China’s campaign against “irrational deals” may have dampened domestic companies’ enthusiasm when it comes to outbound investment, but as the new year dawns, overseas M&A is set to pick up again, and offshore lawyers are ready to assist their clients as they hunt targets abroad.
An order in July 2017 from Chinese regulator to stop banks from lending money for foreign acquisitions to the giant conglomerate Dalian Wanda marked the height of a significant turnaround in China’s outbound investment landscape.
Wanda, owned by billionaire Wang Jianlin, had emerged from its roots as a developer of shopping malls to become a global entertainment player. In 2012, the company had bought out AMC Entertainment of the US to become the world’s largest owner of cineplexes. Then, in 2016, the company spent $3.5 billion to acquire Legendary Entertainment, a movie producer. The company had also spent billions buying up chains of cinemas, a yacht maker in the United Kingdom. Altogether, six of the company’s deals fell under the umbrella of new capital restrictions that were first imposed in 2016.
And Wanda was not the only company affected by this push from Chinese regulators to stop “irrational deals.”
All told, Chinese companies spent some $170 billion in deals abroad in 2016, a record high. This did not sit well with regulators, who saw many of the deals as “irrational”.
Anbang Insurance Group, which gathered global attention in 2014 by topping off a $30 billion shopping spree abroad with the acquisition of the famed New York hotel the Waldorf Astoria, also became the subject of a crackdown. In May, regulators asked banks to stop lending money to the insurance giant and detained its chairman Wu Xiaohui.
Other groups, including Fosun International and HNA Group, also fell under the increased scrutiny of regulators intent on protecting the country’s financial system.
CURBS SUCCESSFUL
The regulatory curbs, ramped up investigations, new policies and other efforts to contain “irrational” investment overseas undertaken through 2017 appear to be successful. The combination of efforts led to drops in the total value of non-financial outbound direct investments last year after big increases in 2016.
As the year 2017 drew to a close, data from the Ministry of Commerce (Mofcom) showed that some 6,236 companies had invested $120 billion in 174 foreign countries. The figure, impressive as it may seem at first blush, represented a 29.4 percent drop from 2016, the first decline in a decade. The drop was not only expected but wanted. In 2016, regulators had been alarmed by the sheer number of deals abroad deals that at times made little business sense for the companies that made them.
Activity linked to mergers and acquisitions (M&A) also declined in 2017. According to a PwC report, the value of M&A in China dropped 11 percent in 2017 to $671 billion (down from $753 billion a year earlier). While the total value of deals in 2017 was greater than in 2014 and 2015 combined, PwC pointed out that there has been a visible move away from efforts to acquire “passive or trophy assets”.
All this is in line with the general push by regulators to curb irrational deals.
Those efforts were first announced early in 2017 and materialized throughout the year with a series of new policies and enforcement efforts. As a result of these efforts, no new deals were announced in areas of real estate, sports or entertainment in the last few months of 2017 and the final figures showed a total that was roughly the same as in 2015.
However, as 2017 drew to a close, there were some signs that while the curbs were not really likely to be loosened, businesses and the law firms that work with them on structuring overseas deals had grown accustomed to the rules and were ready to work with them.
Although authorities made it clear in January 2018 that they had to immediate intention of changing their approach there are now expectations of better deals in the offing. Speaking to China’s national news agency Xinhua in mid-January, Mofcom official Han Yong confidently declared that “irrational outbound investment has been curbed.”
“I don’t see the ban being lifted completely anytime soon,” says Fiona Chan, a partner at Appleby “The capital controls have been in place for over a year since the last quarter of 2016, and the industry was looking for an update in 2017, but from what I heard in the markets, it’s not happening anytime soon.”
Still, there were some indications as 2018 started that that tide might be turning. PwC’s report suggests that, while the total value of M&A deals has dropped, the total number of deals continues to increase. In no small measure, the drop in the total value of deals could be related to the drop in the number of mega deals worth $1 billion or more. Over the last five years, the trend is visibly on the increase.
“The Chinese government is looking to find the right balance between restricting companies from irrational investment in ‘trophy assets’ and accepting that overseas investment is integral to China’s international expansion and strategic investment projects such as its Belt and Road initiative,” says Christopher Bickley, partner and head of Conyers Dill & Pearman’s Hong Kong office.
