, and probably cut better royalty rates for Chinese chip companies. Arm sees it has no choice, and wants to keep its China business on a sound footing. So they set up the JV. They give up 51% control, which theoretically qualifies the JV as a Chinese company, thus satisfying the government. The JV has the right to sell Arm IP in China, and a portion of that is passed on to the parent as a supplier of IP.

But here is the tricky bit. Arm no longer has voting control of the company, they are less than 50%. How do they maintain effective control over a sizable and strategically important part of their business? One method we have seen other companies use is to diversify the holders of that 51%. This way the foreign company may not have majority control, but it does have a plurality as the largest single shareholder.

Then the problem becomes how to manage the various other shareholders and ensure that when push comes to shove, the foreign company still can muster up at least a few more points in any vote. Most US companies we have seen do this by relying on the fact that China is not a monolith. The various JV partners will all act in their own interests. For the most part, that means they will vote their JV shares to whatever will maximize the value of the JV. When issues of national policy arise, they may unify to vote against the foreigner, but most of the other times, they will likely have divergent viewpoints, which the 49% foreign-holder can manage to reach any desired outcome. This is always complicated, and a big part of the reason JVs fail (in most places, not just China).

Over the years, we have worked with dozens of China JVs, probably over 100. They almost always run into problems. We know dozens of examples where one party will walk out the door with customer lists, product designs, the entire management team – pretty much anything of value. To be fair, we have also seen countless examples of Western companies being equally ruthless leaving their JV partner with nothing.

In Arm’s case, something has clearly gone wrong. The Financial Times has been doing the best reporting on this (and here) . Simplifying again, the CEO of Arm China was accused of conflicts of interest. He has set up an investment fund, and is accused of offering discounts on Arm licenses to companies who invest in his fund. Sounds bad, but this is very far from the worst JV horror story we have seen.

So after some period of negotiation, the board of Arm China voted to remove him. However, he holds all the official documents and stamps for the JV, and he has refused to step down. He appeared as the CEO of Arm China in a keynote at an industry event last week. Chinese company law makes removing him at this stage possible, but complicated and time-consuming. The assumption is that he is making things difficult to bolster his position in an ultimate exit negotiation. For the moment he has a lot of leverage by having possession of the seals, but also through the presumed loyalty of much of the local team.

So far it is unpleasant but fairly straightforward. However, the FT story that came out this weekend adds a few wrinkles that make the story positively weird.

Going back to the way that foreign companies can maintain control with less than 50% control of a JV. Foreign companies often find they are dealing with a sea of strangers. All those private equity funds are helpful, but how to gauge where their true interests lay. Wouldn’t it be helpful to have some known actor have a stake in the JV, to provide those extra votes? How about someone who has been an employee for almost 20 years and now runs the China business? Maybe let him invest in the JV, “aligning” his incentives in lieu of some form of restricted stock. It turns out that among the investing consortium who acquired 51% of Arm China, the CEO ended up with 13% of the JV.

It really looks like Arm thought they had found an elegant solution to the trust issues embedded in every JV, but instead have created a bigger problem.

Further complicating the matter is that it appears that at least some of the Arm China board members not only knew about the CEO’s fund, but invested in it themselves. It seems possible that Arm signed off on the fund without perhaps understanding all the details. Part of Arm’s work everywhere is incubating new chip companies which can grow to be big Arm customers. Nowhere is this more important than in China which has 1,000+ new chip companies. So Arm China is working with numerous chip incubators, including the CEO’s firm.

Further complicating the matter is that the principals in this affair are a who’s who of executives from China’s leading chip companies.

Our favorite detail to emerge from this is that the Arm China CEO named one of his holding shell companies “Acorn Spring Limited”. The original name of Arm Holdings is Acorn RISC Machines”, so there is an interesting bit of irony in that.

And then there is the matter of Huawei

When Arm sold its stake in Arm China, one assumption in the US was that part of the motivation was to allow Arm, a British firm owned by a Japanese conglomerate, to continue licensing IP to Huawei. Like every other chip designer, Huawei relies heavily on Arm. And there are concerns that the US government will prevent Arm from supplying Huawei. In the first round of Huawei restrictions last year, Arm made it known that they were only providing Huawei IP from current licenses and were cutting off access to future improvements. With Arm’s complex China holding structure, we can think of a half dozen loopholes that may allow Huawei to continue to access Arm IP. Maybe they take advantage of those, maybe not.

And this gets us back to the root of the problem. The entire notion of Joint Ventures has always been a regulatory hack. China has wanted to limit foreign companies’ control of China’s market. Through various iterations, the JV has been a way for Chinese companies to benefit from foreign companies operating in China, from profit sharing to IP transfer. For almost a decade now, JVs have been on the wane as China’s corporate laws have matured, diminishing the value of the structure. But they persist, especially in sectors the government views as crucial.

JVs introduce so many problems. At heart, they are management by committee. The parties in the JV have conflicting interests, and these conflicts are the reason we almost never see JVs outside of China. There is always a rivalry for control and sharing of gains. These usually lead to internal rifts inside a company, forcing managers and employees to choose sides. Arm is not alone in their struggle, they are just the latest, most public example of the problems that arise with these structures.

We are not sure how this will end. If we had to guess, we think it is likely that the CEO leaves in the coming months. He will likely go with a nice severance package and Arm China will continue to work with his incubator fund. It is quite the soap opera.

Reference: DIGITS TO DOLLARS