In January 2005, China’s State Administration of Foreign Exchange (SAFE) issued a piece of legislation called Circular 11, which was aimed at stopping Chinese nationals from incorporating offshore where they could avoid taxes and foreign exchange restrictions. The circular stated that Chinese companies must be bought for chase and can’t swap out their shares into offshore firm.
Even though the legislations did not have private equity in mind, LBO firms immediately felt the impact. The stipulations of the circular made it virtually impossible for a Chinese company and a financial partner to hold interest together through an offshore vehicle and thereby froze one of private equity’s primary exit strategies. LBO shops eventually were successful in their appeal to authorities and nine months after it was issued, SAFE repealed the circular.
Just this month, the latest installment of this legislation went into effect, in the form of a comprehensive set of guidelines on M&A activity. This time, the rules had more clarity, more breadth, and were sponsored by six different Chinese regulatory bodies including SAFE.
Although the latest guidelines are not uniformly positive - for one thing, they require more approvals, which will lengthen already long exit processes in China - the evolution of these rules demonstrates a trend that is quite positive: Chinese law making bodies are responsive, if sometimes haphazard and inconsistent, in making laws that will encourage buyout activity.
As for Circular 11, “Once they realized the unintended impact on private equity they moved quickly to rectify it,” said Ada Tse, President of AIG Global Investment Group’s Asian operations. “Generally speaking, China is certainly moving the right direction with regard to providing clarity and frameworks to guide business activity.
China is the fastest growing large economy in the world, on that reportedly attracted more than $70 billion of foreign investments law year, and it leads all Asian countries in private equity investments, according to Bain & Co. However, China remains a place where LBOs are not very common, with most multinational firms opting instead for growth capital investment in the form of large minority stakes. Another way to access China’s booming economy, on that many U.S.-based LBO shops take, is simply investing in companies that have Chinese operations.
Part of the reason for this LBO hesitation is the regulations. The Carlyle Group is one example of a buyout firm that has run into regulatory problems., Its planned $375 million buyout of state owned Xugong Group Construction Machinery Co. has been held up now for almost a year. Other stalled non-private equity situations include Citigroup’s ongoing attempt to buy Guangdong Development Bank and the French appliance maker SEB’s effort to purchase Zhejiang Supor Cookware.
“There is a morass of unconnected legislation in various stages of maturity and sophistication that effects buyouts in China,” said David Patrick Eich, a partner with Kirkland & Ellis. Sparing no irony, K&E is currently awaiting regulatory approval to get an office opened there.
As for China’s new M&A regulations, they have inspired ambivalence among observers, as they permit new types of deals but require a smattering of new government approvals. “The new M&A rules on their face are a mixed bag,” said Eich.
The new guidelines say, for example, that Chinese authorities now must be notified if a deal involves a “key” domestic industry or a well-known brand or if it affects “national economic security” The regs do not explain what power Chinese authorities will have in stopping deal.
This vagueness adds to the feeling of uncertainty about which companies in China can actually be bought out. China has shown it wants to privatize certain state-owned industries, but only those that are non-strategic. There have been instances where the provincial or municipal governments will decide an industry is indeed “strategic” after a buyout shop has signed a deal, said Thomas Britt, a partner in Debevoise & Plimpton’s private equity practice in Hong Kong.
“This lack of certainly regarding whether or not a transaction should be completed, based on whatever the prevailing mood is at the time, will certainly discourage some buyout shops,” said Britt.
The new M&A regs permit using shares from an offshore company to do deals, on certain conditions. They also address the issues raised by Circular 11 by approving the set up of offshore vehicles as long as an IPO is staged within a year.
Michael Thorneman, head of Bain & Co.’s private equity practice in China, said he believes the rules will initially have a negative impact on private equity. With the amount of government approvals required, the new regulations will delay IPOs and therefore damage exits. Already, he said, “Exits are a big headache for most companies,” investing in China.
Another issues with regulations in China is that the passing and effective date are only the first steps in a long process of creating laws that the business community can trust. Now that the M&A regs are in effect, there is a waiting game to see how they will be interpreted and what unforeseen effects they could have. Interpretation can also differ from province to province. “Usually the biggest challenge with the regulations is you have to wait for what the real interpretation will be,” said Ed Hotard, who is chairman of Monitor Group’s China practice.
The M&A regs are just the latest in a long list of other Chinese laws created over the last few years that impact LBOs. For example, China has instituted new accounting standards which aim to quash some of the country’s notorious transparency issues and give its companies global quality balance sheets. And in January, LLCs were recognized for the first time in a form similar to that of Delaware, allowing shareholders more flexibility in voting and profit distribution, as well as suggesting that different classes of securities are possible. This was blessing for LBO shops, which need different classes of securities to create more complex capital structures.
One problem that has yet to be dealt with is the accessibility of leverage. Local banking regulations inhibit banks from lending to buyers when the loans are secured by the cash flows or assets of the target company. Moreover, local banks are often not allowed to lend to offshore purchasers the way they are allowed to in other markets. “And, of course, offshore banks cannot lend into China, so there isn’t a readily available offshore solution to this offshore dilemma,” said Britt.
Ultimately, China’s regulatory trends portend more confusion than gloom for LBOs. Many industry veterans are prepared to say that China will be the most5 exciting place in the world for investment in the next 10 0r 20 years, if it is not already. At bottom, China is an immensely commercial culture and that nose for profit must soon trickle upwards into its regulatory stance, said Eich.
“There are complex and sometimes vague new regulations in China and clearly it’s a moving target,” said Eich, speaking of the new regs. “But these are concrete steps forward.”
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