M&A Report 2022: China
Carl Li, AllBright Law Offices
In the first half of 2021, China’s M&A market surged to a high volume. However, since the second half of 2021, the Chinese government has been cracking down on technology and online tutoring firms, and has introduced a series of laws on issues ranging from anti-monopoly to data security.
The strict government scrutiny has cooled down M&A activities for those high-growth sectors and previously active M&A players.
Both private and public M&A transactions are prevalent in China. In 2021, the most active M&A in China’s new economic fields were in the new energy industry. The companies acquired in the new energy field involve new energy development, wind energy, heat supply, lithium batteries, photovoltaic power generation, etc.
In December 2021, Mingyang Intelligent announced that it would sell 100% of its wholly owned subsidiary, Yangjiang Mingyang Offshore Wind Power Development Co., to Three Gorges Energy for a transaction consideration of RMB1.757 billion (approximately $278 million). This is the highest-value M&A deal in the new energy sector in 2021.
Economic recovery plans
According to the Hurun China Cross-Border M&A Report 2021, while the overall number of overseas M&A deals dropped due to a slowdown in economic development brought by the Covid-19 pandemic, the top 50 overseas M&A deals made by Chinese mainland companies reached RMB168.2 billion, a plunge of 45% compared with 2020. The increase of transaction volume shows positive trends and prospects for growth in overseas M&A deals going forward.
However, the domestic deals have been cooling down significantly in the second half of 2021 due to the Chinese government’s crackdown on technology and online tutoring firms, and implementation of legislation on issues ranging from anti-monopoly to data security.
The secondary M&A market has been greatly affected, and this has also affected investment and M&A activities in the primary market. According to Choice data, the total transaction volume of China’s M&A market in 2021 will be RMB4.6 trillion, dropping about 20% from RMB573 million in 2020. In 2021, the regulatory authorities reviewed and approved 45 listed company restructuring projects, down about 48.3% from 87 in 2020, a record low in the past five years.
Compared with the bear market for private companies, state-owned companies remain active in the M&A market in 2021. Statistics shows that from 2019 to 2021, the number of transactions completed by state-owned companies to acquire non-state-owned listed companies was 48, 46 and 34 respectively, accounting for 32%, 34.33% and 40% of the number of changes in the control rights of listed companies in that year, respectively.
“In 2021, the most active M&A in China’s new economic fields were in the new energy industry”
Based on the current M&A market, Chinese enterprises still have appetite for overseas deals. However, the Covid-19 situation is restricting travelling, and the political situation is making it very difficult to conduct large transactions in major developed markets such as the US and Europe. As a result, deals into Asia by Chinese investors will continue to be prioritised.
Inbound M&A is likely to decrease. There might be increasing number of companies established in free trade zones being established in China. As a result, it is expected that there will be more foreign direct investment into China as an alternative to going through M&A activities.
M&A activities related to generic drug, green energy and data assets are likely to boom, while M&A activities in other sectors are likely to slow down or even decrease, especially in highly regulated sectors such as internet, healthcare and education.
The Covid-19 pandemic as well as strict governmental approvals and the regulatory crackdown on several business sectors have caused parties to focus more closely than ever on pre-closing covenants in transaction documents. A balance has to be struck between a seller wishing to reserve sufficient flexibility to react nimbly to changes in the operating environment, and a buyer wishing to ensure that the target business is not unnecessarily adversely affected by how it is run during the period between signing and closing.
Buyers may also seek a right to walk away in the event of a further wave of infection and associated business interruption, but sellers are likely to resist any such rights to include so-called material adverse change (MAC) clauses. The allocation of MAC risk between parties is likely to entail detailed negotiation of each deal.
Private equity (PE) and venture capital (VC) continue to remain active in the Chinese M&A market, and there will continue to be considerable demand for equity capital. There is some risk that valuations and asset prices may come under some near-term pressure due to renewed uncertainties around inflation, economic growth, availability of credit, the ongoing impact of Covid-19 and some recent dislocations in overseas IPO markets, but it is expected that these factors will not slow down new investment activities by PE/VCs.
