Mixed signals, hopes high

Chinese regulators appear to be toying with the emotions of private equity firms through a mixture of pronouncements - some interpreted as good, some bad, others virtually impossible to interpret in the first place. On the whole, though, things seem to be moving in the right direction for general partners. Andy Thomson reports.

“Managers will start to think ‘I can prosper on stock options if I do a good job’. Even if nothing else is added to the regulatory petri dish, this alone greatly increases the likelihood that over the next five years there will evolve a vast new class of management entrepreneurs in China that is private equity-ready.”

“Ready or not, here I come”. Anyone familiar with the children's game of hide-and-seek will be familiar with this refrain. It could be applied equally well to private equity's relentless march around the globe. If the world's leading general partners identify a territory as relatively uncrowded and potentially profitable, expect them to turn up on its doorstep post-haste – invited or not.

The problem for regulators in these territories is that they're often not as prepared as they'd like to be for that knock on the door. In much of Asia, private equity investment is not a new phenomenon: but the scale of it has skyrocketed over the last few years. In certain countries this has caused problems as law makers initially seek to understand the nature of the beast and then find ways of taming it. In South Korea, for example, some GPs have cried foul (rightly or wrongly), claiming that the ‘taming’ part of the process in that country is akin to being hit with a big stick.

In China, regulators have also found themselves playing catch-up as global buyout firms such as KKR and Carlyle Group have turned their hungry eyes to the world's most populous economy. In their determination to keep pace, the Chinese authorities have issued a raft of new legislation recently with profound repercussions for private equity firms active in the country (some of it aimed directly at them; some of it targeted more broadly but which nonetheless catches them in the net).

Here, we take a look at some of the most seminal private equity-related legislative pronouncements to have issued from Beijing's corridors of power in recent months – and consider whether they are intended to represent a welcoming hand of friendship to private equity firms or a defiant line in the sand.

The New M&A Rules (Provisions for the Acquisition of Domestic Enterprises by Foreign Investors) The importance of the New M&A Rules, which came into force in September last year, is hinted at by the number of regulatory bodies that it took to devise them: six in total, the Chinese Ministry of Commerce among them. Suat Eng Seah, a partner at law firm Weil Gotshal & Manges in Shanghai, speaks for many when she says: “We view the Rules as being the most important regulatory development in China for private equity firms over the last year.”

“Economic security is an issue for all countries, including the US. For example, you wouldn't expect to be able to buy a weapons factory anywhere in the world.”

There are three main aspects to the rules, one of which tightens the restrictions on a Chinese company's ability to conduct an offshore corporate restructuring in anticipation of, or alongside, an investment by an overseas investor (a move designed to close a tax loophole). A second allows a foreign investor to acquire equity in a Chinese company by using the stock of an offshore company as consideration (broadly welcomed by the private equity industry, but only applicable in limited circumstances).

The third aspect has generated most debate. It extends the requirement for Ministry of Commerce approval to any deal that affects economic security; key domestic/strategic industries; or well-known brand names. That economic security appears on the list is no great surprise. As one M&A specialist at a Chinese law firm puts it: “Economic security is an issue for all countries, including the US. For example, you wouldn't expect to be able to buy a weapons factory anywhere in the world.”

But this still leaves two troubling questions in the minds of private equity investors: namely, what's the definition of a key domestic/strategic industry, and what's meant exactly by a well-known brand name? Digesting the rules in their entirety won't necessarily enlighten you in this respect, sources say. “They don't go into the sort of detail you might expect to find in a civil law culture,” offers one observer. Another refers to the “opaque consultation processes” which mean that Chinese ‘rules’, at least in their initial form, tend to be strong on generalities, weak on specifics.

The temptation to sidestep Ministry of Commerce approval in the hope that a business will not be viewed as operating in a key industry is obvious. But it should be resisted where there is any reason for doubt. “If you don't notify the Ministry of Commerce and it turns out that you should have done, you run the risk of retrospective recission of the deal,” warns David Eich, head of the Hong Kong office of US law firm Kirkland & Ellis.

In point of fact, there's a fate possibly even worse than the outright rejection of a deal: namely, that it enters a state that might be described as suspended animation. The classic case in this respect is the attempted buyout of construction machinery group Xugong by The Carlyle Group, a deal which, at the time of going to press, was yet to complete – almost one and a half years after regulatory approval was first sought.

But despite all this, there is some positive sentiment about the Rules. Says Eich: “Investors see it as positive that M&A is actually being addressed at the highest level – even if not in an entirely clear or cohesive manner, it's still seen as an important macro development. Also, there is a feeling that, as the economic and political pressure increases on China to open up more, the M&A regime will continue to evolve favourably.”

David Mahon, managing director of China-focused mid-market GP Mahon China, says there are fears that “the Chinese Government will apply the term ‘strategic’, which is vaguely defined, as a protectionist tool in the future”. Nonetheless, there is no immediate sign that the Rules are having a deleterious effect on deal flow. Sources say that, since they were announced, many control deals have been agreed. Says one: “There is much angst, but the market has ploughed on. Investors are taking a bet that the only way is up.”

