Buy-out firms have eagerly pursued China for the past decade, but the country's legal and regulatory regime often forces firms to be satisfied with minority investments. Blackstone Group's first China investment, in China National BlueStar, is no exception. But Blackstone's investment was not as passive as it seems. Within two months Blackstone joined forces with BlueStar's parent to bid for an Australian chemical maker. The bid marked the first time a private equity firm teamed up with a related Chinese enterprise to clinch an overseas buy-out, but it is unlikely to be the last. Chinese industrial policy provides numerous incentives to Chinese companies to grow domestically and expand overseas. As Chinese enterprises continue to mature, private equity firms will benefit from considering them both as targets and as peers eager to pursue corporate partnership transactions. The shift could have a big effect on the ability of Chinese enterprises to expand globally and to pursue transactions in the West with renewed vigour.

In September 2007, Blackstone purchased a $600 million, 20% stake in Chinese state-owned chemical maker China National Bluestar. Within two months, Blackstone teamed up with Bluestar's parent, China National Chemical Corp (ChemChina), and Fox Paine and Co, a San Francisco firm that specialises in agri-business assets, to jointly offer A$3 billion ($2.63 billion) in cash for Australia's Nufarm. The consolidation play would have formed the world's largest supplier of generic farm chemicals. However, the bid faltered in December upon Blackstone's reported inability to line up financing cheap enough to make the deal viable.

Minority prejudice

Yet despite private equity's desire for control, many acquisitions of China's best targets must be structured as minority stake, growth-equity investments. Various laws and regulations restrict foreign investors' ability to acquire companies that involve key industries, famous trademarks or traditional Chinese brands, or affect national or economic security. Investments should also abide by principles of reasonableness, compensation of equal value and good faith. It is often difficult to determine when such issues will be invoked, and closed deals may not be safe from further political pressure. For example, Goldman Sachs gave up control of Shineway Group, China's largest meat processor, in October 2007. It agreed to sell a 5% stake to its Chinese partner, local fund CDH, only four months after completing ownership reform of the target; many viewed the decision as politically motivated.

Growth equity investments can be useful to build a firm's reputation and get in touch with local developments. They may also be necessary to dry up excess investment for large funds that do not have the management to oversee further buy-outs. Many funds are limited to growth equity investments. Some firms, such as the Carlyle Group, have distinct buy-out and growth equity funds directed towards China.

Going global

Despite the tranquil enjoyment of watching minority investment appreciate, private equity firms are often eager to take control, generate value and flip their investments. A number of methods have been developed to extract value from China investments, sometimes of precarious legal validity. The proposed corporate partnership of Blackstone and ChemChina, in its simplicity, may be the perfect template for future deals.

Corporate partnership transactions are an established method of investment, which pair private equity capital and deal experience with the strategic investment and management skills of an operating corporation. Like growth equity investments, they help private equity firms use excess capital without requiring substantial additional management. Corporate partnerships are a signature transaction type for Blackstone. As of June 30 2007, Blackstone had invested approximately $5.8 billion of equity capital in 42 corporate partnerships with companies such as AT&T, GE and Sony. Other private equity firms have attempted corporate partnerships with unrelated Chinese firms. Blackstone joined Bain Capital to support Haier's $1.28 billion failed offer for Maytag in 2005, and Bain is now partnering with Huawei to buy 3Com. Texas Pacific Group, General Atlantic and Newbridge Capital recently cashed their 2005 $350 million strategic investment in Lenovo, which was used as alternative financing for Lenovo's acquisition of IBM's PC business.

The Chinese are in some ways ideal candidates for corporate partnership deals. Chinese companies may prefer working with foreign private equity firms because domestic companies lack the experience to pull off sophisticated transactions in developed markets. Private equity firms can be instrumental in using their deal management experience to help guide and structure cross-border investments. They also provide a level of security to sellers, who may be unsure of the Chinese purchaser's intentions. Chinese companies can find synergies that would not exist for Western buyers. They are also in a good position to maximise value from any overseas investment with the help of government incentives. But the most substantial motivation for partnering Chinese companies is their eagerness to expand globally. And China's national government is driving the boat.

Beijing began to make its companies globally competitive with a series of restructurings initiated in 1998, which sought the consolidation and promotion of the biggest and best state-owned enterprises (SOEs). Joint ventures and minority investments by foreign strategic investors were encouraged to promote technology transfers, strengthen know-how and develop distribution networks. This policy was later refined when the State-Owned Assets Supervision and Administration Commission (SASAC) was established in April 2003 as a holding company for nearly 190 large Chinese enterprises. SASAC was given the task to build 30 to 50 of its best SOEs into "national champions" by 2010.

