However, deals worth USD 75bn are reported as having failed to complete, mostly for regulatory reasons. Indeed, several dark clouds have gathered over what has been a continuous growth story for much of the past decade, and are likely to lead to a slowdown in Chinese outbound M&A activity in the first half of 2017.
Dealmakers are already seeing PRC buyers confronted with myriad challenges when trying to remit monies out of China. In parallel, rampant protectionism in various investee jurisdictions is creating its own set of challenges.
Capital controls and other PRC approvals
PRC domestic approval regime
Any outbound investment must be filed with and/or approved by various PRC regulatory authorities (MOFCOM, NDRC, SAFE, and, for SOEs, SASAC). In line with the country’s policy of encouraging outbound deals, such filing and approval requirements have been gradually relaxed over the past few years, with only a limited category of outbound investments (i.e., those outbound investment projects involving sensitive countries and regions, or in sensitive industries) still requiring formal verification by the State-level NDRC.
Such relaxation was intended to enhance Chinese enterprises’ competitiveness in outbound transactions by flattening the level playing field and thereby reducing Chinese enterprises’ execution risk.
However, the theoretical gains made by regulatory changes at the level of MOFCOM and NDRC have failed to make much practical difference, since the last regulatory hurdle – currency conversion – has proven to become the most significant one.
With the RMB not being a freely convertible currency, any outbound transaction that is domestically funded requires the conversion of RMB into foreign currency – a process that is managed by the PRC’s State Administration of Foreign Exchange (SAFE).
Since late 2015, capital outflows out of China have substantially increased, with monthly capital flight exceeding USD 100bn for several months. In January 2017, China’s foreign exchange reserves fell below USD 3 trillion to hit a 5-year low, and the RMB has first halted and then reversed its path of gradual appreciation against the USD. This spurred regulatory action by SAFE to ensure that most sacred of concerns on the part of Chinese regulators – stability – and to avoid a situation whereby the currency depreciation and capital flight would combine forces into a self-sustained destructive loop.
As a result, it has become increasingly more difficult and lengthy to obtain approval from SAFE (or from the commercial banks to which SAFE delegated certain authorities, subject to daily quota at both bank and provincial level), even for genuine transactions. Any contemplated outbound payment is now subject to strict regulatory scrutiny and requires significant time and resources to be processed – leading to delays in closing deals.
SAFE and other PRC authorities such as PBOC and MOFCOM have been notoriously opaque in their handling of the matter. However, some regulatory guidance has been given from which the following broad guidelines can be discerned:
- authorities will pay close attention to investments in areas such as real estate, hotels, cinemas, sport clubs, and the entertainment industry; and
- the authorities are also paying close attention to the following types of outbound investments:
- outbound investments outside the investor’s main business activities (especially those in excess of USD 1bn);
- outbound investments in excess of USD 10bn;
- outbound investments by newly formed limited partnerships;
- outbound investments by small companies with large subsidiaries (i.e., where the value of the target is larger than that of the acquirer); and
- delistings of Chinese companies that are listed overseas.
To allow relevant authorities to assess the authenticity of a proposed investment, the investor will have to file a series of supporting documentation, including its constitutional documents, a due diligence report and other preparatory documents. Furthermore, the authorities are entitled to ask any further questions as they deem fit – the result of which is often to delay their decision-making and, hence, approval.
All of this points to an overarching desire by the authorities to improve the quality of outbound investments and to clampdown on those investments that do not serve a genuine economic purpose. This may and will impact investments in the above-mentioned industries and sectors (real estate, entertainment, sports clubs, etc.) but it should in principle have less effect on strategic M&A by corporate buyers of targets within their industry, and certainly not when the relevant asset fits within China’s wider strategy of avoiding the middle-income trap – hence, investments in advanced technology, cleantech, food safety and similar sectors should, all else being equal, be able to steer clear of being blocked by regulatory intervention.
SAFE approval is a significant concern for those Chinese companies that are only starting to venture abroad. By contrast, buyers with international experience may already have assets and funding sources in place outside of the PRC, and/or be able to grant security in the PRC for debts owed offshore (a structure known as neibaowaidai, which is increasingly also used to finance domestic acquisitions). However, for those funds that are originated from the PRC, there is often no substitute for early planning, careful preparation and proactive engagement with the relevant PRC authorities and banks.
