[co-author: Guy Ker]
The numbers - Outbound M&A transactions collapse
In the wake of record levels of outbound direct investment ("ODI"), a currency under downward pressure and diminishing foreign exchange reserves, the Chinese government introduced emergency capital controls designed to curb capital outflows in the last quarter of 2016. The first indicators coming from the Chinese private equity market appear to demonstrate that this increased regulatory scrutiny has had an immediate impact in reining in the ODI market. There were 33 transactions completed this January, marginally up from 2016, however, the amount invested in that month fell dramatically from $11 billion in 2016 to $5 billion in 2017. As market participants began to feel the impact of these new measures, only 13 deals worth $1.1 billion achieved completion in February. The first quarter of 2017 saw just 81 outbound M&A deals with a value of $14 billion, a sharp drop from the $82 billion invested in the same period last year.
Exit angst - Uncertainty in the private equity market
The uncoordinated manner in which the restrictions have been implemented has created a high degree of "completion uncertainty" in the private equity community. These new measures were not part of a legislative package, but have been introduced through a combination of internal guidance to banks, press releases and briefings, with no clear guidance as to how they will be applied in practice and/or whether they will be implemented on a unified basis nationwide. Those facing the impact of the restrictions in the future have the luxury of being able to devise creative approaches to mitigate the effects of increased scrutiny, but private equity houses have articulated that devising a considered long-term approach is proving difficult when faced with policies that are opaque and which have no clear end date. Even those measures specifically stated to expire in September 2017 could still be extended if China sees fit. This uncertainty has deterred investors from entering the market, as private equity managers struggle to reassure potential overseas backers, providing foreign direct investment, that they will be able to return capital on exit. This issue is exacerbated by the relatively short lifespan of private equity funds as firms looking for a quick and efficient exit to maximise returns may be hampered by these new restrictions.
Reports and approvals - Regulations and their effect
The practical effect of the newly implemented capital controls also explains the drop in ODI-related M&A activity seen in the first quarter of 2017. The wide-ranging requirements have been implemented by a number of different government agencies, and in the absence of detailed implementing rules on how these will work in practice, market participants need to try and ascertain whether they are likely to trigger any "red lights" under each set of requirements when determining their chances of getting paid within a reasonable period of time. Deals which have been particularly impacted by the new measures include transactions in specifically targeted sectors, such as "irrational" investments in real estate, entertainment and sports clubs together with large investments made outside an investor's main line of business or typical investment size (please see below for more commentary on "irrational" investments).
Examples of the increased regulatory burden on private equity firms include the substantial rise in documents required for deals which need the approval of, or record filing with, the National Development and Reform Commission and Ministry of Commerce. Furthermore, the People's Bank of China (the "PBoC") and the State Administration of Foreign Exchange (the "SAFE") have imposed compliance and authenticity gating requirements for proposed foreign exchange transactions involving as little as $5 million. With PBoC and SAFE only communicating these new requirements via internal or "window guidance", individual banks have been left to formulate their own interpretation. With a lack of formal legislation, and monthly quotas covering both capital and current account payments overseas, these large financial institutions have adopted a risk-averse stance when approving any transaction which needs to be reported to PBoC or SAFE. This has resulted in procedural deadlock, stifling private equity activity.
Scope and potential – Strategic outbound investments
Notwithstanding these new measures, the Chinese government has continued to articulate its continued support of ODI, arguing that these new measures are not directly targeting ODI, but certain "irrational" transactions that the Chinese authorities think make no business sense or are primarily intended to shift capital overseas. Accordingly, it is thought that deals which are consistent with the government's policy agenda are more likely to pass through the gating procedure. One such example would be an investment into a foreign company with proprietary technology that can be deployed to the benefit of China. The value to China's economy in this case is likely to justify the currency outflow. Where Chinese buyers can demonstrate their proposed transactions hold such a value proposition, these applications are more likely to satisfy the "genuine and lawful" test and the banks will be allowed to convert and remit the funds out.
Adaptation and optimism – The private equity market reacts and the loosening of controls
Efforts to adapt to the new measures are already underway, with some private equity houses exploiting well-established relationships with local banks in the hope of streamlining their foreign exchange requests. Others have found more creative solutions to break through the uncertainty and procedural deadlock. These include depositing a specific deal's purchase price in a domestic bank, with the bank's foreign branch then loaning the relevant offshore special purpose vehicle the required amount in foreign currency based on security given by the Chinese bank to its foreign counterpart (内保外贷).
Central to the industry's response is the hope that these new measures are temporary in nature, and that through the course of 2017 regulators will begin to rollback these restrictions. If the controls were to remain in place going into 2018, the "China premium" Chinese ODI advocates fought so long and hard to remove will rear its ugly head, potentially causing long-term damage to the perception of Chinese investors in the international markets. Such damage has already been seen in the market, with some owners of offshore assets requiring higher break fees for potential Chinese buyers, or refusing to consider their bids.
There is an expectation in the market that once the pressure on the Renminbi begins to subside, the government will normalize the regime and capital will again be able to flow more freely. With the value of the Yuan stabilizing in the first quarter of 2017, there has been less incentive for capital flight and China's foreign exchange reserves have again risen above the closely watched $3 trillion level. This has led to reports in China that capital controls are already being relaxed. For example, sources claim that the PBoC is no longer demanding through informal guidance that banks in China match outflows with inflows. Although this may not have a significant practical impact on ODI, it does illustrate willingness on the part of some regulators to slowly relax the controls.
The extent to which these capital controls will be unwound and when is unknown at time of writing, but market experts believe that Beijing is not likely to remove all of the new measures in the short-term. The stabilization of the Yuan was not the only objective of the regulations, with authorities also wanting to limit ODI in sectors deemed undesirable. This implies a value judgment on the deals done by Chinese investors' – concerns about valuations in the energy and resources sectors have been well documented. Whilst the current macro environment favours an easing of the rules on fund flows, the structural issue of the mismatch between the government's centrally-driven approach to offshore investment and the corporate sector's desire for freedom to deploy and recycle capital remains.
For the time being, therefore, private equity houses looking to take advantage of the high levels of return that the Chinese market has to offer will have to continue to navigate their way through some choppy and uncertain waters.
For a more detailed analysis of the Chinese capital controls, please see our client note here.
