3 September, 2018
In the first half of 2018, Chinese outbound foreign direct investment (OFDI) concentrated toward Europe. The value of newly announced Chinese M&A in Europe was nine times that of North America ($22 billion versus $2.5 billion), while the value of completed Chinese investments was $12 billion, six times higher than that of North America. This concentration toward Europe can, in part, be attributed to the increasing trade tensions between the U.S. and China.
In 2018, Chinese enterprises continue to see ample opportunities overseas. However, the investment landscape is becoming increasingly complex. Alongside the tightening of foreign investment regimes by some European countries, the European Union (EU) is working on a European-wide foreign investment regime that will likely provide stronger protection to EU companies in the high-tech sector, among others.
2018 has witnessed several success stories to date, most notably Geely’s $9 billion investment into Daimler and the takeover of Germany’s Cotesa group by AT&M and its co-investors. The latter has been the first successful Chinese investment under Germany’s tightened foreign investment regime.
Tales of caution, however, abound, for instance the recent failure of China’s State Grid to acquire a stake in German power grid conglomerate 50Hertz, or the veto by the German government against Yantai Taihai Corporation’s proposed purchase of Leifeld Metal Spinning. These two consecutive unsuccessful M&A attempts offer lessons for navigating Europe’s changing landscape.
Before embarking on an investment, it is important for Chinese investors to consider the following based on the actual investment experiences of Chinese OFDI into Europe.
1. EU’s regulations on foreign investment are evolving at a rapid pace. Understanding the target country’s current or draft legislation in the target sector is critical, on both the country and the EU-wide levels. Brussels is currently reviewing an EU-wide legislation to possibly control and monitor foreign investment into the EU at a more stringent level than any individual EU country’s existing regulations. It would be essential to understand that draft legislation and its possible ramifications. A deep understanding of the underlying reasons behind unsuccessful Chinese M&A cases in Europe is also key. For instance, State Grid’s unsuccessful investment into 50Hertz can be attributed to 50Hertz being a critical electricity provider, not just to protectionism. In addition, the German government’s veto on the Leifeld acquisition was mainly because Leifeld’s technology can be applied to aerospace and military fields, which are protected by national security laws in most countries.
2. Develop an informed investment strategy. There may be a range of investment hurdles – including regulatory and legal, business integration and counterparty communication issues – to overcome to successfully close and integrate the transaction. The regulatory hurdles may arise from many sides of the transaction, as evidenced by Beijing’s changing regulations on certain types of OFDI; the EU decisions on the Leifeld, 50Hertz and Aixtron deals; and the U.S. block of the sale of Aixtron’s U.S. operations in December 2016. As a result, national industry policies may impact M&A transactions. A plan for addressing known approval risks should be built into the timeline, alongside accompanying cost and advisory impact, which will help build trust with the European party.
Regulation in the EU is national and 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. This should be built 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 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.
Identify early on if the European target company has sensitive technology in the U.S. A good example is the 2016 decision by the U.S. to block the sale of Aixtron’s U.S. operations to Fujian Grand Chip, even though only 20 percent of Aixtron’s global revenues were derived from its U.S. operations, based on sensitivities around the 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 having to be paid by the acquirer.
3. Incorporate the PRC’s 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 OFDI, but the European counterparties are not typically aware of the exact details of these limitations. As the rules within China may be reformulated, it is important to convey any changes or updates to the OFDI limitations imposed by China to the European counterparties.
Also, the dynamics between provincial and national authorities and the resulting procedural delays 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 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.
4. Consider what deal documentation strategy is appropriate. Europe-China deals can be document-heavy, partially due to 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 rounds of translation can be expensive and time-consuming, and might seem inefficient, and even indecisive, to the European counterparties.
We would suggest that a rolling summary of the executive summary of the due diligence 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.
5. Have a solid understanding of European regulation before starting. The EU is heavily regulated. When looking to invest in a project, it is a case not only 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 of Syngenta by EU (and Australian) authorities.
6. 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, and its affiliates, 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 need 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.
7. 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.
8. In an active bidding process, it is important to ensure that the funds are available at the time of closing or when the final bid is submitted. Delays are often viewed with suspicion because a confirmed date is never provided and is one of the largest stumbling blocks between Chinese and European partners.
9. Often in an active bidding process, the PRC company is requested to place some of its funds for the acquisition in a large European/international bank instead of a Chinese bank. Consider initiating contacts with the China branch of a selected European/international bank early on in the investment process.
10. While there may be a tendency to focus on investing in/purchasing high-profile large targets, do not view investing in or purchase of a medium-sized target as a defeat, when investing in a European country for the first time. As mentioned above, Europe is generally heavily regulated and relatively complicated to navigate.
Investing in a medium-sized project allows a PRC company to gain operational experience in the local market, meet local experts and gain the operational experience in the local market, resulting in a better position to successfully manage any of the future investments, large and small, in the local European country.
In summary, while Chinese companies will continue to be presented with a plethora of attractive investment opportunities in Europe in 2018 and 2019, given the rapid changes in today’s investment climate and regulations, 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:
Betty L. Louie, Partner, Orrick
blouie@orrick.com