Foreign investment approvals
Investments into European targets are generally relatively straightforward and do not require regulatory oversight, filing or approval in the European recipient jurisdiction, especially in some very specific sectors (e.g., investments into the financial or energy sectors). However, even in such cases, the regulatory approval is generally limited to a “fit and proper” or similar analysis, and limits on foreign shareholders are few and far between (airlines, certain energy assets).
Of more practical relevance to those Chinese investors that are state-owned SOEs is a recent decision by the European Commission in the Hinkley Point matter (a nuclear power plant project set up as a joint venture between France’s EDF and the PRC’s CGN). Confirming its earlier stance in similar (but non-Chinese) matters, the European Commission held that the aggregate turnover and revenue of all Chinese SOEs in the same industry and that do not have an independent power of decision, should be aggregated for purposes of determining jurisdiction of the Commission.
Whilst the question whether provincial-level SOEs that are owned by local or provincial SASAC should be considered as forming a single entity with State-owned SOEs has been left open, the practical consequence of the Commission’s stance is that SASAC-supervised SOEs should be prepared for a possible merger review even in the absence of already having any activities in Europe.
However, such merger review will generally either be formally cleared or can otherwise be managed via appropriate provisions and undertakings in the transaction documentation, such as hell-or-high-water covenants (undertakings to present remedies if so required by the antitrust regulators).
The more relevant concern for Chinese buyers is whether the transaction will lead to a formal security or other foreign investment review by an investee jurisdiction. Chinese buyers seem to have come under greater scrutiny by foreign investment supervisory authorities than other investors. In particular, acquisitions of companies with assets or activities in the U.S., or that may otherwise impact U.S. national security interests, may fall within the realm of the Committee on Foreign Investment in the United States (CFIUS) – an intergovernmental agency charged with the review of foreign investment and the impact thereon on US national security.
CFIUS has seemingly been particularly active in reviewing, and at times not authorizing, investments by PRC buyers, even if, as in the recent Aixtron matter, a substantial part of the target’s assets and activities were outside of the U.S..
Hence, practitioners all over the world should take into account potential security implications in the U.S. (as well as in other jurisdictions with similar regimes, such as Canada, Australia and New Zealand). Calls for the enactment of similar foreign investment vetting regimes have also grown louder recently in various European countries, including Germany, France, and the UK, both because of (real or perceived) security threats and by way of a tit-for-tat retaliation for the lack of reciprocity offered in terms of access to the Chinese market in particular by Western companies.
Even in the absence of a formal security review (or other regulatory vetting process), there have been several instances of Chinese companies encountering de facto political or public opposition against a contemplated investment. One should expect this to increase given the current protectionist trend, the political upheaval sweeping through various Western countries, and the increasing exasperation on the part of Western companies and their governments about the lack of reciprocity when it comes to Western companies’ market access into China, where market entry is often limited or denied, and where permitted, often blurred by a perception that laws and regulations are selectively enforced. Whilst many of these factors are beyond the realms of influence of any individual Chinese corporation venturing overseas, such corporation would be well-advised to take such eventualities into account in its transaction planning, and to proactively consider communication strategies and other ways to involve relevant stakeholders, and preparing, especially internally and externally, for a degree of transparency and openness that it may not be familiar not indeed be comfortable with.
To conclude, PRC bidders for prime assets in the developed world are experiencing headwinds both in their country of origin, where the PRC authorities are reluctant to allow the conversion of RMB into foreign currency, and in various target jurisdictions, where public debate is challenging the hitherto common and unchallenged wisdom that the pros of foreign investment, also when coming from a rather opaque Chinese investor, should outweigh the cons.
These changes in the regulatory environment have led to increased uncertainty as to whether Chinese buyers will be able to consummate cross-border transactions. As a result, the relative comfortable reality where PRC bidders could offset their lesser brands and slower execution capabilities by the lure of a higher consideration (commonly referred to as the “China premium”) for high-quality assets no longer holds true: PRC bidders now have to negotiate increased scrutiny of their contemplated investments and are thus quickly losing their cachet on the international M&A scene risk. As a result, they will have to offer more creative options to potential sellers in order to secure their seat at the negotiation tables. China premia have shot up in recent months as have reverse break fees, escrow arrangements (preferably outside of China) and other risk mitigating measures.
However, the key drivers for Chinese outbound appetite will continue to underpin outbound M&A activity, and with the timely involvement of experienced advisors, most regulatory hurdles can be successfully navigated on terms that are acceptable not only to the parties involved but also to their respective stakeholders. As such, we expect Chinese enterprises to continue their outbound acquisition spree, albeit possibly on a more rational, less headline-grabbing and overall more sustainable scale.