Originally appeared in Kaye Scholer's Summer 2016 M&A and Corporate Governance Newsletter.
Chinese companies started off 2016 with a record-breaking number of overseas acquisitions, with more than $121 billion worth of cross-border deals announced in the first half of the year, according to Thomson Reuters data. Yet, this impressive figure does not paint a complete picture. As the number of proposed mega deals surges, the number of high-profile failed and withdrawn Chinese offers has also grown—leading potential targets to question whether an acquisition or investment by a Chinese company can actually be completed, and leaving their boards to evaluate deal certainty and potential deal value based on inadequate information.
Despite an unclear political climate in China and macroeconomic uncertainties, the drivers fueling Chinese companies to target overseas assets continue to propel their acquisitive ambitions. In this article, we first describe briefly these trend drivers. We then discuss the elements that create potential uncertainty around these deals. Finally, we highlight strategies that may help to minimize the uncertainty around deal completion.
What Are Some of the Key Drivers of China's Outbound Growth?
The rapid increase in Chinese investments stems from the structural shift of the Chinese economy from an export-driven model into a consumption and service-oriented economy, which is bolstered by a series of supportive political and economic policies. In recent years, China's outbound investments have been largely led by privately owned enterprises (POEs) as opposed to the state-owned enterprises (SOEs) that bought up energy and natural resources around the world in the first wave of Chinese outbound M&A starting in the 1990s. POEs are driven by different motives than SOEs; they are looking for new markets to offset the growing deceleration of China's economy, as well as R&D and technology to bolster their position at home and fuel expansion abroad.
Move Up the Value Chain and Innovate: The 13th Five-Year Plan, adopted on October 29, 2015, highlighted the Chinese government's focus on upgrading the low-end manufacturing economy into a high value-added economy and raising the international competitiveness of Chinese products. The Chinese government announced its Made in China 2025 (MiC2025) initiative, which aims to advance Chinese industry and foster innovation. In particular, it highlights 10 sectors, as key priorities in the next era of the country's economy, including high-end computerized machinery and robotics, clean technology, aerospace equipment, renewable-energy cars, agricultural equipment and biopharma and advanced medical products. This plan will be followed by two other plans with the aim to build the country into a leading manufacturing power by 2049.
Drive for Growth and Portfolio Diversification: Chinese companies are looking abroad to identify new growth drivers in foreign markets and diversify revenue streams beyond their previously domestic-centric focus. In a number of recent Chinese outbound M&A deals, such as the investment by wholesale apparel manufacturer Dayang Group in its customer, Vancouver-based custom suit-maker Indochino, we are seeing a reversal of the previous global trend to separate brands from manufacturers. Chinese companies are acquiring their customers in overseas markets and vertically integrating themselves to gain access to new markets and to acquire brands that can be brought back to China to strengthen their domestic position and raise their international profile.
Simplification of Foreign-Exchange Approval Processes: China Securities Regulatory Commission, Ministry of Finance, State-owned Assets Supervision and Administration of the State Council and the China Banking Regulatory Commission jointly released a notice in August 2015 encouraging listed companies to engage in mergers, cash dividends and share repurchases. Other state agencies, including the National Development and Reform Commission and State Administration of Foreign Exchange, have also recently adopted regulations that are intended to simplify foreign-exchange management and relax regulatory preapproval requirements to conduct cross-border acquisitions and remit currency.
Devaluation of acquisition currency. The PBOC surprised the world with their devaluation of the yuan in August last year. The widespread expectation of further devaluation encourages acquisitive companies to complete their purchases before further devaluations atrophy their cash reserves.
What Are Some of the Factors That Create Uncertainty Around Acquisitions by Chinese Companies?
While the factors described above will continue to drive Chinese companies to hunt for desirable acquisition targets, the regulatory and internal factors that have hampered some of these deals in the past will continue to haunt acquirers and targets in the near future.
Complicated PRC Regulatory Approval and Remittance Process: Proposed acquisitions must be cleared by the National Development and Reform Commission (NDRC), Ministry of Commerce (MOFCOM) and State Administration of Foreign Exchange (SAFE). In addition, Chinese public companies are also subject to the rules of their stock exchange. The acquirer will need to complete a filing to NDRC and MOFCOM or their local counterparts, as determined by the target's industry sector and country and whether the aggregate purchase price meets certain dollar thresholds. The remittance of currency outside China requires SAFE registration and approval. SAFE has recently stepped up ad hoc capital controls to control capital outflows. Regulators may require preinterview and preclearance prior to remittance and impose timing and amount restrictions on the transfer of funds outside China.
CFIUS Roadblock: The Committee on Foreign Investment in the United States, better known as CFIUS, may step in to investigate a proposed foreign takeover when it identifies potential national security concerns or involve critical infrastructure, may require mitigation actions or may block the deal. While there is no mandatory filing requirement, CFIUS may request parties to file and also has the authority to unwind a transaction. A CFIUS review begins with a 30-day period to authorize a transaction or begin a statutory investigation. If the latter is chosen, the committee has another 45 days to decide whether to permit the acquisition or order a blocking or divestment order.
