Risky Business: Private Equity in ChinaPublished: January 26, 2011 in Knowledge@Wharton
China's private equity (PE) market grew at a rate of 40% per year from 2003 to 2008, reaching a value of US$9 billion, and is expected to continue growing at an annual rate of 20% to 25% through 2015. Much of this growth has been driven by foreign funds entering the market, accounting for an estimated two-thirds of the total market share by deal value in 2008, with several larger deals topping US$200 million in size -- such as CVC Capital Partners' 2007 purchase of a 29% stake in bottle maker Zhuhai Zhongfu for US$213 million.
These figures make China a very attractive market for foreign private equity (FPE). Despite this rapid growth, however, the Chinese market is still fraught with hazards for foreign funds, as Carlyle experienced in its failed 2009 bid for the Xugong Tractor Company. To succeed in China, one needs to examine carefully the major legal, accounting, and political risks to FPE, and design strategies for managing these risks while benefiting from China's rapid growth and dynamic markets.
Key Risks: The Law, the Books, Getting In and Out, and the Party
Entering the Regulatory Melee: The complex Chinese legal environment can pose significant obstacles for foreign firms investing in China. In addition, the regulatory system can be confusing: Targets for acquisition are often not in compliance with regulations, the courts are ineffective, and rulings are rarely enforced.
As a unitary state with 23 provinces, five special autonomous regions, four self-governing municipalities, two special administrative regions, and a hierarchy of departments at all levels, China has myriad bodies with legislative and enforcement powers that can influence foreign firms' operations. Combined with the fact that, according to John Garnaut in the Sydney Morning Herald, "officials enjoy unfettered administrative power without transparency," it can be near impossible to navigate the Chinese bureaucracy; efforts to do so can sometimes border on the absurd. In a story related by one entrepreneur, conflicting requirements between the fire department and the health department led him to install a fire door on Monday before the fire official visited, only to take it down on Thursday when the health official visited.
According to one Shanghai-based lawyer who specializes in the acquisition of local firms by FPE, "no firm is 100% in compliance with regulations." In fact, a common phrase in Chinese business circles is, "while the top has policies, the bottom has countermeasures." This attitude presents problems for foreign investors, since it means that any target for acquisition is likely to have failed to comply with government regulations. While the target's countermeasures may have been successful to date, there is no guarantee that the top will not enforce the regulations later and possibly retroactively. This poses a significant legal risk for foreign investors.
Moreover, because the Chinese court system is weak, few foreign investors expect its decisions to be effective or fair. In general, litigation in China for foreigners is a perilous business plagued by judicial incompetence, local favoritism, and a lack of international enforceability. Judges often have no professional legal training. Court decisions rarely favor foreign parties and are often subject to the local government's influence, which is one of the central reasons for the failure of enforcement in China.
Furthermore, traditional Chinese culture and current political policy place a heavy emphasis on preserving social harmony. Throughout its long history, Chinese society has been ordered more by moral precepts, socially enforced value systems, imperial edicts, and mass movements than by positive public law. This is translated into a legal and political system where dispute resolution focuses on mediation and conciliation in order to preserve social harmony, rather than hard enforcement of legislation that will preserve the integrity of the law. This lack of enforcement creates a situation where formal regulation fails to provide sufficient predictable and compelling incentives to ensure that economic actors and local officials comply with legislation.
Counting Contracts: The Chinese market is riddled with fake accounting records. As the managing director of a leading VC firm in China notes, "A lot of accounting and financial data is faked. It is common for firms to maintain two sets of books, and many have three -- one set for tax authorities to minimize profitability, a second set for prospective investors to maximize profitability, and a third private set for the firm's managers showing actual profit and loss."
Chinese business contracts are similarly opaque. They are often viewed as preliminary indications of goodwill and intent rather than enforceable and mutual commitments by each party. They are rarely as detailed as foreign firms are accustomed to and lack specific technical and legal vocabulary. As a result, foreign investors run the risk of not actually getting what they think they are buying or, alternatively, taking on unforeseen and potentially ruinous liabilities as part of a deal.
