Chinese companies invest outside their comfort zone

During the Summit's opening session, a panel discussion on prospects for Chinese M&A, one in-house counsel warned against a lack of caution.

“[One report said] China's outbound investment will reach US$150 billion this year – that's fantasy land,” said Kim Woodard, vice-president of transaction services for Technomic Asia.

“There's a lot of opportunity, but we have to approach it with a fair amount of caution because it's not going to be explosive.”

Although the year ahead will feature significant outbound activity, it will be marked by modest growth and caution, with total deals around US$30 billion, and actual closed deals closer to US$20 billion.

“China is still a very small player in global capital direct investment … You want to keep things in perspective,” Woodard said. He went on to remind the audience that outbound overseas direct investment should not be confused with outbound M&A.

“Outbound ODI is a much larger number than actual completed M&A deals,” he said, pointing out that while there is significant buying in the energy field, outside that category the number of deals is actually very small.

In addition, the regulators (the National Development and Reform Commission and Ministry of Commerce) are taking a fairly conservative approach. While encouraging listed companies and state-owned enterprises to make overseas acquisitions, they are also urging caution. Some proposed acquisitions have been turned down (notably the attempted purchase of Hummer from GM), and the relatively low threshold at which approval is requires means that it is difficult to complete deals without central government involvement.

“The average deal size is US$300 million – that's five-times the inbound size,” said Woodard. “This means that most deals will require government review, which slows things down, makes it difficult for Chinese companies to compete, and may lead to overbidding, sometimes unsuccessfully.”

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Government dialogue helps Australian investments

Chinese investors keen to invest in Australia need to start a dialogue with the Australian government before submitting the relevant application documents.

That was the message from Mallesons Stephen Jaques managing partner international Nicola Wakefield Evans during the Summit's Australia workshop.

Measures to be considered include paying a personal visit to the country's capital city Canberra, and even employing a public relations agency. And Wakefield Evans stressed the need for investors to instruct a law firm in Australia to ensure that “the right forms” are submitted.

“Several years ago, we had a client who had to resubmit seven times,” she said. “It was a complicated deal, but it demonstrates the need to get it right first time.”

Although Sino-Australian relations at a political level have been a little tense of late, the investment relationship between the two countries is 22 years old and has, for the most part, been uneventful. “Any balanced assessment of the relationship shows that it is very strong,” said Beijing-based Mallesons partner David Olsson.

Chinese investment in Australia amounted to A$20 billion (US$17.5 billion) over the last 20 years, but this has dramatically escalated to A$30 billion-worth of deals in the last 18 months alone. “So you can understand why there has been some debate in Australia to make sure that this aligns with the national interest,” added Olsson.

Recent tensions have partly been caused by one or two high profile deals. Chinalco's investment in Rio Tinto ultimately failed for commercial reasons, but the Australian government's handling of the deal was severely criticised with some claiming it demonstrated a protectionist attitude towards Chinese investments.

And the Chinalco episode followed China Minmetals' bid to take over OZ Minerals, which was rejected by Australia's Foreign Investment Review Board (FIRB) on national security grounds (though the bid did proceed in a different form).

Australia's national interest 'test' is deliberately undefined and changes depending on the needs of the day. Instead, the Australian Treasurer decides in each case whether a particular application would be contrary to the national interest.

The closest thing Australia has to a 'test' is following a set of foreign government principles that were introduced in February 2008. Among other things, these stipulate that operations are independent from the foreign government, an investor is subject to and adheres to the law and observes common standards of business behaviour, and that the proposed deal does not hinder competition or lead to undue concentration or control.

Chinese state-owned enterprises (SOEs) are continuing to invest in upstream energy and resources in Australia, and Wakefield Evans clarified the position of Australian regulators to a room full of Chinese business leaders, in-house counsel and private practitioners.

“Australian regulators do not treat China differently from other countries, but they do treat government entities – such as SOEs – differently from privately-owned and publicly-owned companies.”

Due to the global financial crisis, many more companies are now technically government-owned (such as General Motors in the US) and this is having a large impact on how these deals are viewed in Australia, said Wakefield Evans.

The FIRB application process, which can take as long as 60 days, has slowed down recently due to the increased number of applications and the increased number of government-owned entities around the world.

Although it is an issue that prime minister Kevin Rudd is keen to address, Wakefield Evans said it was not a reason to avoid the FIRB process altogether.

“For foreign government investments – including those of SOEs and sovereign wealth funds – a FIRB application is compulsory, and the intentions of the applicant need to be laid out as clearly as possible,” she said. “If there is anything that you take away from this session then that should be it.”

Australia

The Australian government was so concerned over the perceived fallout from Chinalco's failed investment in Rio Tinto that it decided to introduce significant changes to its foreign investment rules in order to remove the view that its regime is too onerous.

Companies investing Down Under need to consider the best way in which to structure their investments, and consider (among other things) the significance of the Foreign Investment Review Board, competition and securities laws, tax, ASX listing rules, and financing options.

US distressed restructurings present investor opportunities

What was once just a small segment of mergers and acquisitions activity in the US is now the dominating feature of such deal making.

“Today, distressed restructuring is where the action is,” said New York-based Cadwalader Wickersham & Taft partner and head of private equity Ron Hopkinson.

There are various reasons for this, but a significant one is that many of the deals struck between the years 2002 and 2007 were very highly leveraged and are now in distress.

For the most part, these involve operationally sound companies that have simply found it difficult to refinance their existing debt or access additional debt financing. “They're still good companies but they have 'problem' balance sheets and have not been able to weather the storm,” added Hopkinson.

