A New Takeover Wave?

Saturday, September 1, 2007 - 01:00

A Prediction

The ancient Chinese philosopher Lao Tzu said, "Those who have knowledge, don't predict. Those who predict, don't have knowledge." Notwithstanding that warning, I predict that this century will be viewed as the Chinese era for the profound effect China will have on global economics, finances and political power. In particular, Chinese acquisitions of U.S. corporations will be a new takeover wave.

That prediction rests on an unprecedented financial trend. China's foreign reserves are now over $1.3 trillion and increasing. Most of those reserves are held in U.S. dollars and are the result of two powerful economic forces. First, the U.S. trade deficit with China is approximately $19 billion per month. Second, the compounding yield of U.S. dollar returns on China's investment of those reserves in dollar debt instruments produces a growing stream of additional dollars.

China needs the U.S. market to continue expanding its manufacturing output, now growing in excess of 10% per year. The purchasing power of U.S. buyers depends on a favorable dollar/renminbi exchange rate. That exchange rate is controlled partly by China's investment of the dollars received from the sale of its goods in U.S. dollar assets, to date principally U.S. governmental and governmental agency debt. The interest on those investments augments China's dollar reserves flowing from the U.S. trade deficit with China. As China's dollar reserves continue to grow exponentially, China will seek other investments for those reserves, including acquisitions of U.S. corporations.

China's Dollar Assets May Become A Problem

The rapid growth in trade of Chinese goods for U.S. dollars in the last two decades, together with U.S. dollar returns from Chinese investments in U.S. assets, have been highly advantageous to China. The size of the U.S. trade deficit and China's accumulated dollar reserves are now recognized as potential sources of political and economic destabilization. China confronts an unusual dilemma - the more dollars they amass, the less likely they will be able to spend them effectively. What are China's choices for its dollar reserves?

Convert dollars into other currencies? While this can be done over the long term, it would be self-defeating in the short term because it would drive down the dollar/renminbi rate, causing China to lose a material part of the value represented by the dollars being converted, reducing the value of the reserves not converted. It would also make China's exports relatively unaffordable in the U.S. market by driving up the value of the renminbi, or, if the renminbi's U.S. dollar exchange rate remains fixed, likely causing increased Chinese inflation.

Increase exports to non-dollar economies? China is implementing this policy and the percentage of its exports to countries other than the U.S. is growing. Growth of China's exports to other markets, however, faces obstacles. Europe, Japan and other countries are increasingly protective of domestic industries and critical of the alleged "under-valuation" of the renminbi. Moreover, increasing exports to non-dollar economies only addresses the trade deficit growth of China's dollar reserves, not the interest compounding on China's dollar investments.

Use the dollars to acquire raw materials and foreign assets?
China's acquisition of assets in resource-rich countries is underway, but it is a long-term solution and requires a growing market for the products produced with the raw materials and assets. Until China's domestic market or its non-dollar export markets are substantially larger, this solution requires the continued growth in China's exports of products to the U.S., which means that this solution is not a near-term solution.

A Solution To The Problem

The obvious solution to this problem is two-pronged - First, reduce China's trade deficit with the U.S. and replace declining U.S. demand with growth in China's domestic and non-U.S. export markets. Second, find the highest-value use for the dollar reserves already accumulated. China cannot accomplish both tenets of that obvious solution by continuing its current course.

The first prong of a solution is reduction of the growth of China's dollar accumulation, preferably without triggering an economic recession or financial deflation. The Chinese have started this process by allowing the renminbi to appreciate against the dollar.

The second prong of a solution is to invest China's reserves in financial and commercial assets other than U.S. government debt. This China has also begun to do, with the recent establishment of a new division of SAFE, charged with the task of organizing a sovereign wealth investment company to improve returns on China's foreign currency reserves, which likely will mean diversifying China's dollar reserves into other currencies. The first public investment on behalf of the new governmental investment company was in dollars, a $3 billion investment in Blackstone Group, followed by the announcement of a larger potential investment in Barclay's Bank.

A third action, however, may be the key to the solution. Chinese companies and its sovereign wealth fund may use China's accumulated dollar reserves to buy productive U.S. assets. China's reserves can be invested in and loaned to private and state-owned Chinese companies to buy U.S. businesses. The initial Blackstone and the potential Barclay's investments are likely the first steps in a series of acquisitions.

U.S. acquisitions provide Chinese companies the additional advantage of establishing control of the entire chain of product manufacture, transport, distribution, and sale. If Chinese manufacturers acquire U.S. retail distribution companies and U.S. raw material producers, China's dollars can be used to acquire control of the entire product distribution chain from raw materials to retail sale.