Entry and Exit: The inability of FPE to freely convert the renminbi (RMB) into other currencies has two major implications. First, in terms of entry, foreign entrants must obtain special permission from the Ministry of Commerce (MOFCOM) to make investments in China using foreign-currency-denominated funding pools. This approval may require specific deal structures -- such as JV arrangements -- and can take months to complete. In fast-moving industries such as high-tech and green-tech, this time lag can be enough to sink a deal. Furthermore, although infrequent, the possibility that MOFCOM might not approve a specific foreign investment project cannot be ruled out, particularly when a foreign investment is considered to be sensitive, or not in line with the state's interest or national policy.
Some FPE firms have begun to raise RMB-denominated funds in China to avoid this need for special MOFCOM approval. Several firms have even adopted the practice of using both foreign currency and RMB denominated funding pools in tandem. Under this approach, the RMB-denominated funds are first used to make a small initial investment, allowing the FPE firm to "seal the deal" quickly while awaiting MOFCOM approval to draw on the larger, foreign currency denominated funds to complete the investment. However, according to a Shanghai-based PE lawyer, "although the concept of foreign-controlled RMB funds is largely welcome and even encouraged by the Chinese government, the nature of these funds remains to be clarified under the Chinese legal regime. [Should they be] labeled as 'foreign' [in the future], they would also be subject to MOFCOM regulation."
Second, in terms of exit, the lack of free RMB convertibility means that foreign funds need to address how to get their profits out of China. Again, MOFCOM approval is needed to transfer equity in Chinese companies and convert/repatriate the proceeds out of China. These approvals are granted largely at the discretion of individual MOFCOM officials, subject to their interpretations of the regulations.
Politics Matter: China's government maintains an active role in the marketplace and can move quickly to act on its political agendas. This introduces unpredictability for the foreign investment environment in China, as regulations and enforcement shift with changes in the political winds.
For example, in 2006, concerned over the flight of capital through round-trip investments -- the most popular investment method at the time -- the government effectively eliminated this practice through new regulations. Similarly, favored industries can quickly lose their regulatory backing if the government is satisfied with their development and moves to support other industries. As the director of a major Shanghai growth capital fund notes, "when the government suddenly decided the solar industry was oversaturated, our exit strategy became complicated and regulatory approvals for IPOs suddenly became very difficult."
While the intersection of politics and the regulatory environment at the macro level has far-reaching implications, there is also a political risk at the deal level. Without a case-law system, officials in the provincial bureaus often interpret regulations as they see fit; and there is no guarantee of consistency across deals, even among those of similar sizes and types. An individual official's importance to a deal cannot be overestimated. One experienced PE lawyer notes that the vast majority of officials are conservative and limited in knowledge, so it is difficult to gain approval for innovative deal structures. However, in one deal in which she participated, the official in charge had a personal vested interest in the development of the relevant industry, which was also a core development focus for the province. As a result, the official was willing to interpret regulations loosely and allowed her client to gain a majority stake in a company, which would have been impossible under a strict interpretation of the regulations.
An extreme example of politics influencing deals is Coca-Cola's recent attempt to acquire HuiYuan. With a negotiated price tag of US$2.4 billion, the acquisition of HuiYuan and its nearly 40% market share of the Chinese juice market appeared set to form the core of Coke's product expansion strategy in China. Despite lengthy negotiations, MOFCOM -- citing concerns over fair competition -- ruled against the acquisition, making it the first to be struck down under China's anti-monopoly law. Despite the published rationale, many analysts saw the ruling as a reflection of growing nationalism in China: There was tremendous controversy when the acquisition was announced, with public outcry centering on the loss of a very successful domestic brand to foreign control. In the words of one analyst, "that deal was dead the minute it made the headlines in the South China Morning Post."
