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Private M&A And Equity Investment Under Threat In China « Back
David Nicholson, May 2005
 
When the Chinese State Administration of Foreign Exchange (Safe) released a circular dealing with foreign exchange controls in late January this year, it set off a number of alarm bells among both national Chinese and foreign investors.

While the measures in the circular have yet to be officially made law, it is already being enforced by Safe and the alarm bells are growing ever louder.

Officially known as The Circular on Certain Issues of Improving Administration of Foreign Exchange in Connection with Mergers and Acquisitions by Foreign Investors, the circular limits the ability of Chinese nationals to take money overseas. For the first time, Chinese mainland-based individuals and companies will have to seek Safe approval in order to make overseas investments.

According to tax and finance experts in China, the circular’s principle aims are three: to prevent wealthy Chinese people taking their assets out of the country (even though these people still intend to remain in China), by setting up companies in places such as the Cayman Islands; to prevent ‘capital flight’ by individuals aiming to leave China altogether; and to put a stop to ‘round-tripping’, where Chinese companies take money out of the country and then re-invest it in China in order to benefit from tax breaks and other incentives which are only available to foreign investors.

The circular extends the limits of earlier legislation, which already limited repatriation of hard currency by foreign-invested enterprises in China and regulated foreign investments by securities, pension and insurance funds. This new circular extends these controls to foreign investments by private individuals.

The difficulty for foreign investors is that the circular, if fully implemented, could have an enormous impact on all M&A activity in China. “This could impact every single deal in the pipeline,” as Robert Woll, managing partner of the Hong Kong office of law firm Morrison & Foerster puts it. “It may have unintended collateral damage.”

For some years, Chinese businesspeople have pursued exit strategies for their companies through M&As or public listings, typically establishing an offshore holding company to circumvent Chinese laws forbidding the direct listing of Chinese companies on foreign stock exchanges. These companies include such giants as China Telecom, China Unicom and China Mobile, all listed on the New York stock exchange.

Companies who might wish to follow this example may now find themselves blocked by Safe, according to Robert Woll. Many new approval attempts for investments in offshore companies have been turned away by Safe in the past couple of months. This blockage may lead to a closedown of much M&A activity in China, as access to capital becomes progressively harder.

China’s domestic stock exchanges are nowhere near advanced enough to support the country’s commercial growth: every company that lists on the national bourses must have a ‘legal person’, normally the CEO or chairman of the company, who must hold around one-third of the shares in the company, which cannot be traded. “Because of the liquidity factor, you must have an offshore company or you’re stuck with illiquid shares,” points out Woll. “That would be a complete catastrophe for a private equity investor.”

Tellingly, neither the Ministry of Comerce or the China Securities Regulatory Commission have endorsed the circular, leading China watchers to speculate that there has been some rift, or at least a breakdown in communication, between different parts of the governmental administration. The government itself has warmly welcomed investment from foreign venture capital funds, seeing them as crucial to the stimulation of technical innovation. A number of Chinese high-tech firms have already listed on Nasdaq, with no demur from Beijing.

What continues to alarm experts in China, however, is the absence of real implementation guidance: “The details of the circular are very badly spelt out,” says Walker Wallace at law firm O’Melveny & Myers in Shanghai. “So the whole business community has been left in limbo. Some local firms think the measure won’t be implemented, but others think that it represents a very significant risk. If you start a company and three years down the line you want to do an IPO or sell the company, there could be regulations saying ‘we’re going to make your life very difficult’.”

Wallace can see the logic of preventing capital flight and clamping down on ‘round-tripping’, but he takes issue with the aim of thwarting successful Chinese businesspeople from investing overseas. “They seem not to acknowledge that these individuals have created world class companies and created value to help the Chinese economy,” he says.

Along with the rest of the Chinese investment community, Wallace is in no doubt that the circular has caused a delay in deals progressing. “People are trying to get to grips with it,” he says. “It’s had a major effect on transactions. People have been forced to go back to more primitive structures.”

It is possible that there are some silver linings to the situation, from foreign investors’ points of view. Since the circular is so limiting on Chinese individuals, foreigners may find that they can increase their leverage in M&A transactions.
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