PRC M&A, JV Buyout Seminar Mark Schaub February 13, 2008 China M&A
K ING & W OOD 3 Whats happening Completed M&A Deal in China YearNo. of DealsRank Value (US$m) 200566818,512 200661627,150 200771528,148 Source: Thomson Financial
K ING & W OOD 4 China definitely on the radar internationally. Move from green-field projects to M&A activities. RMB Appreciation viewed as a given New sectors opened to foreigners under WTO commitment HOT areas include: Why is M&A a hot topic for foreign investors? Automotive Machinery Pharmaceuticals Financial sector Retail Real Estate Construction materials Energy Mining
K ING & W OOD 5 Why a hot topic for Chinese authorities ? Chinese government increasingly fear that foreign companies are taking over the manufacturing base of the country. Worries exist that Chinese brands and ability of domestic companies to innovate will gradually disappear. Concerns of local industries that foreigners enjoy monopoly in many industrial sectors, such as light equipment, skincare, beverages, packaging etc. Stalled projects include Carlyle, Caterpillar, Schaeffler Group Resentment over CNOOC's failed bid for Unocal.
K ING & W OOD 7 Legal Framework for M&A and JV Buyout Foreign M&A Rules (08/08/2006) Takeover Rules of Listed Companies (07/31/2006) Foreign Strategic Investment Rules (12/31/2005) M&A regulations Foreign investment laws and regulations Laws and Implementing Rules on CJV, EJV, WFOE Revised Foreign Investment Industrial Catalogue (10/31/2007) NDRC Foreign Investment Projects Approval Procedures
K ING & W OOD 8 Legal Framework for M&A and JV BuyoutContd FIE Merger and Division Provisions (11/22/2001) Investors Equity Change Provisions (05/28/1997) FIE Liquidation Measures (07/09/1996) JV buyout regulations
K ING & W OOD 9 Endorsed by 6 Chinese regulatory bodies: MOFCOM, SASAC, SAIC, STA, CSRC, SAFE Good news Approval requirements and procedures clearly spelt out. Chinese government and companies more experienced in M&A transactions. Opens the door to acquisition by share swaps. Not so good news New limitations and restrictions imposed. Approval authorities granted with wide discretionary power. New Milestone - M&A Rules Most comprehensive M&A regulations in China to date.
K ING & W OOD 10 Broad scope of applicability may have sweeping impacts. Possible key industries: National Economic Security Concerns Any deal involving a key industry or famous brand, or may affect national economic security shall be filed with MOFCOM (Article 12) nuclear power machinery shipbuilding military power generation/transmission steel MOFCOM may stop a deal it has grounds to believe that it will affect national economic security – similar to US CFIUS review. Vagueness in rules escalates uncertainty in deals.
K ING & W OOD 11 All share swaps subject to approval by MOFCOM Offshore entity must be listed in stock exchange. MOFCOM approval is valid for 6 months only - share swap must be completed in the specified time period. Onshore share transfer will be reversed if the MOFCOM approval lapse. SPV may be used to list PRC assets offshore – small red chip A number of PRC governmental approvals required: MOFCOM, CSRC and SAFE small red chip became much more restrictive if not impossible Proceeds of offshore listing must repatriated. Share Swap Share swap is permitted as a M&A tool for the first time in China.
K ING & W OOD 12 Identify target Signing term sheet Due diligence Contract drafting Negotiation Definitive agreements Negotiation SASAC approval Industrial departments MOFCOM approval Anti-trust filing Business license SAFE approval Approval Conditions precedent Pre-closing audit / due diligence Closing / Payment Post-closing integration Closing M&A Roadmap
K ING & W OOD 13 2007 Foreign Investment Catalogue The Foreign Investment Catalogue lists industries that are encouraged, restricted or prohibited for foreign investors and is updated by NDRC and MOFCOM from time to time to reflect government policy. The 2007 Catalogue has been effective as of 1 December 2007. Encouraged sectors expanded to include more high-tech, energy-saving and environmental friendly industries. Service sector further opened to foreign investment: such as financing services, logistic and service outsourcing industry. Exploration of mineral resources and raw materials of strategic importance is more restricted. Export oriented manufacturing no longer encouraged. Foreign investment in real estate more restricted. Media and broadcasting (incl. news website, news agency, internet entertainment etc.) totally prohibited.
K ING & W OOD 15 Types of Due Diligence Legal - carried out by law firms checking the legal status of Chinese targets i.e. 1) ownership structure; 2) assets; 3) operation; 4) staff and personnel Financial - carried out by accountancy firms to check compliance with accounting and financial requirements (some overlap) Investigatory - carried out by investigation firms to check bone fides of other side Environmental - carried out by expert consultants
Due Diligence - Procedure Meet with client Understand project Draft strategy paper Preparation for field work Field work Draft reportFollow up Draft transaction documentation
K ING & W OOD 18 M&A Transactions in China Share/Asset transfer effective only upon approval NOT signing Governing law for transfer agreement must be PRC law Price must be based on appraisal by independent valuator Payment terms shall comply with mandatory terms: 60% within six months Remainder within one year Major forms of transaction: Share Acquisition Assets Acquisition China is still highly regulated in M&A transactions.
