China Is Booming: M&A Opportunities Open The Door

Tuesday, December 1, 2009 - 00:00

Editor: Tell us about your background.

Zhang: I am a native of Beijing. After I completed my education there, including a graduate law school program, I went to the U.S. for another round of legal education and began to practice in the U.S. in 1989. Since 1989, I have been working on China-related projects and have taken many U.S. companies to China for all kinds of business investment and acquisition activities. I am a resident partner of Jones Day's Shanghai Office and coordinate all China investment projects of its clients. By way of background, the firm has offices in Beijing, Hong Kong, Shanghai and Taipei in the Greater China region, together with 29 other offices worldwide.

Editor: What is being done to improve the climate for foreign direct investment?

Zhang: Foreign direct investment in China has slowed down in the past 18 months, so the government is trying to encourage more such investment. This has been done by addressing procedural issues. We have not seen any change in the substantive requirements for foreign investment in China. Every deal in China still requires government approval.

What has changed is that the Chinese government has delegated the approval process for many major transactions from the central government level to the provincial level, and that has significantly accelerated and otherwise improved the approval process. If all the deals coming from different parts of China had to be approved in Beijing there would be some delays. Also, there is a greater interest on the part of officials located in a province in approving an investment that will benefit that province, so in practice some aspects of the approval process have become easier than dealing with the central government.

Another very positive development is the issuance by MOFCOM of a so-called Guiding Manual to its offices and to all the relevant government authorities. The Guiding Manual states that MOFCOM's goal is improving the environment for foreign investment in China in order to make Chinese companies stronger and hence more competitive. It sets forth policies that make the approval procedures for foreign investment in the acquisition and restructuring of Chinese companies simpler and more transparent.

Editor: Does a foreign private equity firm have a problem if it joins with a Chinese partner to create an offshore company to acquire a company in China?

Zhang: That practice known as "round tripping" or "round-trip investment" is still subject to approval by the Ministry of Commerce (MOFCOM) in Beijing. That creates a lot of headaches for private equity and venture capital funds in terms of restructuring the Chinese company to establish a holding company outside China for IPO and other purposes. If you are an industrial company, you pretty much tend to have a relatively straightforward acquisition structure, but private equity firms need an exit strategy. An IPO outside China is an important way to exit. A private equity firm needs to structure its investments with that objective in mind. However, it is now the trend and practice that such firms are looking at making their investments directly into the Chinese entities within China with the plan to do IPOs inside China to capture the high valuation in the public capital market in China. The challenge is the government's approval for IPOs for such Chinese companies and such substantial equity holding in such companies and having the terms most familiar to such private equity firms incorporated into the legal agreements under the current Chinese regulatory framework and relevant laws in China.

The use of an offshore entity, even one situated in Hong Kong, not only faces the issue of central government MOFCOM approval, but also faces tax issues. New PRC tax regulations create significant difficulties to do a tax-free restructuring, even though some of them are traditionally considered internal restructuring. If you do not meet certain narrow standards, even the internal restructuring of offshore entities will be subject to taxation in China.

China also issued a new set of rules recently against treaty shopping; and under these rules, for instance, a Hong Kong entity that is simply a holding company without substance in Hong Kong may not be entitled to certain benefits of the China-Hong Kong tax arrangement or tax treaty.

Editor: Are there other transactions in addition to those involving round tripping that would require the approval of MOFCOM in Beijing?

Zhang: There are several industries or businesses where the central government approval is required. One example is where a sales organization sells everything through the Internet. Another is where a sensitive area like media is involved.

Editor: I understand that local Chinese banks now can make loans to finance M&A transactions.

Zhang: In the past, the local banks were not allowed to finance M& A transactions. Over the past 18 months, a new set of rules has been implemented in response to the present economic situation designed to encourage local banks to finance M&A transactions. M&A is viewed by the Chinese authorities as a way to make Chinese companies more competitive through the consolidation of businesses.

Editor: Is the current foreign investment climate affected by the Chinese stock markets?