As Chinese companies established themselves locally, Beijing encouraged them to "go global" through overseas acquisitions to increase competitiveness, establish markets and build global brands. Preferred investments benefit from a broad range of incentives offering priority access to financing and foreign exchange, tax concessions and preferential customs treatment. ChemChina is a good example of these initiatives. It was forged in May 2004 from a merger between two large state businesses. The new group absorbed 63 small regional refiners and later absorbed many enterprises of the former Ministry of Chemical Industries. Over the past year it purchased animal nutrition company Adisseo through the acquisition of its parent, Drakkar Holdings, Australian olefins and polyethylene producer Qenos, and Rhodia's silicones business.

Firms analysing potential partners will benefit from reviewing the government's Catalogue for the Guidance of Overseas Investment in Countries and Industries, a blueprint of preferred investments in various sectors and foreign jurisdictions.

Potential risks

Joint acquisitions with Chinese partners often require much greater efforts to close and make successful. Unlike transactions with companies from developed markets, Chinese companies will be more likely to require management assistance from the private equity firm on a continuing basis. The Chinese Ministry of Commerce has cited the acute scarcity of Chinese leadership talent as the main barrier to the global ambitions of Chinese companies. An alternative is to negotiate management agreements with the target's existing management. ChemChina left the management in place upon acquiring Qenos, and was expected to do the same for Nufarm. Sellers loyal to their management may see this as a benefit, but it may not lead to the happiest adoption, as Chinese management styles will differ from those in the West. The existence of Chinese partners may also increase certain closing risks. Haier's bid for Maytag, for example, posed few obvious political problems. But the bid created an unexpected storm of protest to save America's beloved washing machine repairman.

National security issues may also be invoked. In the US, this may result in a review by the Committee on Foreign Investment in the United States (CFIUS), which has the duty of reviewing transactions that result in, or present the possibility of, foreign control of a US business. The only transaction ever prohibited by CFIUS was the acquisition of aerospace parts manufacturer Mamco Manufacturing Company by state-owned China National Aero-Technology Import and Export Corporation (CATIC) because of technology transfer concerns. In 2003, Hong Kong firm Hutchinson Whampoa withdrew its joint bid to acquire Global Crossing upon CFIUS's decision to review the transaction, and Lenovo is reported to have offered several concessions to CFIUS to pursue its 2004 $1.7 billion acquisition of IBM's personal computer.

But Chinese oil company Cnooc's $18.5 billion bid for US Unocal in 2005 may have had the greatest effect on Chinese aspirations in the US. Cnooc wrote to Congress and requested a review of the deal, but energy security concerns sparked active protests from more than 40 congressmen. Four bills were introduced in Congress that directly sought to obstruct or prohibit Cnooc's bid for Unocal. Cnooc eventually withdrew its bid, citing a political environment that created "a level of uncertainty that presents an unacceptable risk to our ability to secure this transaction".

The effect of Cnooc's failed bid continues to be felt. In July 2007, the US Congress passed the Foreign Investment and National Security Act. The Act strengthens national security reviews of acquisitions by SOEs and acquisitions of critical infrastructure, particularly in the energy sector. Meanwhile, recent acquisitions by Chinese companies in the US have tended towards passive investments in industries that do not implicate national security issues.

The participation of Chinese sovereign wealth fund China Investment Corporation (CIC) may also trigger national security issues. Blackstone's investment in BlueStar came four months after CIC purchased a $3 billion, 9.4% stake in the private equity firm. Sovereign funds have been highly scrutinised of late because their actions are feared to disrupt national economies, and because they generally lack transparency. The US and G8 nations have made an effort to legislate against them. Although the Treasury Department was reported to give the Blackstone-CIC transaction an informal approval, some in Congress questioned the investment as giving China an opportunity to have undue influence in potentially sensitive US deals. In addition to its investment in Blackstone, CIC is reported to have held discussions during the summer with Carlyle, Kohlberg Kravis Roberts and TPG to acquire similar stakes. CIC has already gone out of its way to reassure other nations that it will not buy into overseas airlines, telecommunications or oil companies.

Double happiness

Considering the substantial closing, policy and public relations risks associated with partnering Chinese companies on acquisitions, private equity firms should naturally be seeking opportunities with greater upside potential. By bidding with a related company, Blackstone's Nufarm bid provided front-end value through ownership in Nufarm and a back-end interest through Blackstone's equity ownership in BlueStar. As private equity firms continue to develop relations in the Chinese domestic market, we will no doubt see more of those relationships blossom into mutually beneficial corporate partnerships.

By Richard Malish of Mayer Brown LLP