"THATCH YOUR ROOF BEFORE RAINY WEATHER; DIG YOUR WELL BEFORE YOU BECOME PARCHED WITH THIRST"
The Third Plenum’s recognition of the significance of a vibrant private sector to the Chinese economy is likely to mean increased outbound investment by privately owned enterprises (POEs).
This commitment supports the recent trend in outbound investment by POEs. In 2013, POEs accounted for four of China’s top 10 outbound M&A deals and more are likely to follow. A recent report “The Dream Goes On: Rethinking China's Globalization” concludes that many Chinese private firms have reached a "tipping point", at where "going out" is an effective way to upgrade and transform their business.
"Many Chinese enterprises have realised that outbound investment is not just a way to achieve geographical expansion or acquire natural resources. Once enterprises have reached a certain stage of development, outbound investment is a way to break through development bottlenecks," the Report concludes.
This new wave of Chinese outbound investment presents fresh opportunities for Australia. However, it is not without its challenges, particularly for targets keen to ensure deal certainty.
In the past, large State Owned Enterprises (SOEs) undertook the majority of outbound investment with the clear backing of the Chinese Government. In contrast, the POEs are not well known. These companies have, for the most part, minimal outbound M&A experience and, as a result, limited dealings with the relevant PRC regulatory agencies.
The rise of POEs has generally been viewed positively by foreign investment agencies as a retreat of Chinese state capitalism (the approval this month by US regulators of Shuanghui International’s takeover offer for Smithfields, is a case in point). Nonetheless, many boards considering offers from a POE bidder are looking sceptically at bids including PRC regulatory conditions.
Like their SOE counterparts, POEs require PRC regulatory approvals for any acquisition (click here for an outline of the approval process at both provincial and national levels). In addition, financing of any proposed acquisition may also itself be conditional on PRC regulatory approvals.
While there have been recent announcements of relaxations to PRC regulatory approvals thresholds (including those introduced in the Shanghai Free Trade Zone), the PRC regulatory approval process remains opaque. Our detailed review of Australian transactions involving PRC bidders (both SOEs and POEs) does not reveal any clear guidance about the timing of, or indeed ability of either type of PRC bidders to obtain, regulatory approvals.
In some cases approvals are obtained quickly or even prior to announcement (for example Tianqi’s bid for Talison). In other cases the approval is obtained in a time frame more normal for an Australian acquisition (for example China Molybdenum announced the receipt of NDRC approval for its acquisition of an 80% stake in Northparkes within 4 weeks of its announcement). However, other cases show that PRC regulatory approvals can take a very long time or are not obtained at all (for example Hanlong’s aborted takeover of Sundance).
There is therefore some justification in a target board treating a PRC regulatory approval condition with suspicion. This is especially true if they are unfamiliar with the bidder.
Each case needs to be assessed on its merits, but our discussions with bidders and target boards about whether they will recommend an offer have usually focused on matters like the bidder’s reputation for successfully closing deals (likely to be the best indicator for demonstrating the quality of their relationship with PRC regulatory agencies), and whether the bidder has offered a financial inducement (such as a deposit or reverse break fee) to drive the behaviour of the bidder.
The uncertainty about PRC regulatory approval processes can leave some target boards trading their recommendation for both a better price and a financial inducement designed to “underwrite” that the bidder getting the requisite PRC regulatory approvals. Recent market practice both in Australia and the US supports this approach.
Tianqi’s bid for Talison at the end of 2012 included a provision that Tianqi pay an upfront deposit of $25 million (approximately 2.82% of the total deal value). While China Molybdenum paid a deposit of US$40 million (4.87% of the total deal value) by way of bank guarantee to Rio Tinto.
On 23 September 2013, Shuanghui International Holdings Limited (a non SOE) completed its takeover of Smithfield Goods Inc. - the largest ever outbound acquisition by a Chinese company of a US target. In this $4.7 billion acquisition Shuanghui agreed to a $275 million reverse break fee (representing 5.74% of the deal value) payable if the Merger Agreement terminated as a result of, among other things, a failure to obtain the required foreign anti-trust or other regulatory approvals (excluding CFIUS).
Clearly, Australian vendors need to engage with all possible bidders including Chinese POE bidders. What recent market practice and our deal analysis shows is that Chinese bidders can close deals. However, there is considerable advantage to both sides in designing deal protection mechanisms that address the opaqueness of the PRC regulatory approval process.
Click here to view graphs.