Zhang: Yes. Chinese stock markets are flourishing. With stocks reaching very high PE ratios, foreign companies with China operations are waiting for the opportunity to have their China operations listed on one of the Chinese stock exchanges. The authorities here are working on a policy statement that will encourage such listings, which includes a new concept called the International Company Listing Group, so, whenever you look at Chinese stock exchanges, in the future it is very likely that there will be a group of companies like, for instance, HSBC, which may receive regulatory approvals for being listed in China. This is a really positive development for foreign investment.

Editor: What has been the effect of requiring M&A transactions to be subject to a Hart-Scott-Rodino-type review to uncover any antitrust issue?

Zhang: Whenever you do deals above certain thresholds you have to undergo a review of any antitrust implications by MOFCOM's office responsible for reviewing the antitrust filings and going through its approval process. Because the antitrust laws are relatively new, how they will be implemented creates uncertainties for foreign businesses operating in China.

At least at this point MOFCOM's antitrust office has been very cooperative. They are willing to listen and, if you cooperate by providing whatever information they require, it has not so far become a major hurdle in doing deals in China.

Jones Day has an antitrust practice group operating in China as we do in many other countries. In a transaction involving a number of countries, we are able to coordinate the responses where governmental antitrust clearance is required to maintain consistency and yet be sure that the filings take into account the attitude and needs of the respective national antitrust authorities.

Editor: I also understand that the Chinese tax regime is becoming more sophisticated and principles applied are now more similar to those that would be applicable in the U.S.

Zhang: China is beefing up the entire taxation system and in particular its enforcement mechanism. As you mention, the principles being applied are more similar to those applied in other highly developed countries. Like M&A transactions in those countries, careful tax planning becomes a very key element of the entire transaction.

Editor: You have mentioned a number of regulatory areas where having highly qualified regulators is essential.

Zhang: China is moving very fast to address issues characteristically faced by any large and growing economy, including assuring that regulatory agencies are staffed with highly trained professionals. Not only are the law schools providing such training, but China has training companies that specialize not only in training entry-level young people to staff such agencies, but in expanding the knowledge base and expertise of those already serving as regulators. The quality of regulators has been enhanced in a major way in the last couple of years.

Editor: Do you help U.S. companies find business locations in China?

Zhang: MOFCOM is the agency that supervises and coordinates all the foreign investment activities, but it focuses primarily on the legal aspects. Finding a business location in a particular province is pretty much driven by the local government and they sponsor a variety of trips, activities and conventions outside of China to attract companies to set up shop in that province.

We have a good relationship with the central government as well as many local government agencies. Some of the provinces have huge industrial parks. They normally visit us to see if we can help them to find businesses that might be interested in locating there.

If a client seeks our help, we can leverage our contact with the local government to make the whole thing a smoother process. This is something that we do on a regular basis. The fact that we are on the advisory boards of some of the industrial parks and work with them to develop policies to attract more foreign investment provides us with additional insights.

Editor: Summing up, what have you seen in terms of M&A activity by U.S. companies in China and what does the future hold?

Zhang: U.S. companies have been dealing with very tough situations resulting from the economic crisis, but many are recovering and because of cost cutting are able to again look at the unfolding opportunities in China.

U.S. companies are looking at China in a different way. In the past, U.S. companies, especially industrial companies, set up manufacturing operations there to take advantage of the low costs, including access to cheap labor. These days an increasing number of U.S. companies are taking a second look at China and saying, "This has become a very serious market for our products. It is a good time to think about a strategy to enter that market."

In the last year, M&A activities in China coming from the U.S. side have been slow. Starting in the middle of this year, many companies started to look for acquisition opportunities. Now the market is getting hot and people are coming back. Chinese target companies are growing very rapidly. We are going to see some major transactions.

The surging stock markets in China and the high PE ratio of Chinese stocks may deter some U.S. companies from doing acquisitions in China. Basically, if you want to take over a Chinese company or take a controlling interest, that is the problem you will have to deal with. But, on the other hand, a lot of Chinese companies are going to reputable international companies saying, "Why don't you take a relatively low percentage stock position in our company? This will make our company more credible for listing purposes and that alone creates a lot of acquisition opportunities, but the most immediate result will be a significant financial reward." That is pretty much the sentiment in the M&A market in China today.

Please email the interviewee at zazhang@jonesday.com with questions about this interview.