Increased Governmental Scrutiny
In the past decade or so, the Chinese government has been actively encouraging Chinese businesses to expand globally by acquiring resources, advanced technologies, and distribution channels overseas. Following the relaxation of the outbound investment approval process in late 2014 and early 2015, Chinese direct investment into the U.S. hit a record $45.6 billion in 2016, nearly tripling the amount in 2015 (see figure 1 below), including $36 billion invested by private investors. Despite this surge in the total value of deals in 2016, the total number of completed investment projects by Chinese investors decreased from 169 to 142.
2016 saw a dramatic increase in the average deal value, from $90 million in 2015 to $321 million in 2016. Total investment from the Chinese private companies in the U.S. also increased 202% from 2015 to 2016. Some eye-catching deals included the $6.5 billion acquisition of Strategic Hotels and Resorts, Haier’s $5.4 billion acquisition of GE’s appliance business, the acquisition of Legendary Entertainment for $3.5 billion, Lexmark for $2.5 billion, and Vizio for $2 billion. Some of the transactions involved an unprecedented level of leveraged financing among Chinese buyers.
The dramatic increase in the Chinese interest in U.S. assets caused political concerns in the U.S., especially in the semiconductor industry. In 2016, several deals were either blocked by or abandoned due to the pressure from the Committee on Foreign Investment in the United States (“CFIUS”), including:
- A proposed acquisition of Royal Philips NV of an 80.1 percent interest in its Lumileds light business to a Chinese private equity consortium was blocked by CFIUS in January 2016 due to concerns about Chinese control over dual-use semiconductor technology involved in making LEDs (used in vehicle brake lights, digital cameras, and fiber-optic telecommunications systems);
- Fairchild Semiconductor International Inc. rejected a higher offer from a consortium, comprised of China Resources Microelectronics Ltd. and Chinese private equity firm Hua Capital Management Ltd. citing the CFIUS concerns;
- Former President Obama blocked the proposed acquisition of the U.S. business of German semiconductor company Aixtron SE by Chinese investor Fujian Grand Chip Investment Fund LP for $752 million, leading to the termination of the entire transaction.
Starting from the second half of 2016, it has become clear that the Chinese government is poised to tighten its reins on outbound investments. Many investors started to receive interview requests and the filing process to obtain foreign currency slowed down significantly. In a Q&A statement published in late November 2016, the National Development and Reform Commission (“NDRC”), the Ministry of Commerce (“MOFCOM”), the State Administration of Foreign Exchange (“SAFE”), and the People’s Bank of China (“PBOC”) announced that the following types of offshore M&A transactions are subject to additional governmental scrutiny:
- Investment in certain sectors deemed speculative in nature such as real estate, hotel, movie theatres, entertainment, or sports clubs;
- Major investment in business outside of the investor’s core business scope;
- Outbound investment by limited partnership (note that most PE and VC funds are organized as limited partnerships in China);
- Investment by newly set-up companies with recently received capital contributions;
- Investment in a big overseas subsidiary or target with a much smaller parent company in size.
Various local government agencies have also implemented rules restricting capital outflow through overseas acquisitions. Although MOFCOM and NDRC, at the national level, have not implemented any formal rules imposing additional restrictions on foreign acquisitions, the recent actions at local level indicate that all overseas acquisitions going forward must meet the following criteria to complete the registration and currency exchange process:
- The Chinese investor must have operated for more than one year without a high debt-equity ratio, supported by audited financial reports;
- The target company’s operation is closely related to the Chinese investor’s core business (including upstream or downstream businesses);
- The investment is strategic in nature (PEs, VCs, and other investment companies will have a hard time to get money converted into foreign currency);
- The transaction itself does not require significant leverages; and
- The equity interests to be acquired cannot be less than 10% if the target is a public company.
It is generally expected that NDRC and MOFCOM would promulgate formal rules in the near future to provide legal support for case-by-case reviews of outbound investment transactions.