The 2016 CFIUS annual report to Congress showed that Chinese companies were the leading source of CFIUS filings, with 24, in 2014. The 2016 annual report highlighted the areas on which CFIUS is continuing to focus, including targets that provide products and services to government authorities with national security functions, have access to classified or other sensitive US government or US government contract information, are part of the defense, security or law enforcement sectors, produce advanced technologies useful to national security (including semiconductors, network and data security products), are in geographic proximity to certain kinds of US government facilities, may be acquired by foreign persons controlled by a foreign government and may be acquired by foreign persons that have a history of taking or intending to take actions that could impair national security.
Internal Challenges of Chinese Acquirers: Historically, the lackluster post-acquisition performance of Chinese acquisitions has been partially due to inadequate due diligence and strategic planning by the Chinese acquirers. A survey conducted by The Boston Consulting Group showed that many acquirers lacked a clear M&A roadmap and knew little about the value of possible synergies or how to capture them.[2] In addition, financial advisors have observed that novice Chinese acquirers have limited experience quantifying risks and understanding the profitability models in overseas markets and are more familiar conducting valuations based on historical financial information as opposed to forward-looking valuation techniques, such as discounted cash flow, which are more commonly used as a basis for valuations of US companies.
External Scrutiny of Unfamiliar Acquirers: Sometimes Chinese acquirers may find themselves being confronted with suspicions about their ultimate motives. Chinese acquirers are criticized as being too "opaque" and any official or unofficial ties to the Chinese government draw suspicion that the acquirer will engage in data theft and industrial espionage. In February 2016, 46 members of Congress sent a letter to CFIUS in connection with the proposed acquisition of Chicago Stock Exchange by the private property and investment firm Chongqing Casin Enterprise Group to demand rigorous scrutiny of the company's ties to the Chinese government and security concerns around granting a Chinese company access to US financial markets and proprietary information of listed companies.
What Are the Strategies That May Reduce Deal Uncertainty?
To address some of the factors creating uncertainty, we recommend focusing on the following areas when evaluating an offer and negotiating deal terms:
Understand the Acquirer's Financing Sources: As Chinese companies are not allowed to use equity to make overseas acquisitions, acquirers rely on a combination of cash on hand, onshore and offshore debt financing and partner with financial investors to come up with the cash consideration for an acquisition. It is important to understand the location of the funds the acquirer will use to fund the purchase price and clarify the timing, monetary caps, preapproval and filing requirements that are required to remit currency outside China to fund the incorporation of the acquisition vehicle, escrow deposits and purchase price.
Remittance of onshore currency to fund overseas acquisitions are subject to the approvals of SAFE or a SAFE-designated regional bank. In addition, Chinese law limits onshore bank financing to 60 percent of the purchase price of any acquisition. In contrast, there is no similar restriction on the ratio of offshore debt financing to purchase price and Chinese acquirers may issue corporate bonds and rely on offshore financial institutions outside China to fund the purchase price. If the acquirer's funds are already in an offshore entity, then there are fewer concerns that the PRC regulatory process will block or delay the remittance of funds.
Incorporate Reserve Break-up Fees and Escrows
As uncertainty of completing deals with a Chinese acquirer increase, targets have increasingly demanded a reverse break-up fee. Recent reverse break-up fees accepted by Chinese acquirers have ranged from approximately three to nine percent of the enterprise value of the transaction. Triggers for payment can include:
- Failure to obtain CFIUS and other required regulatory approvals of the target's industry
- Failure to obtain PRC regulatory or stock exchange authority to clear the transaction
- Financing failure
- Inability to get shareholder approval
In addition, to minimize enforceability risk, targets may also demand that the fee be placed in escrow in a bank in the target's jurisdiction to ensure that no additional regulatory approvals will be required to remit the escrow deposits outside China. The escrow deposit will typically cover 100 percent of the highest possible reverse break-up fee specified in the agreement.
Manage the Chinese and US Regulatory Approval Process
US companies are often unaware of the numerous and elaborate preapproval, timing and reporting requirements of PRC regulators for Chinese companies to complete acquisitions, particularly acquisitions above a certain dollar threshold or targets in certain sensitive industry sectors and countries. During the negotiations, it is important that the parties detail all of the regulatory application and procedural requirements in connection with the acquisition and agree upon an approach and transaction timetable to address the issues that may be raised by Chinese regulators.
On the US side, the parties will have to consider potential filing requirements for CFIUS and Hart-Scott-Rodino Act, as well as any specific requirements related to the target's industry. Targets in industries that have received increased scrutiny from CFIUS in recent years may engage in prefiling consultations with CFIUS or member agencies and modify the transaction and determine acceptable "mitigation" measures before filing to expedite clearance. These measures can range from divestiture of assets, forfeiture of sensitive contracts, appointment of special compliance personnel, and appointment of proxy boards consisting of US persons.
As China's economy continues to evolve into a consumer-oriented higher value economy, the interest of Chinese companies to buy overseas assets will likely remain strong, particularly in technology, life sciences, retail and consumer discretionary sectors. As Chinese acquirers gain experience completing cross-border M&A and develop track records in managing targets post-acquisition, the instinctive wariness toward Chinese acquirers may fade and deal implementation will become a smoother process.
[1] Special thanks to Weiran Song and Yuanyuan Li for their research assistance on this article.
[2] The Boston Consulting Group, "Gearing Up for the New Era of China Outbound M&A," September 2015.
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