A deal that takes flight: China's HNA agreement for minority stake in Virgin Australia matches growth plan

A few weeks ago, HNA announced yet another outbound investment deal. This time it was the purchase of a minority stake in Virgin Australia (VA).  In my mind a deal that makes sense for both parties. I gave a brief interview to the South China Morning Post when the deal was first announced (click here).

HNA's deal making appetite seems to have no limits. They are definitely very bold in pursuing aggressive growth and building a global footprint through M&A.  At times it might seem irrational and opportunistic but there are certainly synergy opportunities across many of the deals they are doing.  

The risk for HNA is that they are taking on too much hay on their stack given the size and volume of deals they are closing.  Can they give each business the right amount of attention and resources they require, especially in a centralized management model?  How do they balance potential conflicts of interest? They probably have to take a backseat and refrain from too much operational involvement in the mid-term and work out exactly how they make all the units work together.  But eventually they would need to create value by assembling a group that is greater than the simple sum of its parts.

Strategic rationale?

For HNA, it relatively easy to see the potential synergies with VA.  Australia is a key destination for Chinese outbound travel for business, leisure and study.  And wealthy Chinese increasingly have homes in Australia.  By aligning their networks and cross-selling tickets through their respective distribution channels both HNA and VA can attract more passengers by virtue of now having a more attractive network coverage. 

The deal that will entail code-sharing and other cooperations between VA and HNA’s airlines give both parties greater access to the aviation market in China and Australia. It also gives HNA an advantage over other Chinese airlines to capitalise on commuter flights within Australia by Chinese tourists when visiting the sparsely-populated country.

Potentially HNA and VA can also have a go at capturing part of the lucrative ‘Kangaroo’ market between Australia and  Europe.  A stopover in Asia or the Middle East is required and HNA can tap into VA’s local sales and distribution  capability to potentially route some of that through Hainan or one of HNA’s other hubs in China.  They would be up against some very strong incumbents though and it’s not clear how many passengers would want to switch.

The evolving aviation partnership model

Equity participations  or joint ventures are increasingly common in the airline industry and the HNA-VA agreement is not at all an unusual deal, especially given the complementary network coverage between the 2 carriers.

Once focused on modest collaboration such as selective codesharing and reciprocal frequent flyer benefits, joint venture agreements today have in many cases become so tight as to be virtual mergers. Emboldened by the spread of Open Skies agreements, which provide the foundation for airlines wishing to coordinate activities, a growing number of carriers are seeking the synergies of a merger even as they stop short of full unification.

In some cases, immunized JVs occur between large, global airlines, such as the recent market-disrupting tie-ups between Qantas and Emirates, and Delta and Virgin Atlantic. In other cases, executives for flagship carriers pursue JVs with regional airlines to gain access to growth markets – a proposition that appeals to regional airlines because of the economies of scale offered by a global partner. Japanese carrier ANA’s recent purchase of an equity stake in Myanmar Airlines and Delta’s innovative partnership with GOL are examples of such symbiotic relationships between big and small carriers.

We believe that deeper integration between JV partners of all sizes is inevitable, and that "virtual mergers" will become increasingly popular around the world (click here for a piece by fellow L.E.K. colleagues). Our market forecasts suggest that by 2023, 45% of all global long-haul traffic will be part of a JV. With transatlantic markets largely mature, this substantial growth is likely to come from increased collaboration between developed and developing markets. How these partnerships are structured and managed will determine their success.

The key questions

Determining the structure of the partnership between HNA and VA lays the groundwork for all subsequent negotiations. At this point it is not clear how deep the relationship will go at the operational level but several key questions will need to be addressed:

• Which regions or routes will the partnership agreement cover? Will there be full metal neutrality for all of these routes? How will “behind” and “beyond” traffic be handled – that is, the connecting flights to and from the shared gateways?

• How will exclusivity be addressed? Will there be carveouts to preserve existing relationships? Will multiple parties be permitted to operate on the same city-pairs?

• Will service standards and selling practices be aligned across carriers? Will fare buckets and pricing programs be integrated?

Once these higher level strategic questions are addressed, the most tenuous and time consuming portion of partnership formation often involves determining how revenue or profit will be calculated and ultimately allocated. Negotiating an equitable mechanism to calculate and allocate the current and future performance of the joint business is critical given the permanence of the agreement. Critical questions include:

• Will the joint enterprise operate as a revenue-sharing or profit-sharing venture?

• How will standalone (i.e., baseline) profitability of each party be determined? How many years prior to the agreement will be considered? Will adjustments be permitted to account for irregularities?

• Will there be a parity-payment adjustment (that is, a payment from a poorer-performing partner to a higher-performing partner to make that partner whole) to address differences in baseline profitability? How will the financial mechanism to protect standalone performance be structured?

• Which sources of revenue will be subject to the agreement (e.g., ancillaries, loyalty revenue, cargo, etc.)?

The easy bit is done. An agreement for HNA to acquire a stake in VA has been completed.  To realize the synergies and truly create value from this deal, a long a road lays ahead. The hard work will only now begin.

Michel Brekelmans is a Partner at L.E.K. Consulting and Managing Director and co-head of L.E.K.’s China practice. He has 20 years of experience in strategy consulting and has been based in Shanghai since 2006. L.E.K is a global consulting firm that supports business leaders in evaluating investments and developing strategies and organizational capabilities to deliver significant impact on the performance of their business.   L.E.K. helps investors and executives across three major areas:

• Strategy formulation and activation
• Organisational and operational development
• M&A Services

L.E.K has been operating in China since 1998 through offices in Shanghai and Beijing.