China outbound deal structure: Risk factors

Is Buccellati one of China’s offshore orphans? The 99-year-old Italian jeweler, known for its intricate handcrafted pieces, was acquired by Gangtai Group last year at a valuation of EUR270 million ($310 million). The Chinese company, which has interests in gold mining and jewelry, wanted Buccellati to spearhead its move into the global luxury goods space. 

More than 12 months after the signing ceremony in Milan, Buccellati has yet to be integrated into Shanghai-listed Gangtai Holdings. The company said in August that it had scrapped the plan, citing an unfavorable economic environment, a credit squeeze by Chinese banks, and underperformance by Buccellati. Gangtai Holdings added that it was suffering a “short-term liquidity crunch,” which is likely tied to the shares pledged by the parent group in return for cash to sustain daily operations.

Last month, Gangtai Holdings revealed it was involved in a string of lawsuits over allegedly fraudulent contracts and courts had frozen the parent group’s shares due to a failure to settle some of these cases. It should come as no surprise that Gangtai is looking to offload assets. It was reported earlier this month that Richemont was in talks to acquire Buccellati.

Halfway there

The clampdown on Chinese outbound investment initiated towards the end of 2016 nixed many proposed deals as well as some that were already half-completed. In addition to restricting the movement of capital offshore to support transactions, the regulators started scrutinizing companies that tried to shift newly-acquired businesses into locally-listed subsidiaries. The aim was to protect public shareholders from exposure to assets that were too large, too off-strategy, or too indebted. It is unclear whether Gangtai abandoned the Buccellati integration due to a regulatory warning.

“It is still possible to buy a company through a SPV [special purpose vehicle]. The problem is you can’t flip the SPV into the listed company without taking a lot of risk in terms of failing to get approval or being forced to sell at a lower price,” says Zhiping Chen, a founding partner at local fund management and advisory firm RJ Capital Group. “The CSRC has stepped in, said the valuation doesn’t make sense, and instructed companies to get a proper appraisal.”

The standard structure for an offshore deal is a SPV in a jurisdiction like Hong Kong. If the goal is to merge the acquired asset into a company listed on the A-share market, that company would raise the required capital through a private placement. By establishing the SPV outside of the listed entity, the material asset acquisition approval process is not triggered immediately, thereby allowing a degree of flexibility on timing. There is also the option of bringing in third-party investors to support a deal.

However, during the 2015-2016 boom period, versions of this structure were abused. For example, when the State Council issued new guidance on outbound M&A last year, it specifically sought to curtail outbound investment funds. Corporates were sourcing capital from domestic investors for blind pool structures that pursued a range of deals in certain sectors and regulators suspected these vehicles were in fact being used for speculative real estate investments.

“The type of SPVs they were targeting are those that are not acquisition vehicles but set up to get around the foreign exchange regulations and move money outside of China,” says Ning Zhang, a partner with Morgan Lewis. “If a company is doing a real deal that has strategic value and is aligned with its primary business, using an acquisition SPV is not a real concern for the government.”

As of March, the National Development & Reform Commission (NDRC) has also required SPV owners to report their offshore transactions. Companies that fail to do this and get found out after the fact risk having the regulators target their onshore businesses. 

Pick your moment

Not all company founders want to merge SPVs into listed subsidiaries, but those that do might be challenged as much by timing as by regulation. According to Gian-Marc Widmer, head of international M&A at CITIC Securities, weak capital markets – the Shanghai Composite Index has fallen 22% in the last seven months – has led to a reluctance to launch private placements. Either a company doesn’t want to issue shares while trading at lower-than-normal valuations or the founder-majority shareholder doesn’t have the means to participate in the placement and maintain his stake.

It’s difficult to get a sense of how pervasive this problem really is. Gangtai certainly isn’t the only listed player to run into trouble because it pledged shares and then saw market conditions deteriorate. But several other industry participants play down the impact of declining equity prices and say that A-share companies are as acquisitive as ever – they must just be careful to target assets that are of an appropriate size and strategic fit.

Moreover, if additional capital is needed to support a deal, there are people willing to provide it. While RJ Capital’s Chen notes that Chinese financial institutions have become more conservative in their lending activities, local private equity funds are stepping into the breach. They typically commit capital to the SPV alongside the listed company or founder with a view to achieving liquidity once the entities merge.

“A lot more enterprises are teaming up with local private equity funds - you see that in almost every deal now,” says Samson Lo, a managing director and head of Asia M&A at UBS. “Even some of the SOEs [state-owned enterprises] are doing it. They like to have government-owned private equity funds as minority shareholders.”

The PE funds are essentially providing bridge financing until the private placement kicks in, but this comes with an element of risk – the placement might be delayed or the regulator could intervene. “There is a lot of uncertainty around approvals,” says John Gu, a partner at KPMG. “While some deals seem good value, there are reasons why approval doesn’t come. There has been a historical assumption that assets would be acquired by A-share companies down the road, but this doesn’t necessarily materialize.”    

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• Topics
• Greater China
• Buyouts
• Regulation
• Advisory
• China
• M&A