China outbound M&A: Time will tell

China’s recent curbs on outbound investment have given rise to familiar complaints among investors. “In general, the problem of the Chinese policymakers is they almost never make things clear,” says Lin Feng, founder and CEO of advisory firm Dealglobe. “What’s happening now is there are so many rumors from here and there, but the government has not been coordinated. The only thing they’ve said is that they continue to support outbound investment, and in the meantime they want to keep foreign exchange rates stable.”

Feng’s frustration is echoed by others who were largely taken aback by the rollout of the new measures last year and the limited warning they were given. While most industry participants say they understand the reasoning behind the restrictions, having so little time to adapt puts them in a difficult position.

Much about China’s regulatory environment remains in flux for the time being. Those facing immediate impact may try creative foreign exchange approaches to keep their plans moving forward, but the industry’s ultimate fate may be out of the community’s hands.

The regulatory moves, which started in the last quarter of 2016, followed a surge in outbound M&A transactions: data from MergerMarket show more than $208 billion was invested across the 383 transactions announced last year, compared to $92 billion across 307 deals in 2015. February 2016 saw a particularly large spike in deal size with nearly $60 million in 31 deals – including the $47 billion acquisition of Swiss seed and agrochemicals player Syngenta by China National Chemical Corporation – but both figures were higher for every month of 2016 than the year before.

While Chinese buyers were racking up deals, the country’s banking system was hearing alarm bells. Because most of the outbound deals required conversion of renminbi to foreign currency, the foreign exchange reserves were dipping to what regulators considered dangerously low levels – from nearly $4 trillion in 2014 to less than $3 trillion at the end of last year.

“Last year was quite interesting, because the outbound volume was just amazing – not just among private equity funds, but also Chinese investors generally,” says Nanda Lau, a partner in the Shanghai office at Herbert Smith Freehills (HSF). “So I suspect that the government felt it had no choice but to issue interim measures to try and stabilize this fund flow and the RMB exchange rate.”

Down trend

Though regulators’ heightened scrutiny has only been in effect a few months, they appear to have had an arresting effect on outbound deals. While 33 transactions were completed in January, more than the preceding year, the amount invested fell to $5 billion from $11 billion in 2016. In February the drop was even more precipitous, with just 13 deals for $1.1 billion. Although there is still one month to go, it is unlikely the current total of $6 billion will approach the $82 billion from the first three months of 2016.

Limiting capital outflows might be an understandable goal for China’s financial regulators, particularly given fears of protectionist measures from the US and other key trading partners. But the method for achieving the desired cutbacks has created a high degree of uncertainty in the investment community, with no way to know how strict the new measures will become or how long they will last.

“When the Chinese government issues things I think they don’t want to give a very negative message to the market, given China just joined the IMF and they have made a commitment to further open up the Chinese economy to global competition,” says John Gu, head of private equity for KPMG China. “They’re hoping that more foreign capital will come in to China to counter the effect of the capital going out. But how long it will take to balance the outflow, we don’t know.”

So far the curbs have not included an outright halt on outbound investment. Instead, the slowdown has been achieved through measures from a number of agencies, including the People’s Bank of China (PBoC), the National Development & Reform Commission (NDRC), the Ministry of Commerce (MofCom), and the State Administration of Foreign Exchange (SAFE) aimed at increasing the scrutiny of investors who seek to exchange renminbi for foreign currency.

Deals coming in for a closer look include large investments outside the Chinese investors’ main line of business; transactions in sectors such as real estate, hotels and cinemas; and investments by limited partnerships. Each agency has implemented its own requirements: NDRC and MofCom have substantially increased the supporting documents required for deal approval, while PBOC and SAFE have strengthened reporting requirements among local banks for proposed foreign exchange transactions for as little as $5 million.

Though all of the new restrictions ramp up the difficulty of outbound investment, the banking regulators’ moves have prompted the most debate given their lack of transparency. SAFE and PBOC communicated the new requirements via verbal “window guidance” rather than formal regulations, leaving it up to individual banks to work out their own interpretation. This has meant that in practical terms, gaining approval for transactions has become much tougher.

“We’ve heard a number of banks saying they want to err on the side of caution and not take risks themselves, because ultimately they have to report back to PBOC and SAFE,” says HSF’s Lau. “So I think a lot of situations are being interpreted very cautiously on a local basis, because everyone’s trying to minimize their own risk.”

It is important to note that outbound investment itself is not being targeted, but only certain transactions that might deplete the country’s foreign exchange reserves. Deals that support the government’s policy agenda are considered easier sells than those which are based more on speculation.

KPMG’s Gu gives the example of a strategic investor looking to buy a foreign company with proprietary technology that it can bring to China. The value to China’s economy in this case is likely to justify the currency outflow required in the eyes of regulators. “As long as you can prove that there is such a value proposition, then such applications are likely to be granted foreign exchange approval,” he says.

In addition, GPs with existing US dollar assets remain free to invest in outbound transactions, while domestic-focused renminbi funds have no need for currency exchange.

For Qiming Venture Partners, the effect of the regulatory moves has been negligible so far. While in the last year the firm has seen renminbi funds begin to angle for the same group of offshore-incorporated Chinese companies that Qiming targets with its US dollar fund, the new regulations have put a lid on those GPs, at least for the time being. “Their impact actually was very small to begin with, and now it’s been shut out, so it doesn’t really make much difference,” says J.P. Gan, managing partner at Qiming.

Exit angst

But depending on the longevity of the restrictions, US dollar investors could still be impacted – not at the time of investment, but at the time of exit. A number of industry professionals say they have already seen managers struggle to reassure potential overseas backers that they will be able to return capital. Even though returns should not be affected, it is a measure of the uncertainty surrounding the measures that investors feel the need for clarity.

“One of our private equity clients is raising funds, and they actually do receive questions from LPs who are really concerned about capital controls in China, and want to find ways of getting around that,” says Judie Ng Shortell, a partner at Paul Weiss. “Unfortunately there aren’t many ways that can be done. The only comfort that people can take is that hopefully these measures aren’t permanent.”

Efforts to adapt to the new measures are underway. In some cases GPs go to banks with which they have a good relationship in the hope of receiving assistance in streamlining their foreign exchange requests. Others have tried to be more creative. For example, by depositing the purchase price for a deal in a domestic bank, the bank’s foreign branch can then loan the GP’s offshore special purpose vehicle the required amount in foreign currency.

Central to the industry’s response is the belief that this strict approach is only temporary and that by the end of this year regulators will ease off. Otherwise they risk long-term damage to the prospects of Chinese investors among owners of offshore assets, who are already beginning to require higher break fees for potential Chinese buyers or refusing to meet with them altogether until the currency issues are resolved.

“Life cannot be this way forever. I think the expectation is that while there won’t be the same freedom as we’ve seen before, once the pressure on the currency is reduced the government will slowly normalize the regime, and there will actually be some regulation,” says Shortell. “Unpredictability is always bad for the market.” 

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• Topics
• Greater China
• Investments
• Regulation
• China
• Outbound investment
• Qiming Venture Partners
• M&A