K ING & W OOD 19 Buyer will take over all business, assets, liabilities of the target. Careful due diligence is a must - pre-closing restructuring may be required. Share deal may be achieved through: share purchase from current shareholders subscribe to an increase in equity of the target share swap Share Deal Target Foreign Investor Seller Share transfer
K ING & W OOD 20 Background: A foreign energy company (Foreign Co.) intends to acquire the retail energy business of a domestic energy company in eastern China (China Co.). China Co. has 2 subsidiaries and over 50 branches over 3 provinces. Factors considered after due diligence: Case Study (I) Purchase SharePurchase Assets No need to re-issue operational licenses. New operational licenses will need to be issued to the New Co. No need to change existing contracts Existing contracts should be re- entered by the New Co. Inherit existing liabilities of China Co.Liabilities limited to the purchased assets.
K ING & W OOD 21 Factors to be considered based on the due diligence: Case Study (I)Contd Purchase SharePurchase Assets Accept the existing employeesSelect accepted employees, trigger severance Final decisionclient decided for Share Deal because: The existing liabilities of China Co. were found to be at an acceptable level. Pre-issuance of license would lead to massive disruption of the business. Payment in installment against milestones to reduce risks. Share pledge by Chinese partner as security Chinese partner would need to stay in the JV
K ING & W OOD 22 Diagram of Share Deal Foreign Co. China Co. Subsidiary ASubsidiary B Chinese Partner Share transfer 50% 50% shareholder Branch Business continued Closing much easier Operational license remained in place Liabilities remained in company
K ING & W OOD 23 An onshore vehicle is required to own and operate asset in China. Complication in transfer all business, customers, contracts, assets and employees - notification to creditors is required. Encumbrance will need to be discharged before the transfer. Recommended if: The target has high level of exposure / noncompliance Only part of the business is desired. Buying the Assets Chinese Target Foreign Investor Investment Asset Transfer Investment Vehicle
K ING & W OOD 24 Background: A foreign machine company (Foreign Co.) intends to acquire a domestic machine building company in North-eastern China (China Co.) Factors to be considered based on the due diligence: Case Study (II) Purchase SharePurchase Assets No need to re-issue operational licenses (not many). New operational licenses should be issued to the New Co. No need to change existing contracts Existing contracts should be re- entered by the New Co. Inherit existing liabilities of China Co. (large loans) Liabilities limited to the purchased assets
K ING & W OOD 25 Factors to be considered based on the due diligence: Case Study (II)Contd Purchase SharePurchase Assets Unpaid land grant feeNot to purchase land Accept the existing employees (more than 1,000) Select accepted employees; trigger severance Final decisionAsset Deal because: The existing liabilities of China Co. were found to be large in the due diligence, including loans, land, employees. Not difficult to re-apply for new operational licenses.
K ING & W OOD 26 Diagram of Assets Deal Foreign Co. WFOE China Co.China Investors Asset Purchase Agreement Various other agreements i.e. land, patents, transfer of business, key employee contracts No inherited liabilities Clean start Difficult and time consuming closing Destroyed sense of co-operation between parties
K ING & W OOD 27 No need to transfer title of assets No need to transfer operational license More difficult to spin-off undesired assets or liabilities Structuring the Deal Generally reduce risks of legal liabilities tracking back to newco Ownership of all assets and contractual agreements need to be transferred New operational licenses required Possibility to cherry pick assets or liability More favored by lawyers and accountants because less exposure to hidden liability Inherit all debts and liabilities of target Favored by business people because less disruption to existing business Asset Deal Share Deal + - Higher risk that Chinese party will carry on competing business Less risk of Chinese party continuing business as competitor - + + + - - ! -+ ! VS.
K ING & W OOD 28 JV Buyout in China Buy out the Chinese partner and transform the JV into a WFOE Buy out a large proportion of the shareholding of the Chinese partner, with the Chinese partner remaining as a minority silent shareholder Sell shares in the JV to the Chinese partner/other company Liquidate the JV Sue the Chinese partner for breach of contract Walk away, i.e. cease the cooperation A JV buyout may be realized through the following ways:
K ING & W OOD 29 Summary of Different Options In summary, the pros and cons of the various options are as follows: OptionPros/Cons Foreign investor converts the JV into a WFOE Clean break + Possibility to move to a better location + Improve IP protection + Foreign investor buys large majority of shares Chinese partner is a silent partner only + Foreign investor improves control + Chinese partner retains influence – No clean break – Possibility for later problems remains – Possibly delaying inevitable split –
K ING & W OOD 30 Summary of Different OptionsContd In summary, the pros and cons of the various options are as follows: OptionPros/Cons Chinese partner/other company buys foreign investor out Probably very low purchase price – High risk to IP rights – Foreign investor liquidates the JV Clean break, foreign investor can start again + Difficult, time-consuming procedure – Destruction of current business – Foreign investor sues Chinese partner for breach Difficult and time consuming – Destroys current business – Foreign investor walks awayUnlikely to be practical – Involves risks of breach of contract –
K ING & W OOD 31 Background: A foreign company intends to buy out the Chinese partner and transform the JV into a WFOE. Factors to be considered: Whether a WFOE is permitted under the Industry Guidance Catalogue Relocate the WFOE Call option in the JV Contract Price determination Restructuring of personnel Case Study (III)
K ING & W OOD 33 How to deal with non-compliance? Evidencing ownership of assets State-owned assets requirements Labor issues Anti-trust review Intellectual property rights protection Common Problems in M&A
K ING & W OOD 34 How to deal with non-compliance Chinese companies are more used to informal arrangements. Non-compliance is widespread: labor, tax, social contribution, licenses, IP etc. Risks shall be assessed from both legal and practical perspectives. Not surprisingly foreign invested companies are subject to more stringent scrutiny of Chinese government than their local peers. Regular internal audit is recommended post transaction. Almost all Chinese companies have variant level of non-compliance.
