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China – M&A: Looking Ahead To 2013.

26 January, 2013



China M&A 2012 Market Overview


The upsurge in both deal volume and value of Chinese M&A transactions that followed the height of the global financial crisis in 2008 and 2009 did not extend to 2012. Because of its myriad interconnections with global finance, China’s economy was brought down to earth last year.


In addition to the effects of the global economic slump, China was impacted by several other circumstances, including, among others, the flight of capital, unstable inflation, rising cost of wages, a still-unclear regulatory approval system and collapsing black market loans. All of these factors caused a slowdown in GDP growth from 9.2 percent in 2011 to less than 8 percent for 2012, resulting in, among other things, muted investment interest into China:


  • The total number of announced Chinese M&A transactions (inbound, outbound and domestic transactions) for the first half of 2012 declined 33 percent compared to the corresponding period for 2011. Deal value declined by 10 percent over the same period. The number of inbound M&A transactions suffered the most, with a decrease of 42 percent. (PricewaterhouseCoopers)
  • For the third quarter of 2012, the number of closed transactions in the China M&A market decreased 28.1 percent compared to the same period in 2011, and disclosed transaction value declined by 48.4 percent. Among the reported 233 completed transactions in the third quarter of 2012, only six were inbound M&A deals, reflecting a 64.7 percent decrease in deal volume compared to the same period in 2011 and a 60 percent quarter-on-quarter decrease. (Zero2IPO Research Center)

  • Despite the decline in inbound M&A activity, a handful of deals are noteworthy for both their size and their structure, including General Electric Company’s acquisition of a 15 percent stake in Shanghai-listed China XD Electric Group for $535 million.


Amid the overall gloomy statistics, two trends continued and are expected to do so for the foreseeable future:


  • China continues its emergence as a force in the global M&A market with the conclusion of several landmark outbound transactions. Its increasing energy consumption, championed by China’s state-owned enterprises (SOEs), has solidified investment outflow into natural resources and energy supplies, despite the country’s slowdown in economic growth. 
  • Lingering questions regarding accounting irregularities and other factors causing Chinese-listed companies to trade at a discount continue to stimulate the goingprivate trend. 


Regulatory Framework and Implications


China’s regulatory regime is a vital consideration for the feasibility and success of any M&A transaction with a Chinese component. The multilayer approval and registration process may affect the timeline for the completion of the transaction and, to a certain extent, could become the most critical — and problematic — step in deal consummation. While direct acquisition of a Chinese target is subject to stricter scrutiny, outbound M&A deals and certain indirect offshore acquisitions are not immune to regulatory restrictions or requirements.


Access to China’s Industry or Market. Not all industries in China are open to direct foreign investment. The Chinese government regulates foreign access to the various industries and markets through its foreign investment guidelines and catalogues, adjusting them from time to time in accordance with the state’s overall economic plan.


Foreign investments in China are divided into four categories that determine the relevant approval authority and level of scrutiny the transaction will receive: “encouraged,” “permitted,” “restricted” and “prohibited.” The Foreign Investment Industrial Guidance Catalogue (Catalogue) specifies the sectors and activities under the encouraged, restricted and prohibited categories; those not covered in the Catalogue are deemed to be in the permitted category. Subject to the Catalogue, certain acquisitions of shares may be limited to only a minority interest given the requirement for a Chinese partner to hold the controlling or majority equity interest.


The relevant approval authority also depends on the scale and nature of the proposed transaction. In general, the two main authorities for acquisition approval are the National Development and Reform Commission (NDRC) and the Ministry of Commerce (MOC) (or their local counterparts). In addition, investment or acquisition into certain industries also may require further approval by the specific industry’s responsible authority. Examples include the Ministry of Industry and Information Technology for telecommunications, Internet and online commerce; the China Banking Regulatory Commission for banking; and the China Securities Regulatory Commission for securities investment. Other regular authorities likely to be involved in a foreign investment-related deal include the State Administration of Foreign Exchange (SAFE) for financing matters requiring conversion between RMB and foreign currencies and the State Administration of Industry and Commerce for company registration and reporting formalities. 


