Make no mistake, China still matters. To some extent, the meltdown reflects a broader slippage in global M&A. But it also speaks to a newfound sobriety among corporate dealmakers when it comes to high-growth markets such as China.
For sure, expectations soared. Just flip through the stacks of M&A surveys in recent years and invariably, almost everyone not there already checked off China as the next stop on their strategic roadmap. China continues to offer one of the best growth stories out there. Even though the country recently reported 7.8% GDP growth for 2012 -- it's lowest in 13 years -- almost no other country can touch that, which is why one M&A executive at a U.S. industrial company that's had a presence there for more than 10 years concedes, "It's still a great market."
But the realities of investing in the People's Republic are becoming much starker, even if the opportunities remain compelling.
"There was a big rush in 2008 to buy Chinese companies," the executive continues. "There's probably been some digestion problems for companies to get on top of what they bought. Also, the Chinese economy has been slowing and there have been big downdrafts in certain sectors since the financial crisis. This has all pushed people back and made them more cautious to invest."
Enthusiasm has been tempered more recently for a number of reasons besides slowing GDP. These range from the difficulty of finding skilled advisers to dealing with vast cultural divides, from the complexity and high cost of doing business in China to a relative paucity of attractive targets. U.S. and Chinese regulatory and political clampdowns have also increased. In 2010, for example, the Securities and Exchange Commission launched a special unit to toughen its enforcement of the 1977 Foreign Corrupt Practices Act, or FCPA. While the conviction rate appears relatively tame -- last year there were a total of 12 U.S. companies forced to pay penalties, up from 10 the prior year -- the number of active investigations is much higher. In 2012 the number of U.S. companies on the SEC investigation list rose to 88 from 78 the prior year, according to the website, FCPA Blog.
As U.S. companies come under greater scrutiny, many are looking for ways to shore up their compliance and due diligence expertise.
"You've got to get extremely smart with local guidance and relationships to know if what you want to do can go through as laid out," says Elias Mendoza, former global head of corporate development at IBM Corp. until July 2011, when he joined Union Square Advisors LLC as partner. Mendoza, who worked in Asia from 1989-1993 and 2001-2009 for IBM, says getting the advisory part of the M&A equation right is "extremely risky at the beginning, which is why a lot of folks look at a market like China with trepidation: who's going to help me get through this?"
For anyone thinking they can go it alone with their own in-house counsel, forget it. If you're doing an M&A deal in China, this invariably means you will need support on at least three fronts: your own counsel; local counsel for due diligence and related issues; and a local antitrust lawyer if you're tapped for an antitrust review. Only qualified antitrust Chinese lawyers can appear before the Ministry of Commerce, or Mofcom, and tracking down the right experts is no picnic.
"In this regard, there are restrictions on what foreign law firms can actually do in China -- basically we can advise our clients on our interpretation of Chinese law but we cannot formally practice Chinese law," says Anthony Wang, a partner in the Shanghai office of the U.S.-based Weil, Gotshal & Manges LLP.
Like other foreign practices, Weil Gotshal runs legal disclaimers stating that it isn't authorized to "practice" Chinese law in China. Making things more complicated, Chinese lawyers who work at foreign law firms are required to temporarily give up their Chinese law license while working at foreign law firms, Wang explains.
Finding advisory guidance in China is further hampered by the relative newness of the legal system when compared to the one in the U.S. As more Chinese companies have stepped up their own M&A activity in recent years -- both domestically and overseas -- the domestic legal profession has been undergoing a growth spurt and a big learning curve. Firms range in quality and size, from smaller firms with five to 20 lawyers to a handful of megafirms with 500 to 1,000 of them.
More Chinese companies doing deals overseas has also spurred consolidation among local and foreign firms. Over the past two years, there have been at least two powerhouse mergers in Asia. In 2011, China's King & Wood said it would merge with Australia's Mallesons Stephen Jaques to create Asia's largest law firm, and late last year the U.K.'s Herbert Smith and Australia's Freehills combined.
"If you look at the legal side, Chinese law firms are growing in size," says William Striebe, vice president of business development, UTC Climate, Controls & Security, at Farmington, Conn.-based United Technologies. "Most Western companies would still go to Hong Kong and engage U.S. and Western European law firms that have a strong presence there and related offices in China."
Striebe, who has extensive deal experience in China, said this is especially the case "as most foreign investments in China are made through Hong Kong corporate structures. Although the foreign firms cannot technically practice law in China, they have relationships with Chinese firms who carry out what needs to be done locally. The foreign firms are not just made up of expat lawyers, but do hire Chinese professionals who have attended western law schools or have experience in foreign firms. This provides some of the local knowledge and feel which is necessary and beneficial."
Some Western lawyers with a local presence say competition can be intense with local law firms anxious to win new client contracts in private equity, M&A and investment deals.
"We're often pitted against local law firms and have to confront compliant versus noncompliant deals, where clients complain that other law firms are getting similar deals done," says one lawyer from a well-heeled international law firm in New York with offices in China. "'Why aren't we agreeing to the same terms?' [they ask]."