The Role of Relationships-- Guanxi: It is often said that nothing can be accomplished in China without guanxi. While this may be an exaggeration, guanxi can make the difference between identifying a truly stellar company for acquisition and one that is stellar only on paper.
Guanxi refers to relationships based on mutual obligation, goodwill, and personal affection, with an emphasis on family and shared experiences. With guanxi, both parties express an implicit trust and understanding to help each other when requested, including performing favors and sharing information. However, guanxi is also a form of political capital, and the give-and-take must remain in balance, although not necessarily in kind. Failure to return favors or demonstrate a willingness to go out of one's way can irreparably harm guanxi and potentially dissolve the relationship.
In China's murky regulatory and business environment, guanxi offers clarity to foreign investment firms. Local industry contacts can provide detailed information and context to help verify or discredit financial statements that appear too good to be true. In one instance recounted by a Shanghai-based private equity player, a foreign firm was able to back out of a highly sought-after deal when industry contacts discredited the target company's reported profit margins. Although the information was obtained through informal phone calls, it involved privileged operational data from the contact's firm, which could not have been obtained without guanxi.
Guanxi also plays an important role in interactions with the local government. The deal approval process has lengthened in recent years as competition continues to grow and more applications clog the already highly bureaucratic process. Local officials prefer familiarity and are known to shuffle applications around, making guanxi an important tool to ensure prompt or early review. Informal dinners and deep guanxi with officials also act as political barometers, providing off-the-cuff comments on specific industries or internal party politics that could guide deal-sourcing strategies.
Adapting to Local Conditions While relationships are fundamental to business success in China, they should be reinforced by appropriate legal-risk-management practices. In the best interests of all the parties, the method of dispute resolution should be specified clearly in the contract. Chinese contracts usually include provisions for resolution through voluntary methods such as negotiation and mediation. However, because these methods are often unsuccessful in resolving serious disputes, it is necessary to have clear procedures for non-voluntary measures such as litigation and arbitration.
Although some commentators have confidence in Chinese courts, foreign firms should not rely on them for impartial and competent adjudication. Thus, arbitration is the preferred method of dispute resolution: It is usually faster than litigation, it is internationally enforceable and procedurally simple, and the arbitrators are more likely to be competent and impartial.
Because Chinese law allows for foreign arbitrations and enforces arbitral awards in accordance with its New York Convention obligations, parties have the option of arbitration outside mainland China. The Hong Kong International Arbitration Commission and the Singapore International Arbitration Commission are common choices. Another option is arbitration in Taiwan. Chinese authorities are particularly keen on enforcing Taiwanese arbitral awards as a political statement of Taiwan's unity with the mainland. This can be used to the foreign firm's advantage.
However, it may be more advantageous for the foreign party to accept arbitration in Beijing at the China International Economic Trade and Arbitration Commission (CIETAC) in exchange for other concessions in contract negotiations.
Although it was established in 1956, CIETAC remained ineffective until its rules were thoroughly revised in 2005. As a result of the dramatic improvement in its arbitration process, it is now generally well-regarded by foreign firms in China. In fact, limited statistical evidence suggests that foreign firms fare particularly well in CIETAC arbitrations. According to the international law firm Minter Ellison, "the key advantages CEITAC has over foreign arbitration commissions are its favoured position with Chinese parties and its experience with Chinese business."
Chinese parties favor CIETAC arbitration as the method of dispute resolution. This preference can be turned to the foreign parties' advantage: The latter may agree to CIETAC arbitration as a bargaining chip to induce the Chinese Communist Party to concede other points in the negotiations. This may be achieved at minimal cost to the foreign firms, as CIETAC arbitration is generally satisfactory.
However, foreign parties should be mindful that a provision in the Civil Procedure Law allows Chinese courts to refuse to enforce CIETAC awards that are deemed to be "against the social and public interest of the country." This renders these awards vulnerable to local protectionism and refusal of enforcement on broad, vague, and exploitable grounds. The adage "go with the Communist Party" takes on particular relevance in this situation. Foreign firms should adapt to local conditions and be wary of crossing the Party.