K ING & W OOD 35 Build in Safeguards/Set Guidelines Management By-Laws Employment Contracts Non-Competition covenants Employee Handbook On-Going Involvement Corporate Governance New Company Law improves fiduciary duties but much the investor can do:
K ING & W OOD 36 Ensure HQ involved and exercises oversight Safeguards/Set Guidelines Internal audits Active board Avoid ethical blindspots Management guidelines Fraud Prevention Not a priority for most companies, but a serious and growing problem in China:
K ING & W OOD 37 Land use rights and real property are often problem areas. Granted land vs. allocated land In most cases assets are subject to encumbrances or third party claims. Connected party transaction may result in intermingling of company assets. Evidencing the Assets Ownership of assets and properties are often in question.
K ING & W OOD 38 State-owned Assets Rules Mandatory valuation by licensed appraiser firms Commonly used valuation methodology – replacement value Appraisal results must be confirmed by SASAC Transaction price cannot be lower than 90% of the appraisal results. Target must be listed in Asset Exchange Center Substantial delay in the closing schedule Risk that a potential bidder may crash the party Standard contracts of the Exchange Center must be used Disposal of state-owned assets is subject to complicated approval procedures.
K ING & W OOD 39 Labor Issues An employee settlement plan must be prepared for M&A deal. Lay-off is to be negotiated with local government. Labor related costs should be considered in valuation: Severance pay to laid-off workers Compensation for change of status Should be considered in the valuation Settlement of staff and workers may cause substantial costs to the transaction.
K ING & W OOD 40 Threshold for anti-trust is rather low: Turnover of a transaction party in China exceeds RMB 1.5 billion. The foreign investor has cumulatively acquired more than 10 domestic enterprises in one year. Current market share of a party exceeds 20% in China Post-deal market share of a party will exceed 25% in China. Anti-trust review may also be requested by domestic competitors, government agencies or industrial associations. Offshore M&A may also be subject to anti-trust filing in China if meeting certain thresholds. Anti-Trust Filing So far most anti-trust filings have been procedural, but it is expected to have more teeth.
K ING & W OOD 41 Intellectual Property Rights IP due diligence necessary to assess risks of IP infringement: Targets using technology to which they are not entitled Particular risks in export market Trademarks/patents not properly registered in China Risk of technology leakage Chinese partners, employees, competitors Measures to be installed to avoid technology leakage and protect IP IP protection in China is better than its reputation.
K ING & W OOD 42 Instruments to Lower Risk Due Diligence – investigate ownership and title over assets, business, compliance Closing Conditions – correction measures on basis of due diligence results Payment – installments within the mandatory frame Reps & Warranties – ownership and compliance Indemnity – any undisclosed liabilities Unilateral termination – set out triggers, exit
K ING & W OOD 44 M&A is becoming increasingly popular in China. BUT also becoming increasingly complicated. Structure the transaction to suit your needs. Due diligence is a must before any commitment. Transaction documentation is a key way to limit exposure Main Points to Note Make it as simple as possible but not any simpler - Albert Einstein
K ING & W OOD 45 Mark Schaub Partner in the Business Group of King & Wood, specialized in foreign direct investment, M&A, compliance, intellectual property and private equity investment in China. Mark has advised foreign investment projects in major sectors including retail, power, media, internet, renewable energy, transportation, automotive and manufacturing, etc. Tel: 0086 21 2412 6300 Email: email@example.com Website: www.kingandwood.comwww.kingandwood.com www.china-artoflaw.com Q&A
K ING & W OOD 46 Mergers & Acquisitions in China Seminar – February 13, 2008 Clarence Kwan, the National Managing Partner of the U.S. Chinese Services Group for Deloitte & Touche USA LLP moderates the seminar
K ING & W OOD 47 Mergers & Acquisitions in China Seminar – February 13, 2008 Felix Chang and Harvey Cohen of Dinsmore & Shohl LLP listen in on the conversation