And this uptick may turn into more mandates for law firms, particularly offshore specialists that are often tasked with bridging the divide between mainland Chinese firms and the countries where their investment targets are located.
Regulators in the PRC may not have taken steps to loosening curbs on irrational deals but the companies are now learning how to operate within the new normal environment, which may pave the way for domestic companies to step up their activities abroad after a year of curbs. This, in turn, created new opportunities for more offshore work for firms, both domestic and international.
And this may be helped by relatively good economic news at the end of 2017. Official data released in mid-January showed growth for 2017 clocked in at 6.9 percent, beating both the government target of 6.5 percent and the total growth of 6.5 percent in 2016. While growth in 2016 was the weakest in 26 years, the increase in 2017 was the first since 2010.
RULES FOR QUALITY GROWTH
Still, Beijing’s new approach is to focus on quality growth rather than rapid growth. It has become a cliché to point out that the age of double-digit growth is over. And one of the ways in which the government is pushing for high-quality growth is its curb on irrational investments.
At the heart of these efforts to curb investment was a clear push to not only put in place more rules on everything from the flow of currency to risk management but to enforce those rules and share information more effectively among regulators. And those rules are now becoming part of the norm.
On Jan. 26, a group of regulators issued a set of (for now) temporary rules that would be used to oversee outbound investments. While companies were only expected to file records with local or central planners (or both) before launching projects, they are now expected to file information on the whole lifetime of the deal. Regulators plan to pay particular attention to any deal worth more than $300 million as well as deals done in “sensitive countries and region” and “sensitive industries.”
“Chinese outbound investors will need NDRC approval for deals in ‘sensitive’ countries and industries, and for deals over $300 million, even if the deal is transacted entirely via offshore entities,” says Bickley. “Apart from infrastructure investment in support of One Belt, One Road, we would expect investment to be strategic in technology such as AI and in education and healthcare.”
At the same time, various regulatory agencies have put in place information-sharing mechanisms that will allow them to work more closely together.
This information sharing mechanism will make it possible to cases involving, for example, tax evasion to be passed to the right authorities, such as police or industry departments.
“Over the process, market rules and international practices must be followed,” State Administration of Foreign Exchange spokeswoman Wang Chunying said during a press conference earlier in the month.
Another effort that was also announced would see curbs on the use of insurance funds to invest abroad, in a set of rules that will take effect on April 1. According to data from the China Insurance Regulatory Commission (CIRC), there is plenty of cash that insurance companies could draw from to invest abroad. Income from insurance premiums across the country increased 19.2 percent year-on-year from January to November 2017 to hit 3.44 trillion yuan while the industry reported combined assets of 16.64 trillion yuan, up 10 percent from the beginning of 2017.
THE SLOWDOWN OF 2017
Between January and October of last year, China's non-financial outbound investment plummeted 41 percent to $86.3 billion, according to figures from the Ministry of Commerce (Mofcom) released in mid-November. The ministry released the figures even as it claimed to have curbed "irrational" investments abroad.
The bulk of these investments, which were done by some 5,200 companies in more than 154 different countries according to Mofcom, went to businesses engaged in leasing and commercial services, manufacturing, wholesale and retail as well as information technology.
Speaking during the 19th National Congress of the Communist Party of China in October, Minister of Commerce Zhong Shan said a key factor in curbing deals was strengthening risk management, a key consideration for regulators given the sheer uptick of investment abroad. China has assets worth $6 trillion abroad and overseas direct investment (ODI) has increased by some $660 billion in the five years to 2017. Altogether, China is now a net exporter of capital.
Often, this is good news. Chinese investments have helped create some 1.5 million jobs abroad and directly contributed to tax payments worth more than $30 billion. Since 2010, the flow of capital out of China and into markets abroad had been accelerating year after year to peak at $170.1 billion in 2016, up 44.1 percent from a year earlier, according to Mofcom.
Still, Zhong pointed out that risks are often the result of inexperience, saying that there have been “difficulties in the process of progress.” Irrational deals, he pointed out, have taken up large chunks of the country’s foreign currency reserves.
The constant and rapid increases did not sit well with authorities that wanted to stabilize the renminbi (RMB). So, new rules for overseas investments were implemented in August 2017 that implicitly barred irrational acquisitions in a range of industries, from real estate to hotels and restricted investments in property, hotel, film, entertainment and sports.