As a comprehensive overview of specific regulatory approvals is not available, a foreign investor in China likely will need a thorough analysis of the required approvals. Because of these various regulatory approval hurdles, flexibility in structuring a direct inbound acquisition is limited and potentially time-consuming. For acquirers or investors to execute a deal quickly and minimize approval risks, the most straightforward strategy generally is to acquire or invest into the target’s offshore holding company. 


In terms of approvals, acquisition of an offshore holding company typically does not require governmental approval. However, in recent years, the advent of China’s national security review scheme and anti-monopoly scheme has added another layer of barriers to the successful completion of the transaction. 


National Security Review. In 2011, the Chinese government established a new type of process closely analogous to the Committee on Foreign Investment in the United States (CFIUS) for reviewing the national security implications of foreign investments in Chinese companies. The Security Review Committee, an interministerial committee led by the NDRC and MOC, must be notified to approve a transaction if it is deemed to (1) involve a foreign investor merging with or acquiring Chinese enterprises in (or supporting) the military sector or located near key or sensitive military facilities, and other entities relating to national defense; or (2) lead to the foreign investors taking control of Chinese enterprises in other sensitive sectors (including key agriculture products, key energy resources, important infrastructure, important transport systems, key technology and critical equipment manufacturing) that have a bearing on China’s national security.


Circumventing the review by any means (including contractual arrangements) is explicitly prohibited. The implication of a catchall effect is widely thought to have had a significant impact on the current structuring and estimated completion time of M&A transactions involving targets or assets in China. In sectors where China has imposed stringent access restrictions (e.g., telecommunications), foreign investors commonly utilize a variable interest entity (VIE) structure, through which the foreign investor can exercise effective control over the Chinese operations, even though it does not invest in a form of direct ownership. It is unclear whether one of the actual objectives of prohibiting any attempts, whether direct or indirect, to bypass the national security review is to take account of the VIE structure and its ability to avoid other regulatory reviews and approval process. For now, however, the national security review mechanism has forced investors and acquirers to be more wary of the scrutiny the VIE-related transactions may face.


Anti-Monopoly Clearance. Ever since the PRC Anti-Monopoly Law came into effect in 2008, the anti-monopoly filing with the MOC has been one of the key considerations in any M&A transaction, since it may affect the timeline of the transaction, and the authority may impose additional restrictions. This requirement may apply to both inbound and outbound M&A transactions, as well as transactions that are entirely between foreign entities with some revenues derived from China. A filing will be triggered if (1) in the previous financial year, the combined worldwide turnover of all parties to the transaction is more than ¥ 10 billion, and at least two of the parties each has turnover in China of more than ¥ 400 million; or (2) in the previous financial year, all parties to the transaction have a combined turnover in China of more than ¥ 2 billion, and at least two parties each had turnover in China of ¥ 400 million.


In addition, even if the above thresholds are not reached, the MOC may initiate a review if it views the concentration from the merger as affecting, or likely to affect, competition through elimination or restriction.


Since the adoption of the anti-monopoly clearance scheme in 2008, the MOC, as the authority responsible for merger control, has reviewed more than 450 transactions, 95 percent of which have been approved without additional conditions. At least 15 transactions were approved with additional conditions, and one deal, the proposed $2.5 billion bid by Coca-Cola Enterprises, Inc. for China’s top domestic juice-maker, China Huiyuan Juice Group Limited, was blocked in 2008.


Important Developments in 2012 


The VIE Structure Under the Regulatory Magnifying Glass. In August 2012, the MOC issued a decision on the conditional anti-monopoly approval of Walmart’s acquisition of Yihaodian, a major China online retailer, which expressly precludes Walmart from engaging in value-added telecommunications business (VATB) services currently provided by Yihaodian via the VIE structure. This is the first time that the MOC explicitly prohibited the use of a VIE structure. One interpretation of this decision is that the ministry was concerned over Walmart getting access to the restricted VATB business without obtaining the requisite regulatory approval. Another interpretation is that the MOC’s primary concern was competition in the online retail market and its position on the use of the VIE structure has not changed. However, despite this recent development and questions that continue to surround the long-term viability of the VIE structure, for now, it continues to be an important structuring tool for transactions that otherwise would not trigger the anti-monopoly filing threshold. 