Such distressed M&A transactions have of course become vehicles for foreign buyers to purchase US assets at significantly discounted prices. And with the renminbi now at its highest value for the last five years, relative to the US dollar, US assets have never been more attractive to Chinese investors.

This may explain the large attendance of Chinese business leaders, in-house counsel and private practitioners at the US session of the outbound-focused Summit.

As the oldest law firm in the US, Cadwalader has witnessed financial turbulence before, “but I would challenge anyone to find a more unique time to do transactions,” said Hopkinson's fellow panelist and head of M&A and securities Louis Bevilacqua.

Hopkinson and Bevilacqua should know, having each played prominent roles on the government bailout of the US auto industry – in particular the deals struck for General Motors and Chrysler.

Each of these transactions was sealed through a Section 363 sale, which involved selling the bulk of the carmakers' assets into new entities. Advantages of a 363 sale include moving the majority of a company's assets out of bankruptcy, reducing the uncertainty of the bankruptcy process, and completing the deal relatively quickly (GM and Chrysler were completed in approximately 45 days).

Hopkinson and Bevilacqua told the audience that although the term 'bankruptcy' tends to scare everyone, in many cases it can actually be a friend. For one thing, it removes any unknown liabilities.

“Two to three years ago, almost all of these deals were done via auctions. There was a very limited time period to do due diligence, and for the most part investors got very little protection from contracts,” said Hopkinson.

“Contrast that with today, where a lot of the private equity firms are sidelined and so there is not a lot of competition for buyers.”

Despite the end of the recession, traditional methods of financing acquisitions, such as bank debt and securitisation, remain scarce. Extreme stock market volatility has made valuation difficult and largely prevented stock-for-stock deals. This means that transactions that can be done without financing offer great advantages in execution.

“If you're willing to inject cash into these assets,” said Hopkinson, “lenders are very willing to do deals so that they end up with a capital structure and debt levels that make sense.”

The Cadwalader partners stressed that although bankruptcy can be a very good way to acquire companies in the US there are lots of other ways. One option is trying to utilise private equity firms' knowledge of international companies given that many of them have been involved in substantial inbound work over the years.

And another option is through so-called 'carve-out' deals, where distressed US companies look to liquidate valuable non-core assets in order to raise cash to satisfy their lenders.

“This means that there are a lot of good smaller companies for sale,” said Hopkinson, “and this works to the advantage of Chinese companies doing outbound deals.”

While admitting that some of these alternative options are more complex than plain vanilla transactions and can take some time, Hopkinson stressed that without the threat from private equity houses the marketplace is giving investors that time.

“On many deals, the process has got a lot more efficient,” he said. “It is certainly more complex, but don't be afraid of that because it is that which creates more value and ultimately gets you a good asset for a good price.”

US

As the world's largest and third-largest economies, the US and China have not always enjoyed the smoothest of trade relations, with each preaching to the other about the dangers of economic protectionism. But China is undoubtedly a key stakeholder in how the US economy performs, and this role has assumed greater significance as a result of the financial crisis.

Chinese enterprises looking Stateside must consider their options carefully. There are many options available when acquiring distressed companies, for example. As Lenovo/IBM and CNOOC/Unocal have shown, considerations of due diligence, foreign ownership thresholds, existing shareholders, the regulators and financing are all vital.

Watch out for potential deal killers

Many potential outbound Chinese transactions fail because of issues related to local employment laws and conditions, and it is vital for companies to be aware of this and other issues which might put a halt to an otherwise attractive deal.

This was the message from the stage during a workshop on team construction at the Outbound Investment Summit.

“The labour issue, in our experience, is the number one deal killer,” said Greg Liu, a partner of Paul Weiss Rifkind Wharton & Garrison.

Another difficult issue can arise when the buyer purchases only part of an overseas company. In some transactions, for example, the distribution is carved out and the Chinese buyer takes the brand, R&D and technology but not the distribution (as the seller may be using the distribution for other products).

“That's very difficult to manage when you are not in charge of your own distribution,” said Liu.

When structuring deals, the buyer may not be interesting in taking on distribution as part of its acquisition, and its advisers might simply carve out this part of the business, for simplicity. But, Liu warned, this may backfire.

“If the buyer wants to get into the international market, there's no way around it,” he said.

The increasingly close links between Hong Kong and mainland China mean that many Chinese acquirers find it easier to use their Hong Kong subsidiaries to make acquisitions. While this may simplify some parts of a transaction, the deal team should be thinking about the Hong Kong shareholder disclosure and approval process from the beginning.

Another factor which often complicates things is the length of the deal. The panellists said that many deals involving Chinese purchasers acquiring control of a foreign company can take longer than other cross-border acquisitions – perhaps up to a year, particularly when there is a complicated post-closing arrangement involved. And extended timings and complexity also make it almost impossible to keep everything confidential and unannounced.

Liu advocated dividing the deal into three distinct phases: in the first, a detailed memorandum of understanding can be worked out while due diligence is going on; next, the companies can work on definitive agreements, government approvals can start, more due diligence can take place and the deal can be announced; and in the final phase, regulatory and shareholder approvals are obtained and the buyer should continue to plan its integration – further due diligence. Liu's comments emphasised how vital it is that the Chinese company be given time and opportunity to fully understand the deal and work out a detailed integration strategy.

In the words of an earlier speaker at the Summit, the keywords for any outbound deals are: “Due diligence, due diligence, due diligence”.