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23 December, 2016
Chinese outbound foreign direct investment ("ODI") has grown rapidly in Europe. 2016 was no exception, and Chinese enterprises are constantly presented with new opportunities to expand overseas. China's footprint as a global investor is expanding at a rapid pace, and the entire world is taking notice. 2016 certainly contains many success stories of Chinese investments in Europe, most notably the UK's approval of China General Nuclear Power Corporation ("CGN"), EDF Group's project to build a new £18 billion nuclear reactor in the UK, Midea's successful acquisition of publicly listed German industrial robot manufacturer Kuka, and Portugal's approval of Fosun's purchase of 17% of the shares of Millennium BCP Bank. However, some tales of caution are also emerging, notably the Swiss government's review of the China National Chemical Corporation ("ChemChina")-Syngenta transaction, the German and the U.S. governments' review of Aixtron transaction, which ultimately resulted in Fujian Grand Chip Investment Fund LP ("Fujian Grand Chip") rescinding its voluntary takeover offer in December 2016, and the German government's review of the Osram transaction.
In addition, as outbound investment is facing tighter foreign exchange controls within China with the State Council announcing new restrictions since late November 2016, it is especially important for Chinese enterprises to be well prepared when they are ready to capitalize on investment opportunities in Europe. These types of preparation may be especially important to ensure success of the ODI in light of the new investment climate on both sides of the transaction, whether in China or in Europe.
Before a Chinese enterprise, fund or entrepreneur embarks on an investment in Europe, it may be helpful to consider the following points.
These points are the accumulated observations of evolving themes
over recent years, based on the actual investment experiences of Chinese ODI into Europe.
1. Start with an informed investment strategy.
While this may seem to be a self-evident statement, there are several aspects to this in practice.
Structurally, there may be a range of investment hurdles to overcome in order to successfully negotiate, close and integrate the proposed transaction: from regulatory and legal through business integration to counterparty communication issues. The regulatory hurdles may arise from many sides of the transaction, as evidenced by Beijing's plan to lower thresholds and formulate new restrictions on certain types of ODI, the EU decisions on the Syngenta, Aixtron and Osram deals and the U.S. block of the sale of Aixtron's U.S. operations in December 2016. All of these can impact the proposed deal timetable, and a plan for addressing known regulatory approval risks should be built into that timeline in a realistic way.
A good strategy will take these issues into account in terms of the cost and advisory impact and will thereby build trust in the process with the European party.
Regulation in the European Union is not just national but is also directed at the EU's internal market. For example, the joint selling of a product by a contractual joint venture may require specific clearance by the EU Commission's competition directorate for the impact that it will have on competition in a defined sector of the EU internal market. A full-function joint venture operating in the EU may be subject to merger control depending upon the functions of the participating businesses affected. A seasoned adviser will assist in building this into the People's Republic of China ("PRC") party's process at the outset of the deal engagement process as this may not always be immediately obvious and could cause complications for the PRC internal supervisory and approval process. Two recent examples of this arose in the resources space: the Shah Deniz Consortium (seeking to export pipeline gas from Azerbaijan) and the partners of an LNG production project in Angola both sought joint selling clearance from the EU upon taking advice from counsel. This was on the basis that, even though these projects were located outside the EU and the sales were effected outside the EU in several cases, the jurisdiction of EU competition authorities could be invoked if some or most gas shipments were to be directed to the EU by their buyers. There was therefore a potential effect on competition in EU internal markets that could potentially be attributed to the decision to effect joint sales.
Importance of identifying early on if the European target company has sensitive technology in the U.S. The recent December 2016 decision by the U.S. to block the sale of Aixtron's U.S. operations to Fujian Grand Chip is an emerging lesson. Even if only 20% of Aixtron's global revenues was derived from its U.S. operations, the U.S. was able to block the sale based on the American defense and security officials' views on the sensitive technologies held by Aixtron U.S.