The move was spurred, in part, by a rapid drop in China's foreign exchange reserves in the second half of 2016. By the beginning of 2017, there was no unified or formal regulatory policy to deal with the risks created by cross-border capital flows and stabilize the foreign exchange market. As 2017 started, all the major regulators including the People's Bank of China, the State Administration of Foreign Exchange (SAFE), the National Development and Reform Commission (NDRC) and Mofcom, agreed to move forward on addressing four goals including checking overseas investments for their authenticity and compliance, strengthening the authentication of deals, requiring more information on deals and strengthening regulation on overseas lending denominated in RMB.
“The recent measures by the NDRC announced in December have expanded regulatory oversight but have at the same time made it easier for more straightforward deals to be done,” says Bickley.
Over the months that followed, regulators in Beijing all but put a ban on any outbound deals that they considered to be “irrational.” In broad strokes, this meant any deals that were not obviously related to the typical business of a company.
Anbang’s deal to acquire the Waldorf Astoria, an insurance company buying into the hospitality business, is a case in point.
Another was the deal that HNA did for the refrigerated transport business of Automotive Holdings Group. For HNA, the cost of an insatiable $40 billion push was significant. The company started acquiring assets at breakneck speed in 2016 but it also acquired plenty of debt and interest payments that added significant risks to its balance sheet. In November 2017, the company issued the most expensive short-term dollar bonds ever and had to pay additional interest to push back the repayment of a loan linked to a construction project in Hong Kong.
These are examples of risks that Chinese authorities are not really keen to live with. They not only want to curb irrational deals but also lending to get a better handle on the amount of debt floating in the economy.
In November 2017, Chinese regulators doubled down on their efforts to curb irrational investments by issuing new rules that included 39 possible penalties for firms that violated rules and opened the possibility of blacklisting firms that made moves seen as not authentic. The aim of the new rules was to prevent firms from engaging in illegal outbound investments or profit by short-selling the RMB.
It wasn’t until the end of the year and the emergence of data showing that Chinese growth and the RMB had both stabilized (and the economy actually grown at just a little bit above target) that the clampdown loosened somewhat. Still, the taps have not opened. Rather, the new rules are likely to represent a new form of “business as usual,” one that has already helped stabilize the market.
“It’s really not surprising [that the ban hasn’t been lifted], and whatever effect it was going to have on the market has already taken place,” Chan says. “We have learned to adapt and got used to the new rules.”
“The controls were quite specific on investments not related to the original business in sectors such as entertainment, sports and real estate,” Chan notes. “And it did help curb random and irrational investment in these areas, [the regulators] were very successful from that aspect.”
“We do see a continuous decrease of outbound investment in the real estate sector, but in terms of other forms of investment, the work is still there,” adds Chan. “Even though the ban is still there, banks are still doing a lot of investment including offshore structures, in various places around the world. Africa, for example, is an emphasis at the moment; the China- Africa fund has been very active lately as an investment vehicle.”
The ban has created plenty of questions marks.
“We’ve had clients sending enquiries about the effect the ban could impose- and this is not exclusive to PRC clients. But for the normal, premium investment, financial transactions have not been an issue,” Chan says.
This is likely to continue apace.
“Unless there’s any particular change, it will be a continuation of what happened last year,” Chan adds.
Interestingly, the ban has had some somewhat unexpected and not always positive side-effects for law firms that saw some mandates paused, slowed or delayed, if not cancelled outright. Given the size of these deals, it is not entirely surprising that stakeholders might choose to take their time and, perhaps, even wait until the winds change.
“Our payment period got longer due to the additional paperwork required after the ban was in place,” Chan says. “We were required to have formal engagement letters or other forms of written evidence with our mainland Chinese clients to substantiate the payments, and the banks will have to do a thorough check, which would result in delays in payment.”
BELT AND ROAD
These efforts to curb irrational deals happened just as the government was putting the pedal to the metal on anything related to the flagship Belt and Road Initiative. First launched by President Xi Jinping in 2013, the Belt and Road Initiative is a massive foreign policy initiative aimed at boosting trade and investment in more than 65 countries along two modern silk roads, one maritime and one overland.