Legislation and policy changes
There is no single law or regulation specifically regulating M&A in China. An M&A deal may involve many laws and regulations. PRC company law may be relevant when designing the corporate structure of the target company. PRC securities law and its supporting regulations may come into play in a public M&A transaction.
The PRC Civil Code may govern when an asset purchase is part of the deal. Employment law and employment contract law may come into play when employees need to be transferred in the transaction. Tax law is always relevant. Foreign exchange policy and regulation is important when payment of the deal needs to be made cross-border. Antitrust law may be relevant if a deal meets a certain threshold triggering a regulatory requirement to make a filing.
In 2021, China further strengthened its legislation on data security in view of the popularity of cross-border transactions of Chinese internet-based companies. In particular, China promulgated the PRC Data Security Law (DSL) at the national law level on June 10 2021, establishing a data security review system under the national security review regulatory regime.
The promulgation of the DSL indicates that China has been making an effort to implement a more structured and comprehensive system to strengthen the review and enforcement of transactions that might have national security implications. Foreign investors should continue to be mindful of the National Security Law, Foreign Investment Law, DSL, Unreliable Entity List and other new national security legislation, and pay special attention to transactions that might fall within the industries that are more likely to trigger national security concerns.
Foreign buyers should be cautious when completing transactions before obtaining national security approval, as they might be forced to divest the acquired assets if the transaction ultimately fails the security approval process.
The PRC Civil Code has been adopted effective from January 1 2021. Upon its effectiveness, a number of fundamental civil law statutes of the PRC (including PRC Contract Law, Property Law and General Provisions of the PRC Civil Law) were abolished and replaced, while their provisions were integrated into the PRC Civil Code with certain changes and supplements.
The adoption of the PRC Civil Code is commonly perceived as a major milestone of recent PRC legislation and a step forward in advancing a more systematised and modernised civil legal system. Since M&A documents adopted civil laws, the adoption of the Civil Code has had a great impact on the laws applying to M&A deals in China.
Environmental, social and corporate governance (ESG) considerations have become a proxy for good stewardship. With the rise of ESG-related discussions, M&A deals have been focusing more on the ESG issues than before.
The Chinese government has set steps to achieve a low-carbon economy, one of which is launching the national carbon emission trading system. As a result, many companies will have to purchase their emission permit if their emissions exceed the quota they are assigned. The anticipation of an increasing carbon price will subsequently boost investment in clean-energy technology and other higher carbon-efficient industries.
With the shifting global and local conditions and markets, private equity firms are recognising the value that strong ESG management brings to their portfolio companies, including improving accountability to stakeholders, reducing systemic risks and uncovering opportunities. We have seen more and more China-based PE firms adopting the United Nations-supported Principles for Responsible Investment and considering ESG factors at all stages of investment and value creation processes.
In response to the DSL, the Cyberspace Administration of China released the Draft Amended Measures for Cyber Security Review for public comment in July 2021 to include more triggering events of cybersecurity review and expand the reviewing scope. Since the amended measures are still in draft form, the implementation of these rules is subject to further clarification and guidance from the relevant regulatory authorities.
Due to enforcement uncertainties and the broad scope of captured industries, foreign investors interested in sensitive industries may wish to conduct a comprehensive pre-transaction analysis, and to consider scheduling pre-application consultations with officials from the Foreign Investments Security Review Office to determine the risk before commencing any M&A deal.
The most common misconception that exist about M&A in China is that a successful M&A ends upon closing. However, post-merger integration is a more critical phase.
In designing post-closing clauses, buyers should consider whether to include non-compete and non-solicitation obligations imposed on sellers in order to maintain a stable operation of the target company. Such obligations in a business sale context are usually upheld in courts. In contrast, a seller or actual controller of the target company may consider imposing post-closing obligations on the buyer such as retaining employees for a specific period of time.
For dealmakers, the M&A process will now need to incorporate even more data and a more sophisticated review. Technology will play an increasingly important role in the analysis of M&A data, from reviewing sensitive personal information in a secure environment during diligence to the application of artificial intelligence to analyse troves of environmental or workplace data.