Any decision to restructure the deal once commenced can have a major impact. This can commonly occur with respect to decisions around investment protection strategies. There are a number of investment protection and double taxation treaties that will offer protections to the foreign investor and affect the structuring of the chain of investment vehicles used by the acquirer. There is a complex interplay between these and the tax structuring of a deal for the acquirer. If it is ultimately more efficient, and also offers better investment protection, for a particular investment to be structured through multiple holding companies (e.g., non-EU and EU), then this should be determined at the outset or, at the latest, before finalization of transaction documentation. Having to change the structure of the acquirer later in the deal process can lead to avoidable changes of control and additional counterparty costs of legal and investment adviser review to be paid by the acquirer. Inevitably, this is best achieved where there is a high level of understanding of the potential tax structuring outcomes at a very early stage of the transaction evaluation process.
Protectionism and national industrial policy may have a role to play. Most recently, there are some indications of a rise in regulatory review in Europe for certain foreign investments, notably for certain large Chinese investments, as we have recently seen in Switzerland and Germany. While this is a moving landscape, a seasoned adviser will assist in managing this delicate and changing process. The approval of the Hinkley Point C investment by CGN and the EDF Group was made in September 2016 with an unprecedented number of conditions, including a "golden share" for the UK government and an undertaking by the foreign investors not to dilute their holdings until the project was fully constructed.
2. Incorporate the PRC investment approvals into the timetable early.
It is understood by European counterparties that there is a domestic process supervision and approval authority process for the Chinese bidder to go through. There has been ample press about China's recent plan to limit certain types of ODI, but the European counterparties are not typically aware of the exact details of these limitations, nor would they typically keep abreast of updates on any changes to China's rules on ODI. As the rules within China may be reformulated, it will be important to convey any changes or updates to the European counterparties. In some cases, European counterparties may ask for more definitive PRC regulatory information before spending management time and advisers' fees on
advancing a transaction.
In addition, the dynamics between provincial and national authorities and the delays that can be caused by changes to the approval sought are already less well understood by European counterparties. Explaining this will obviate the possibility that the deal dynamics change unnecessarily due to such delays or that the European party mistakenly believes such delay is a negotiating strategy.
Articulate the timing and contingencies to the other side early in the process. Even a sophisticated PRC party may not fully anticipate the extent to which changes to the fundamental parameters of the proposed transaction require further interplay between supervision and approval authorities at the provincial and national levels. This ensures an open communication flow and minimizes any misunderstandings.
Chinese companies may consider this process to be well understood by western companies with PRC operations and might not feel the need to fully explain it to the counterparty when, in fact, the governance of western companies can be such that different divisions operate at commercial arm's length and there is not institutional communication between those divisions on such issues.
3. Consider what deal documentation strategy is appropriate.
Europe-China deals can be document‑heavy, not least because of the need for translation. In some deals, it might be more appropriate to develop detailed term sheets for approval purposes before moving on to principal documents that are then developed in fewer drafts. Too many turns, each translated, can be an expensive and time‑consuming process that appears inefficient, and even indecisive, to the European counterparty.
We would suggest that a rolling summary of the executive summary of the DD report is translated periodically from English to Chinese to allow decision-making while also preventing the document production process from becoming expensive and the primary use of trusted advisers' time.
Consider appointing a mid-senior level in-house business/legal executive to prioritize the risks involved from an internal viewpoint (after he/she reviews the due diligence reports). Outside advisers provide companies with the complete range of risks. Someone inside the company needs to properly digest all the risks and prioritize them in the ambit of the company and its investment strategy. Too often, the failure to delegate leads to an inefficient and unresponsive process from the acquirer.
Understand what documents must go to the board for approval of the transaction. It is not the case that all documents need to go to a board for approval. A term sheet at an advanced, but not excessive, level of detail will lead to a better process. This vets out potential issues in the documentation.
The perceived value of this to the European counterparty should not be underestimated as, where this process more closely resembles their own, they will view it as being more decisive. This is the case even where, in actual fact, the PRC process may mask other layers of considered review and value addition in the quality of decision‑making.
4. Have a solid understanding of European regulation before starting.
The European Union is the most complex, and heavily regulated, free trade area in the world. When looking to invest in a project, it is not just a case of competition law and foreign investment approvals but also of internal market rules. In addition, keep abreast of the recent developments in Europe. The European investment landscape is also evolving as foreign investments are increasing at a brisk pace. For example, infrastructure may be governed by third‑party access rules. Sales by joint ventures can invoke merger rules, investigations of pricing or a need to seek approval for distribution and marketing agreements. A failure to have a good understanding of this first is a common reason for deal delay and deal failure.
