Editor’s Note: The author is a Shanghai-based lawyer who focuses on corporate M&A.
By Z. Alex Zhang, Partner, White & Case
China is an increasingly central player in global cross-border M&A. After almost a decade of consistent double-digit growth in global investment, China is now the second largest investor worldwide, behind the United States, with US$140 billion on deals in 2016. This is almost double the previous annual record the nation set in 2015 and up from US$30 billion in 2009.
However, Chinese outbound M&A is facing near-term challenges with regulatory hurdles confronting these deals from both China and host nations. These include balance of payments pressures in China, which have driven stricter controls on outbound investments, as well as growing levels of scrutiny from target markets, due to national security concerns and objections about asymmetries in market access.
These challenges have caused debate about the future of China’s global M&A. However, while these short-term risks could cause a more volatile pattern of outbound M&A in coming years, they should not overshadow the long-term outlook for Chinese outbound investment, which is still yet to reach its full potential.
One of the driving forces behind the broader growth in Chinese outbound M&A has been the far-reaching liberalization of China’s administrative controls on outbound investment. This has now reversed somewhat, with the level of capital outflows causing Chinese authorities to retighten some administrative controls for outbound M&A transactions. While the government still publicly confirms its support for legitimate outbound investments, informally, Beijing is steering regulators and local banks to scrutinize certain types of outbound investments. Other new developments may have raised the bar even further for Chinese companies, with reverse break fees and other concessions coming into play when these companies compete for foreign assets.
However, Beijing’s new stance on outbound acquisitions is unlikely to completely halt deal flow, but rather it will cause a slowdown in certain types of transactions. The government’s current view of overseas direct investment puts the most scrutiny on transactions in certain areas including large offshore transfers of foreign exchange and the purchase of assets unrelated to the buyer’s existing core business.
On the other side of the transaction, Chinese buyers also face regulatory and political backlash in host economies, amid changing attitudes towards Chinese capital. This continues to be a major risk factor for the trajectory of Chinese outbound deals as anxiety in host nations grows around deal volumes and the potential national security implications of foreign control over local assets.
Many countries have specific review processes in place to assess the risk of inbound investment, looking at foreign control of strategic assets, sensitive technology, proximity to military installations and other ‘critical’ infrastructure. Given the Chinese appetite for technology assets, many of which have potential for military use, this has manifested in the collapse of a number of recent Chinese takeover deals in the technology sector, based on objections from the Committee on Foreign Investment in the United States (CFIUS). CFIUS, whose review process is ostensibly voluntary, is limited by law to review cases related to national security. However, the term “national security” is not defined and the committee tends to interpret its jurisdiction generously. CFIUS also has a growing mandate as the level of inbound deals increases, limited only by the increasingly stretched capacity of its staff. Additionally, new legislation under the current administration could make CFIUS more aggressive.
As Chinese M&A continues to grow and to target particular companies and industries, it is natural for there to be some level of concern from governments that the country’s corporate crown jewels are being taken over by Chinese companies. China’s sheer economic scale can make the scope of acquisition levels seem overwhelming to host nations.
Yet China’s outward foreign direct investment (OFDI) as a percentage of GDP remains only 10%, compared to 72% in the UK and 39% in the US. China is the second-largest economy in the world and its global investment footprint is still relatively small, compared to its economic size. Given this, despite near term policy challenges at home and abroad, China’s potential for growth in deal volume is impressive. Some of the current obstacles are expected to abate, with China’s foreign exchange reserves rallying since the launch of policies aimed at curbing capital controls. Additionally, Chinese companies are expected to realise opportunities for strategic acquisitions around China’s One Belt One Road initiative, which should drive the upwards trajectory of deal levels.
China’s economic fundamentals suggest that the long-term potential for growth in outbound investment is tremendous, according to a recent research report from Rhodium Group and White & Case on Chinese M&A. If China is able to address short-term challenges, Chinese companies are poised to invest hundreds of billions of dollars in the coming decade. The future level of deal flow will vary greatly based on whether China successfully makes structural reforms which allow it to rebalance its economy.
A pessimistic view of the situation would anticipate China further postponing the necessary structural adjustments and continuing on its debt-fueled path. This would mean a risk of a ‘hard landing’ which would exacerbate the current short-term challenges facing OFDI. A neutral ‘base case’ scenario assumes a ‘soft landing’ for China’s economy as a delayed implementation of the needed reform causes volatility and disruption.
The ‘optimistic’ best-case scenario would see China successfully implement structural reforms which allow it to rebalance its economy with little disruption. Market-oriented reform would help to downplay concerns about the risks of Chinese investment. Together with a favourable growth trajectory in GDP, this would allow China’s annual OFDI to rise to an average of US$275 billion per year, nearly three times the average achieved between 2010 and 2015.