Given the speed in which deals are now being pursued and the pressure to secure strategic acquisitions, the analysis will need to be tackled smartly. The adoption of digital platforms for deal management will be a critical factor for the successful embrace of a deal as M&A professionals need to direct their attention to the key value drivers and risk factors associated with the deal.
In public transactions, obtaining a certain percentage of stock is the key to gaining control of a listed company. The acquirer should be the largest shareholder of the listed company and hold at least 20% of the stocks after the completion of the control acquisition of the listed company. Therefore, a key factor for the acquirer to consider is the method of obtaining a sufficient percentage of equity.
In general, the acquirer may purchase stocks through: (a) agreement from existing shareholders of the listed company; (b) purchase from the secondary market; or (c) tender offer. It is important to note that the existing shareholder of a listed company, either being the actual controller of the listed company or management of the company, is likely to be subject to a restricted stock trade period as well as restrictions on the percentage of stocks they may trade in a certain period.
The acquirer is required to publicly disclose its information during the public takeover. The purchase price, the purchase price payment method, the offer validity/commitment period, the change of the offer and the cancellation of the offer are usually attached to a public takeover offer. Covid-19 has no impact since there are no changes of laws/regulations in this area in China.
Break-up fees and reverse break-up fees are sometimes used in M&A transactions in China. Break-up fees are usually limited to a seller’s refusal to close the transaction. Reverse break-up fees are typically triggered by failure to make timely price payments. Such fees are usually in the form of liquidated damages. It is noteworthy that any liquidated damage that exceeds the actual losses by 30% may not be supported by the courts in China.
Locked-box mechanisms, completion accounts and earn-outs are common mechanisms for consideration in private M&A transactions. In some cases, a locked-box mechanism is combined with earn-outs calculation by requiring the equity seller to bear certain operational risks in order to protect the buyers’ interests. In terms of protection mechanism, escrow accounts are commonly used in M&A transactions in China, while indemnity insurance is only used in major M&A deals.
It will be a different story if state-owned assets/shares are the target to be acquired in a deal, in which case pricing is statutorily determined by an appraisal agent. It is mandatory that the pricing of the assets/shares shall not deviate more than 10% from the appraised value unless a special approval is obtained from the state assets management authority.
Generally speaking, in a private takeover, parties may agree on different conditions based on the nature of the transaction, the needs of both parties and the negotiation leverage. Closing conditions usually include regulatory approvals or filings, accuracy of warranties, compliance with pre-closing obligations, third-party consents and no occurrence of material adverse effects. A buyer may also seek to include conditions that are case-specific and identified in the due diligence process.
It is not common to provide for a foreign governing law and/or jurisdiction in private M&A share purchase agreements, unless both parties are foreign enterprises and prefer foreign jurisdictions or the target company is located in a foreign jurisdiction.
There are many ways for a company to exit after an acquisition. Initial public offerings, share transfers, share buy-backs and liquidation are all feasible and common exit plans for investors in China. Before the execution of a M&A transaction documents, parties usually have a specific goal for the future of the target company. In addition, these exit options should be carefully and clearly listed in the transaction document to prevent any dispute in the future.
With the continuing challenge of the Covid-19 health crisis, strong antitrust sentiment and regulatory supervision, the M&A deal trend in China may slow down.
While M&A activities related to generic drugs, green energy, data assets are likely to boom, M&A activities in other sections are likely to decrease, especially in highly regulated sectors such as internet, healthcare and education.
AllBright Law Offices
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About the author
Carl Li is a senior partner at AllBright Law Offices, primarily working from the Shanghai office. His practice areas include M&A, PE funds, FDI and compliance.
Carl has provided comprehensive legal support to the Chinese part of multiple renowned transnational group companies’ global reorganisations, separations and mergers. He has also facilitated the equity merger and assets acquisition of multiple foreign enterprises and public companies in China.
Carl has represented a number of foreign enterprises and private enterprises in the sale of their main business and assets to investors. In addition, he has extensive experiences in the medical, health, and life science industries, providing long-term services to medical treatment investment funds, health care start-up companies, pharmaceutical companies, and medical instrument companies.