The Revised Catalogue for Market Access. The 2011 edition of the Catalogue provided further liberalization of several industry sectors in China. The change of market access is in line with China’s latest national policy, reflected in its 12th five-year plan for national economic development, from 2011 to 2015. The number of “encouraged” business activities was increased while the number of “restricted” and “prohibited” activities was reduced. More activities are now encouraged in sectors relating to environmental protection, renewable energy, high-technology and services. Restrictions have been removed from activities, including wholesale and retail of drugs and automobiles; operation of medical institutions, financial leasing companies and franchise management companies; importation and distribution of publications; and certain mining activities in a form of equity joint ventures. In contrast, activities added to the “prohibited” category include construction and operation of residential villas and domestic express delivery of mails.


Applicability of Share-Swap Mechanism. Use of equity as investment capital is not prohibited by Chinese law, per se. However, due to the absence of specific rules regarding such “share-swap” structures, inbound investments utilizing this structure have faced substantial regulatory obstacles.


In general, it has been practically impossible for foreign investors to either directly contribute equity to their Chinese subsidiary or joint venture, or directly use equity as consideration for purchasing shares in a Chinese company. This has forced parties to be creative in structuring transactions containing share-swap elements. One such new approach is to cross-invest with cash — whereby a foreign investor makes a cash investment into a Chinese company, and the Chinese company makes a corresponding cash investment into the foreign investor’s offshore entities. 


However, the regulatory situation on share-swap transactions may be improving following the MOC’s October 2012 notice on this topic, which provided a clearer approval procedure and policy basis with respect to investment in a foreign-invested enterprise in the form of the equity of a Chinese onshore enterprise. The notice clarifies the type of equity that is ineligible to be used as capital contribution (e.g., unpaid-up equity, pledged equity, the equity interest of real estate enterprise, a foreign-invested holding company or a foreign-invested venture capital company). As to the value of the contributed equity, the parties can agree to an amount based on the appraised value of the equity, with a maximum capped at the appraised value. While the notice is directly addressed at investment into China by way of establishing a foreign investment enterprise or executing a capital increase in an existing enterprise, it also applies to circumstances in which shares are used as consideration for the acquisition of a Chinese company.


Although the notice does not further expand on how its guidance should be interpreted in share-swap transactions (and thus its practicability remains to be tested), it seems to provide greater flexibility for deal structuring. It can be expected that following the MOC’s notice, ancillary rules from other regulatory authorities such as SAFE may be promulgated to further elaborate on the relevant procedures for consummation of equity contribution or share-swap-based transactions. 


Looking to 2013


Two trends likely will continue. First, consistent with Chinese national macroeconomic interests, the SOEs will continue to take the lead in outbound M&A transactions, in particular, in the traditional energy and resources sectors. Second, given the announced going-private offers, these transactions will continue to account for a considerable share of China’s M&A market. The SEC recently filed charges against China affiliates of the Big Four accounting firms for refusing to produce the audit work papers and other documents related to China-based companies, which sparked market speculation of a stronger wave of China-based U.S. companies opting for delisting in the coming years.


At the same time, efforts are being made to encourage inbound investment into China. With the launch of a series of implementing guidelines under China’s 12th five-year plan in 2011, the Chinese government signaled its proactive support for mergers and acquisitions and reorganizations. This provides a more positive policy environment for M&A transactions and cross-border investment in the relevant sectors.


In addition, the transition of China’s top leadership in November 2012, together with statements issued from the new leaders regarding accelerating economic reform and liberalization, herald a new wave of domestic growth and, coupled with improving global market outlook, are stoking a positive outlook for Chinese M&A.


For further information, please contact:


Daniel Dusek, Partner, Skadden


Z. Julie Gao, Partner, Skadden


Michael Gisser, Partner, Skadden

[email protected]


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