The Accelerator Of The Solution

Once the initial deals have lighted the path, the sheer amount of China's accumulated dollar reserves will give its U.S. acquisitions momentum. China's acquisitions will also be facilitated by private equity, hedge funds and investment banks. While U.S. hedge and private equity funds have been involved principally in investments into China, they will be ready players when a U.S. company, public or private, comes into play as a target of a Chinese buyer, a "play" that would seem perfectly suited to those funds and U.S. investment banks. To assist, or invest alongside, a Chinese client in a U.S. takeover deal presents the ideal M&A landscape - almost limitless targets and almost limitless dollars available to spend acquiring such targets.

The Likely Targets

While there are some exceptions (businesses protected by the "national security" wall, for example), almost any U.S. industry and any business could reasonably be expected to be an acquisition candidate unless the field is closed to foreign investment. The following are some examples:

Resource companies of all types;

Alternative energy companies;

Food products producers, processors and distributors;

Transportation companies;

"Processors" of raw materials from food to petroleum to pollution control technology;

Telecommunications technology companies; and

Companies with technologies that support the foregoing industries.

U.S. distribution outlets for Chinese products may be high on the target list as they are already "functionally" in Chinese control because their products are produced in China. U.S. companies with well-known brands that can penetrate a large export market may also be favored acquisition targets of Chinese companies because China seeks export markets other than the U.S.

The Targets' View Of The Solution

If it "makes sense" for Chinese acquirers to acquire U.S. companies, what are the initial legal considerations for the targets? That question can be viewed in different ways. The acquisition by a Chinese acquirer will be welcomed if the target's management views it as an effective route to efficient global production and distribution and the offered price is acceptable. Some targets undoubtedly will view the potential acquisition by a Chinese company as warranting only defense. If defense, initially, is chosen, the defenses will be similar to defense against a U.S. acquirer. Takeover defenses are too numerous and complex to be discussed here. Defenses that might be particularly relevant to a takeover by a Chinese acquirer, if they exist or can be put in place, include:

Rights plan (aka poison pills);

Staggered Board of Directors;

Exclusion of shareholders actions in writing; and

Cumulative voting for directors.

Even a private company, unless it is small enough to have in place a shareholders buy/sell agreement that would protect it from a takeover, should consider whether the public company takeover defenses, if put in place in advance, will enhance its ability to obtain maximum value if a sale to a Chinese acquirer becomes desirable or inevitable.

Media campaigns from the domestic takeover defense arena may be an effective tool in defending against a Chinese acquisition. Companies should select in advance a media consultant experienced in international transactions that could be immediately available when the "offer" or "contact" is made by a potential Chinese acquirer. Corporate and strategic planning for a potential takeover should be discussed with the company's investor relations department and public relations advisors. Preparation for a Chinese takeover can increase the ultimate value of the company in any acquisition.

The composition of the target's shareholders may be more important in a Chinese acquisition than in a domestic takeover. The reaction to a Chinese acquirer's approach by hedge and private equity funds may be different from the reception by pension funds and mutual funds. A target's relationships with its shareholders can enhance its position in a takeover struggle.

Certain U.S. takeover defenses may be especially valuable vis--vis Chinese acquirers. The following are examples:

The recently enacted Foreign Investment and National Security Act of 2007, which updated the Exon-Florio Amendment to the Defense Production Act, will likely make Chinese acquisitions of U.S. businesses more complex.

Hart-Scott-Rodino notification.

State Anti-Takeover laws.

Federal and State contracts that cannot be assigned or are assignable only after obtaining governmental consent.

Realistic risks of litigation and administrative sanctions can be a deterrent - International Trade Commission/FCPA and other litigation causes of action that could be asserted through litigation in the takeover process may warrant consideration.

Employee protections and benefits, such as expanded change of control arrangements, indemnification agreements, and other non-terminable benefit plans may become acquisition obstacles.

If the above prediction proves accurate, U.S. companies should not consider Chinese companies as only foreign manufacturing competitors. China's accumulated dollar reserves may soon result in those companies also competing through ownership of U.S. corporations.

John A. St. Clair is a partner of Jones Day, resident in the Los Angeles office. He practices the firm's mergers and acquisitions practice group, representing clients in international and domestic transactions. This article is for information only and sets forth the personal views of the author and does not necessarily reflect those of the firm. It does not constitute legal advice, nor does it establish an attorney-client relationship, and it should not be interpreted as providing legal advice or establishing an attorney-client relationship.

Please email the author at jstclair@jonesday.com with questions about this article.