Throughout 2017, investments in Belt and Road related projects grew to $14.4 billion with deals recorded in some 59 countries, according to Mofcom data. The total investment was virtually unchanged from 2016 (when investment in Belt and Road countries added up to $14.5 billion) but the share of total Chinese investment that went to Belt and Road initiative locations and projects increased to 12 percent of the total, up from just 3.5 percent in 2016. The difference, of course, had to do with the visible drop in total outbound investment recorded in 2017.
“Investment in line with the Belt and Road initiative is also increasing, but not a lot is via offshore vehicles,” Chan says. “They don’t tend to use the traditional offshore vehicles for investments in countries like India and Indonesia.”
Total investments in Belt and Road projects in 2017 did not match the record $18.5 billion investment in 2015, but those projects were generally less affected by the increased regulatory scrutiny on foreign investment.
"The Belt and Road Initiative will also continue to be a major driving force in Chinese outbound investment,” says Stanley Jia, chief representative of Baker McKenzie's Beijing office. According to Baker McKenzie’s Belt and Road report, China-linked Belt and Road initiative projects will be worth $350 billion over the next five years.
There are already a lot of Chinese companies actively developing their Belt and Road projects, particularly in infrastructure and power. Chinese companies are investing in South Asia and the Middle East in the power sector very actively. They are also helping to develop rail systems in Southeast Asia, Eastern Europe and Latin America.
“Cross-border transactions of this kind can involve multi-layered local regulations for financing, contracts, and environmental considerations,” Jia says. “This drives up demand for advisory services not only in M&A and project finance, but also in other related advisory areas, including antitrust and competition, compliance, regulatory, employment and tax.”
“For law firms, having the right mix of capabilities will be the key to unlocking this opportunity,” Jia adds.
A set of guidelines released in August 2017 by the State Council aimed to regulate healthy foreign investment – with emphasis on healthy – but also encouraged firms to invest in more infrastructure projects that promoted the Belt and Road Initiative or facilitated cooperation with high-tech companies abroad. The guidelines also encouraged investments and cooperation in agriculture and service sectors in foreign countries, particularly in Belt and Road countries, but restricted investments in real estate, hotels, movie theatres, entertainment and sports clubs.
“Offshore entities are likely to have a significant role to play as the Belt and Road initiative develops,” says Anthony McKenzie, partner at Carey Olsen.
Offshore entities have a long-established use in Asian cross-border transactions, especially in jurisdictions where it is difficult to find experienced local legal advisors, or where financing is sought from international third-party investors.
“Given that there may be a significant funding gap between the cost of each project and the amount on offer from PRC banks, it is likely that opportunities for foreign investment would be created,” McKenzie says. “Offshore entities are often seen as providing the necessary impartiality and stability to be the medium for such investment.”
GOING FORWARD, LOOKING UP
As 2018 starts, change is in the air. Companies, many flush with cash are chomping at the bit to get back on the M&A trail with new strategies to better fit the new reality. And offshore law firms are getting ready to help them. Some sectors are likely to benefit in more spectacular fashion than others.
Commentators believe overseas M&A is predicted to increase in both volume and “orderliness” in 2018. More deal volume balanced by more scrutiny may lead to delays as investors adjust to the new rules.
“Offshore entities are now included in the regulatory framework for overseas M&A and an accepted part of the investment landscape. They will continue to provide a neutral platform through which Chinese companies can structure their overseas investment strategies,” says Bickley from Conyers Dill & Pearman. “As more domestic industry focused companies look to opportunities outside of China, firms will need to dedicate time to familiarizing these companies with the advantages of ‘offshore’.”
Any relaxation of restrictions could have an almost immediate impact on the market.
“If the ban is lifted, even if just a little bit, the real estate sector will benefit the most from it as it was the sector that got hit the most,” Chan says. “Real estate is the number one type of investment Chinese investors would go to, it accounted for 40 to 50 percent of China’s outbound investment before the ban came in.”
Chan also noted that offshore firms have to adjust their strategies and help their clients deal with the situation. “Appleby was not hugely affected by the ban because we have a whole range of different offshore services in different jurisdictions,” she says. “But the smaller firms that specialize in one area, especially real estate, were greatly hit by it.”
The investor-friendly, tax neutral, politically stable, well-regulated legal systems of the Cayman Islands and BVI continue to be the preferred jurisdictions for overseas outbound and financing acquisitions.