The Chinese government’s plan to stop outbound capital flight has also included increased scrutiny on exchanges of the RMB. Shortly after the joint statement was published, SAFE announced that any exchange of the RMB in the amount over $5 million would be subject to additional review, versus $50 million in the past. Starting July 1, 2017, PBOC, as the regulator of banks, has also required all financial institutions in China to report any cash transactions over 50,000 RMB (approximately $7,200) or overseas transfers over 200,000 RMB (approximately $29,500). All of those measures will make it more difficult for both individuals and companies to exchange RMB into foreign currencies, regardless of the purpose of such exchanges. In the past, individuals and companies did not face too much regulatory supervision and were generally allowed to purchase under $50,000 in foreign currencies for trade purposes and certain personal uses, such as tourism.
Practical Considerations for U.S. Companies Dealing with Chinese Investors
Many U.S. companies with recent experiences working with potential Chinese investors in M&A deals have shared the same frustration.After several months of conference calls either in the early morning or midnight, the parties finally reach agreements on the commercial terms. The deal seems to be going smoothly until all of a sudden, the Chinese investor calls to say that the promised signing or closing has to be delayed due to some new restrictions on currency exchange. Even if there is a binding agreement in place, a seller probably does not have much recourse under the agreement for the change of law, other than waiting patiently for clarity from the Chinese counterpart on the prospect of closing.
Given the recent uncertainties in this area, we will recommend that a potential seller or target consider the following steps after receiving a call from a potential Chinese buyer expressing interest in your company:
- Engage a legal counsel familiar with Chinese rules and regulations and CFIUS process to review the potential transaction from both U.S. and Chinese regulatory perspective. It will be helpful for the seller or target to get a good sense of overall timing and process involved before negotiating the terms of the transaction;
- Conduct a quick due diligence on the potential buyer. If the buyer is a newly formed entity without a sound operational record, the chance is slim that the transaction will reach the finish line regardless of how much cash the buyer has in its bank in RMB;
- Negotiate a binding MOU or LOI requesting a small earnest deposit (but not a de minimus amount which could be obtained through other legal means quite easily) before engaging a legal counsel or investment bank. Even if the deposit is refundable to the Chinese investor and does not constitute a break-up fee, it will be helpful to have the buyer go through the process of getting the money out of China and force it to start the filing process with the Chinese government;
- If the Chinese buyer plans to obtain financing outside of China to consummate the transaction, ask for the necessary commitment letters from the bank or the financing party, and make sure that the financing will be sufficient to cover the entire purchase price if needed;
- Negotiate a reasonable long-stop date and a break-up fee arrangement if possible. In the event that a break-up fee is unacceptable commercially, consider a well-drafted bridge financing provision clause requiring the potential buyer to obtain necessary bridge financing to consummate the transaction before the investor completes the registration and exchange process in China; and
- Negotiate a good dispute resolution mechanism which will allow the parties to obtain an arbitration award relatively quickly at a low cost. Damages awarded by arbitration tribunals are generally payable in foreign currency without going through the outbound investment registration process.
Alternative Means to Finance the Deal
Even if you are in the middle of the process without a finishing line in sight, there are other means to finance the deal despite of the recent governmental scrutiny on outbound investments.
- Offshore M&A funds: Quite a number of offshore investment vehicles or funds with Chinese affiliation are actively financing offshore M&A deals for Chinese investors.
- Financing through existing foreign operations: Some of the Chinese companies with established foreign arms can finance a deal through local financing including issuing bonds or borrowing directly from banks offshore. A Chinese parent is also allowed to finance its offshore subsidiaries subject to certain limitations under the current Chinese foreign exchange regime.
- Bank financing secured by Chinese assets: If the Chinese investor has sufficient cash or other assets in China, some banks with Chinese operations may be able to provide loans secured by such assets located in China.
Finally, most analysts believe that the current restrictions are temporary merely aim at preserving China’s foreign currency reserve and discouraging speculative transactions without commercial substance in light of the current economic uncertainties. In the long run, those restrictions could either be modified or lifted when the foreign currency reserve in China or RMB’s exchange rate stabilize.