Structure the Deal Creatively: To address accounting risks, structuring the deal and conducting proper due diligence are critical. The scale of accounting problems in China, combined with the difficulty in securing legal remedy, suggests that particular attention to detail is needed in the due-diligence phase. As part of this phase, measures that may be considered extraordinary in other markets are both prudent and commonplace in China -- e.g., going through the detailed language of individual business and real estate contracts, with an eye for any unforeseen obligations or irregularities in property rights and conducting on-site, detailed physical inspections of all significant individual operations. One Hong Kong-based venture capitalist states that he would even "hire private investigators to thoroughly evaluate the background of potential business partners and target company executives."
The last point is particularly critical: It is not enough to just audit the books, supported by high-level spot checks of flagship operations. As one prominent venture capitalist with decades of experience in China notes, although a Chinese firm may claim to have an extensive sales network in third-tier cities, many of those outlets may not be built or operated to the same standards as the company's flagship outlets in Beijing or Shanghai, while some may not be operational at all and others may not even exist.
Deal structuring is just as critical as due diligence. Several legal and industry experts have recommended the following practices:
- Have a trial period: As part of this arrangement, the investor arranges to pay only 30% to 60% up front, with the balance postponed to a later date (e.g., six months later) and conditional upon a termination clause. This arrangement is aimed at keeping any potential partners honest for the critical period immediately after the company's handover, as well as allowing FPE firms to back out if any additional material accounting problems are discovered.
- Do an asset deal: Where possible, instead of buying the old company, FPE firms should consider setting up a new JV instead to buy all the old company's assets. Funds can thus potentially avoid taking on unforeseen liabilities. However, regulations do place some limits on this practice: for example, assets cannot be transferred between firms at undervalued prices, and state-owned assets cannot be transferred to private firms at all.
- Keep the managers: Even after a total buyout, it is particularly important to keep the previous management on in a consulting role for one to two years, with the appropriate incentives in place to keep their interests aligned with the company's continued success. Corporate success in China is due as much to personal guanxi as to institutional strength. If a key manager leaves to join a competitor, he may be able to take the entire client base and supplier network with him.
Follow the Party and Keep a Low Profile: The best way to avoid unforeseen political complications in China is to simply stay off the political radar. This involves not only pursuing investment strategies that fit with the Communist Party's objectives, but also avoiding large deals that could draw unwanted attention and scrutiny from the government.
According to private equity participants and observers, much can be accomplished in China as long as you "go with the Communist Party." The government authority's tight grip means that actions and strategies must align with the Party's political objectives. To do otherwise, as Google did recently with reports of Chinese-sponsored cyber-attacks, is to risk failure. According to an experienced executive from a competitor, Google's clash with the government severely damaged the company's relationship with the Chinese government, putting Google under intense scrutiny going forward. Conversely, another major online player's neutral stance on the issue has increased its political sway and afforded it greater room to maneuver. In the words of an executive from that company, "they can do almost anything now; they're on [the government's] good side."
What Does All This Mean?
The risks and ambiguities inherent in the Chinese PE environment may seem daunting at first, but they also present an opportunity. Unpredictable legal enforcement or shady accounting can all be mitigated through local knowledge and networks; those firms best able to exploit this knowledge will have a competitive advantage. Combined with a hands-off approach from headquarters, local offices are empowered to act quickly within the often short window of opportunity.
China has just overtaken Japan to become the second largest economy in the world. And, despite the global financial crisis, China's GDP growth is projected to exceed 9% for both 2010 and 2011. While these risks and ambiguities are daunting, there is no doubt that China will remain an attractive market for foreign investment firms seeking growth in an increasingly slowing world. Those firms that embrace local knowledge and networks and that build and empower local offices will be best positioned to succeed.
This article was written by Jason Chen, Kenneth Liang and Dominic Skerritt, members of the Lauder Class of 2012.