Invest in a preliminary study of the market beforehand. Talk to local advisers on the ground. Also discuss with local advisers any trends they may notice. Set aside a budget to engage local European advisers for the pre-deal stage.
A failure to do this may likely lead to the process and regulatory stumbles identified above and may very well be more expensive in the end. An example of this is the continuing regulatory review of ChemChina's $40 billion+ takeover for Syngenta by EU (and Australian) authorities, having been announced in February.
5. Be prepared to disclose a PRC company's ultimate beneficial ownership ("all the way up the chain").
European disclosure and transparency standards are fairly rigorous, and a PRC company should be prepared to respond to these types of questions and requests for supporting documents. The queries and diligence on the true beneficial ownership of the PRC company could likely extend to any affiliate that becomes a party to the transaction.
There needs to be frank internal discussions within the company and with core legal and financial advisers on this topic before substantive engagement with the counterparty.
Determine what public disclosures will be required before formal engagement with PRC supervision and approval authorities so that any issues around state secrets or restricted economic or ownership data can be addressed in the relevant approval process. The ChemChina-Syngenta merger alluded to above is stalled pending more detailed information about the merger being provided to regulatory authorities.
6. Localization and Integration.
Consider the extent to which local employees are a key part of the business continuity based upon financial adviser's advice and as modeled. Consider the extent to which the securing of their commitment to the business during the transaction period requires further understanding by them as to how the business and their roles will be integrated post-completion. Key employees will have an understandable apprehension about the commitment of the new business owners to them.
7. In an active bidding process, or with any coveted target, it is important to ensure that the funds are available at the time of closing or when the final bid is submitted.
This timing/delay/lack of clarity is one of the largest stumbling blocks between Chinese and European partners. The delay is often viewed with suspicion because a certain date is never provided.
8. In an active bidding process, we are seeing with some frequency a request for the PRC company to place some of its funds for the acquisition in a large European/international bank, as opposed to a Chinese bank.
Companies that are involved in one of these bids might want to think about initiating contacts with the China branch of a selected European/international bank early on in the process.
9. While there may be a tendency to focus on investing in/purchasing high‑profile large targets, it should not be viewed as a defeat to invest in/purchase a medium‑sized target when investing in a European country for the first time.
This may be especially relevant given Beijing's recent plan to limit certain ODI above €1 billion. In addition, as mentioned above, Europe is generally heavily regulated and relatively complicated to navigate. By investing in a medium‑sized project in the first instance, it would allow a PRC company to build up its name in the local market, meet local experts and gain the operational experience in the local market. Then the PRC company could be in a better position to successfully manage any of the investments, large and small, in the local European country. The German authorities' withdrawal of the approval and reopening of the review of Fujian Grand Chip takeover of Aixtron in October 2016, the U.S. authorities block of the sale of Aixtron's U.S. subsidiary in December 2016, and Fujian Grand Chip's withdrawal of its voluntary takeover offer in December 2016 have arguably damaged all parties concerned.
10. Consider hiring some local professionals to assist the PRC company in integrating the business and navigating the local business climate post-investment.
This will assist the PRC company immensely in terms of efficiency and having its own "set of ears" in Europe. We would recommend hiring locals with various levels of experience and in different operational roles so that the PRC company can receive direct feedback on its European investment on multiple levels.
Designate at least one director with specific veto rights. A PRC company may also consider designating its CFO. On the operational side, we would recommend incorporating some of the PRC company's own senior technical and operational people to be on the ground of the target company post-acquisition.
In summary, while Chinese companies will still be presented with a plethora of attractive investment opportunities in Europe in 2017, given the rapid changes in today's investment climate and regulations and the increasing competitions between bidders, the difference between a well‑prepared investor and one less prepared could be the determining factor in the success of a transaction.
For further information, please contact:
Maurice Hoo, Partner, Orrick
mhoo@orrick.com