Taking a scan at some other recent developments in Chinese regulation hints that those prepared to take such a gamble may well find it paying off in the course of time. Below are a few examples: less hyped perhaps than the M&A Rules but not necessarily any less significant.

Acquisitions of domestic listed companies
Around a year ago, trading in the shares of listed Chinese companies – most of which are state-owned – was an unrealistic prospect. Either the shares of such companies were not traded at all or were, at the least, not tradable to a foreign party. Last year, all that changed. Shares in such companies were, for the first time, divvied up into tradable classes, and all state enterprises now have potentially tradable shares.

Says Eich: “Restrictions on the ability of foreigners to buy shares in large Chinese companies have therefore loosened – subject to certain conditions being met, which have to do with the duration of the proposed investment and the credit worthiness of the buyer.”

“Restrictions on the ability of foreigners to buy shares in large Chinese companies have loosened – subject to certain conditions being met, which have to do with the duration of the proposed investment and the credit worthiness of the buyer.”

At the same time as the possibility of buying into these companies has increased, moves are also afoot to improve their transparency as a result of new accounting laws that were introduced by the Ministry of Finance in January 2007. The rules involve compliance with 39 standards structured to reveal the economic value of a firm, with the aim of using market prices wherever possible. “It doesn't mean that Chinese companies will necessarily meet IFRS or GAAP standards, but it will take them a lot closer,” predicts Eich.

For the time being, the rules will apply only to listed companies. However, where new accounting standards have been introduced in other countries, they have often been adopted by the largest and/or listed companies first before gradually becoming universal. Sources say this should also happen in China, whether by way of a natural trickle-down effect or through the law makers forcing the rules on everyone in due course.

In Eich's view, such a development would be viewed as a “sea change” by private equity firms lured by China's growth prospects but troubled by lax corporate governance.

Company law and management incentivisation
When running through the checklist of criteria fundamental to the development of a healthy private equity market, one that you'd expect to find at or near the top of the list is the ability to incentivise management in a way that aligns their interests as closely as possible with those of investors.

When it comes to Chinese stateowned enterprises, such alignment has traditionally been difficult if not impossible. “If you've been running a state-owned enterprise, says a source, “your goal has not been to create profits but to employ people and to make local government look good. In other words, you've had non-economic incentives.”

Until now, that is. At the end of 2006, as part of a new Company Law, the government announced that stateowned enterprises would from now on be allowed to compensate management with stock options and other equity incentives to a much greater extent than was previously permitted. China also recently introduced new categories of tradable shares (see ‘Acquisitions of domestic listed companies’ above), including the preference shares frequently utilised in private equity deals.

Eich views the changes as potentially transformational: “Managers will start to think ‘I can prosper on stock options if I do a good job’. Even if nothing else is added to the regulatory petri dish, this alone greatly increases the likelihood that over the next five years there will evolve a vast new class of management entrepreneurs in China that is private equity-ready.”

Enterprise bankruptcy law
All around the world, imitations of America's Chapter 11 framework for company restructurings have been dubbed “the Chapter 11 of [insert name of relevant country]”. In August last year came the Chapter 11 of China. In the words of a client note issued by law firm Paul, Hastings, Janofsky & Walker, the so-called Enterprise Bankruptcy Law “transforms China's bankruptcy regime from an administrative or even political process into a judicial process”.

Prior to the new law, the normal state-prescribed route for struggling companies was liquidation (and, in many cases, consequent fire sale). Its implementation means that, for the first time, secured creditors are recognised and granted preference in restructuring scenarios.

The move has obvious benefits for the market in China, among which are: banks will likely be prepared to lend to companies with less than perfect credit characteristics; debtor companies can go into a restructuring and obtain relief from creditors as long as they can evidence ability to emerge from the process; and the creation of a new route to control deals, which might be expected to lure debt-toequity specialists to the country for the first time.

All of which is, at this stage, theory rather than practice. As in many other countries where Chapter 11-style frameworks have been introduced, a long period of time may pass before the new regime comes to be tested. However, the fact that it's in place at all adds one more tick in the box when it comes to the Chinese market's credibility in the eyes of global investment groups.

As the above examples show, there is much to be optimistic about when viewing recent Chinese regulation in relation to private equity. Plenty of press ink has focused on those aspects of the new M&A Rules that appear to suggest a country struggling to loosen the firm controlling grip that it has traditionally had over its economy. Nor should this view be readily dismissed: the ongoing travails of Carlyle Group in its efforts to buy Xugong are a reminder that even the sunniest of predictions may not necessarily match any time soon with the reality on the ground.

However, there are at least two reasons for believing that the Chinese authorities are not merely teasing when they appear to be siding with the investment community. One is that, under its World Trade Organisation (WTO) commitments, China is required to open up its market as fully as possible to foreign investors. A second is that China wants its largest companies to be in a position to compete effectively on a global level: private equity capital and expertise is seen as a vital catalyst to this end.

Expect plenty of obstacles on the way to a fully functioning Chinese private equity market – and expect regular outbreaks of panic when some new, vaguely-worded regulatory pronouncement appears to place a spanner in the works. But look at the global LBO firms raising funds for China and opening offices in the country: their confidence tells its own story.