Chinese private equity: Teething troubles

Author: | Published: 1 Dec 2006
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Everyone knows Asia's private equity market is growing. It now makes up 15% of China's M&A market, compared with 5% in 2003. But less reported are the problems for both law firms and investors, with the latter finding that on occasions, mere capital and enthusiasm do not guarantee success. Carlyle, the US private equity group, announced last October that it had agreed to pay $375 million for 85% of Xugong, a state-owned machinery company. After facing resistance from authorities, the deal was reduced to a 50% joint venture.

So while private equity investors have been drawn to China over the last twelve months, they've encountered difficulties, from the sometimes entrenched attitudes of their targets to the burdensome nature of recent regulations. Law firms have felt the effects of both.

Private equity is relatively new in China and, understandably, it may have tried to grow up too quickly. "There has been a change of M&A dynamic, with lots of money chasing a few ideas," says Paul Strecker, partner at Shearman & Sterling in Hong Kong. Pricing is also an obstacle. Lots of private equity houses believe that domestic targets have set unfeasible prices, aware of the queue of investors. "Chinese sellers have to become more realistic in their asking price," says Gary Lock, managing partner at Herbert Smith in Hong Kong.

However, investors are not blind to the risks involved in China. Undeniable market growth aside, there are legal challenges involved that many private equity investors are not used to. "China's legal market is not as sophisticated or reliable as that in London or New York. We're at the higher end of risk analysis, there's certainly a difference," says Roger Denny, partner at Clifford Chance, Hong Kong.

Andrew McGinty, Lovells

The question is whether there are enough quality start-ups that can clear the hurdle rate. Investors have to be convinced they'll receive their usual rate of return. "Investors are looking for the potential of the business model and the quality of the management team, and whether they (Chinese companies) can successfully combine their local savvy with the demands of international investors looking for certain corporate governance requirements, so as to prepare the company for an exit," says Andrew McGinty, partner at Lovells, Beijing.

The problem of marrying separate business and legal frameworks has its roots in the way domestic targets are funded. Many young Chinese companies have trouble getting financing when starting up, because there is a considerable bias among banks towards state-owned enterprises. "Consequently, these young companies have to use various other means of financing. Many of the targets will not be clean companies," says McGinty.

For law firms representing investors in China, this can be a challenge. "Private equity houses like to go into a deal with their eyes open, but in China there is a tradition of not fully appreciating due diligence. There are concerns for us in getting access to full information for this. There's certainly an education involved," says Denny. Investors want varying degrees of due diligence. "The firm's role can be as big or as small as the investor wishes. Some want full belt and braces, others just want the basics," says McGinty.

But investor confidence and unfamiliar business practice were not the only things affecting law firms involved in private equity in China in 2006. Regulatory changes were the biggest challenge.

In August 2006, the Ministry of Commerce (Mofcom) issued new regulations on Chinese merger and acquisition transactions. They became effective on September 8 2006. While the regulations were marketed as an attempt to provide a clearer framework for the deluge of foreign investors entering the country, some elements (particularly the National Economic Security test) have had the opposite effect. The regulations are certainly vague, and have been dissected in previous issues of IFLR, most recently by Paul Chow in November's issue and Robert Lewis in this issue. But for private equity lawyers in China they are just another burdensome regulation to get to grips with.

"China has always been a country where the ability to anticipate and quickly interpret rules has been important. This year, that's been particularly challenging," says Denny. Some market observers have even noted both the Carlyle deal and the politicised regulations as a return to economic nationalism. This is perhaps a little extreme, but there is certainly a hint of retreat in the air. Li Deshui, former head of the National Bureau of Statistics, spoke in a press conference of the dangers in allowing "malicious take-overs" of Chinese enterprises to go on.

Investors are largely biding their time. "There are a lot of funds looking to invest in China. But there could be more. They're sitting on the sidelines with money, wanting to invest," says Lock. Firms in China are hoping that 2007 will be the year they do. TY