“Offshore law firms providing Cayman and BVI legal advice must be accessible in being able to be easily contacted in the same time zone by Chinese companies and to also offer legal services by a properly bilingual workforce who are able to effectively communicate and build long-term relationships with their clients,” says Matt Roberts, partner in Maples and Calder’s corporate team in Hong Kong. “The provision of legal services is a personal service and building long-term client relationships of trust and goodwill are the goals of every good lawyer.”
At the same time, it is important offshore law firms are aware of the needs of their PRC clients and understand the business culture.
“Having the ability for team members to visit the clients in person, and who are able to converse in Mandarin is an increasingly important differentiator between offshore firms,” McKenzie says. “Our clients in China now have direct access to our specialist lawyers who are in the same time zone as them and in the context of their own commercial environment.”
In the end, most observers expect good things in the future.
“We are optimistic about the long-term growth of China M&A,” Jia says. “It is true that China's capital control and foreign investment restrictions have had some negative impact on the country's outbound investment in select sectors. These measures, however, will help to foster a more sustainable ecosystem that would favour not only corporate China's outbound investment strategies but also the country's economic development in the long run.”
China clampdown on overseas deals crimps Asia Pacific M&A volumes in 2017
By Reuters
Asia Pacific deal-making activity slipped in 2017 as outbound transactions nearly halved, led by China as Beijing increased scrutiny of cross-border investments and clamped down on some of its most acquisitive – and indebted – conglomerates.
Chinese overseas mergers and acquisitions investments slumped by more than a third to $140 billion last year from a record in 2016, data from Thomson Reuters showed, and investment bankers expect the deal-making environment to remain cautious in 2018.
The slowdown in new deals, especially large-sized ones, could pressure Asian revenues of Wall Street banks, which are facing growing competition from Chinese investment banks that are beefing up their M&A businesses.
Chinese companies have faced lengthy approvals for their outbound deals after Beijing tightened capital controls late last year in an effort to stabilize a weakening yuan. Sectors such as real estate, sports and media that previously saw heightened activities were hit particularly hard as investments in them were labelled “irrational.”
“People are treading carefully amid capital controls. They don’t want to be too flashy,” said Samson Lo, head of Asia M&A at UBS.
Overall M&A volume in Asia Pacific hit $1.08 trillion in 2017, down 4.3 percent from 2016, the data showed, as regional activity was propped up by banner transactions such as French property firm Unibail-Rodamco’s $24 billion purchase this month of Australia’s Westfield Corp.
It was the third consecutive year that Asia-Pacific deal-making surpassed $1 trillion.
The region’s outbound deals, however, plunged 46 percent, hurt by China’s retreat from global deal-making compared to the record $218 billion the country did in 2016.
Some of China’s most acquisitive conglomerates, such as Dalian Wanda and HNA Group whose recent growth was largely based on overseas purchases, have struggled to roll over the debt that fuelled those buys as lenders focused on overall high debt levels.
HNA, which alone contributed over $36 billion to China’s outbound deals in the past years, announced less than a quarter of that amount in new acquisitions in 2017, Thomson Reuters data showed.
Overseas regulators also stepped up scrutiny of Chinese buyers last year. US President Donald Trump blocked Chinese-backed private equity firm Canyon Bridge in September from buying US-based chipmaker Lattice Semiconductor Corp citing potential national security threats.
New Zealand turned down HNA Group’s $460 million purchase of a vehicle finance firm owned by Australia and New Zealand Banking Group, citing uncertainty over HNA’s ownership structure.
“Buyers need to establish a high degree of credibility with sellers and provide as much clarity to onshore regulators as those abroad, and clarity on funding as well as other disclosures,” said a senior M&A banker with a Wall Street bank in Hong Kong.
Despite these challenges at home and abroad, China’s $140 billion outbound volume is still its second largest in history, the data showed, as it continued to seek advanced technology and investments related to its Belt and Road initiative.
“There will be a cautious recovery of China outbound investments in 2018 with deals being done at $1 billion-$3 billion,” said Lo from UBS, adding he would not rule out $10 billion deals.
Goldman Sachs Group Inc retained its position as the region’s top M&A adviser, with a 12.3 percent market share, followed by UBS Group and China International Capital Corp, the highest ranking the Beijing-based investment bank has ever achieved, according to Thomson Reuters data.