The lawyer says his group has walked away from a number of deals that have had questionable legal foundations. If it's tough for competing lawmakers who already know the rules, then just think how daunting it is for U.S. dealmakers new to China.
"As a person responsible for M&A, it was important to work with the legal department to pick the right outside counsel -- firms and individuals that weren't going to get us in trouble," Mendoza says. "I knew that it would come down on me if, for whatever reason, we were shortsighted. There can be issues with lack of training [when choosing local counsel]. They don't have as much experience. It's not been an economy where there's been as much activity yet as in the U.S. or Europe, so folks there have relatively less experience and have seen less in terms of potential issues -- although that is changing."
Culturally, however, lawyers in China are loathe to admit to shortcomings and will say they can take on a deal even if, overall, something may be problematic, others say.
The alternative -- finding U.S. legal expertise with a strong presence in China -- isn't easily available, either. Although actual numbers are tough to come by, some lawyers estimate that there are roughly 20 U.S. law firms with established practices in China. Many corporate development executives, when initially looking around for help, tend to rely on word-of-mouth from friends at multinationals or from outside counsel.
One general counsel who works on M&A for an S&P 500 technology company initially thought it would be a breeze getting a big deal done in China a couple of years ago. After all, the transaction, a multibillion-dollar merger with a company that derived just a small part of its revenue in China, was the fourth transaction the company had done which involved an antitrust review in that nation.
The company already had business operations on the ground and had used local counsel in three small transactions in prior years.
But this particular deal was much bigger than anything the tech company had yet attempted, and it ultimately proved to be unexpectedly complicated and frustrating.
"In China we have filed notifications with Mofcom on four different transactions and the first three were relatively straightforward, there weren't reasons to be terribly concerned -- it was mostly perfunctory and they were approved without an investigation within 30 days," the general counsel says. "Then the world changed."
And in many ways, too. Start with Mofcom. It has been flooded with merger control filings since the adoption of the Anti-Monopoly Law, or AML, in 2008. More than 450 filings have been reviewed during the first four years after its adoption.
"While Mofcom continues to streamline its review process, the process in China still tends to be longer, as compared to the U.S.," says Weil Gotshal's Wang. "In addition to internal resource constraints, changes to Mofcom's notification and disclosure requirements have also affected the review process."
The general counsel for the U.S. technology company said that previously, he had mostly relied on large international firms and the lawyers they had on the ground in China. But when it came to the multibillion-dollar deal two years ago, that strategy didn't make getting approval any easier. Ultimately, China was the last of four jurisdictions to approve the deal -- a month after the U.S. gave its final blessing.
In the past couple of years, it's become all too common to get caught in the crosshairs of a Chinese antitrust review. Under AML, companies are subject to review if they have a combined aggregate worldwide turnover for the previous fiscal year of all parties exceeding the equivalent of $1.59 billion and at least two of the parties each have an aggregate turnover exceeding the equivalent of $63.5 million for the previous fiscal year in China.
That threshold, compared to many Western countries, lawyers say, is relatively low. In other words, companies don't need to do a whole lot of business in China to get snagged in a review that can tack on additional months for a deal closing.
Such delays can cause headaches for corporate development executives who have to explain what's happening to upper management, especially since those execs hardly know what's happening themselves. For example, while the investigatory periods in China are roughly similar to other jurisdictions, in China the review clock doesn't start ticking until Mofcom formally accepts the filing. That can take weeks or even months after the initial filing is made -- and acquirers often field piles of questions and requests for additional information from Chinese authorities before they even accept the filing.
"Our experience in China was extremely frustrating, but consistent with experiences we understood other companies were having," the general counsel says. "Mofcom didn't articulate their concerns to allow us to have the kind of give-and-take we would with Western regulators.
"Overall, we thought we had good local counsel in front of Mofcom, and our target did, too. But having said that, we still don't really know how you ensure success in that process."
With that discouragement still fresh in his mind, he packed his bag as soon as the deal was finally closed and booked a flight for Beijing to handpick a local antitrust firm for future deals. It took months of searching before he found one.
"We realized that we needed to pay more attention and make sure we were confident that we had the right counsel for our next transaction requiring Mofcom review, whenever that might happen," the executive explains.
Such frustrations are one of the reasons Tom Shoesmith, China practice leader at Pillsbury Winthrop Shaw Pittman LLP in Palo Alto, Calif., says he turned his focus from working with Chinese companies doing deals in the U.S. to American companies looking for help in the People's Republic. He recounts how a client asked him to write up a list of the 10 biggest mistakes U.S. companies make when they look at China.
"When I got to 50, I thought, 'We have a problem,'" he quips.
Courtship confusion is probably one of the worst trouble spots. Just when you think your Chinese host is going to propose advancing a deal, Shoesmith says, that's when you should reach for a fresh dinner jacket or hardhat to tour another factory floor.
"You go to China to explore doing a factory and an official from the local government comes out to meet you and takes you out to dinner," he notes. "If it happens in Nashville, it means something."
But not in China. "So six to nine months later, when you're still having dinner and viewing empty plots of land, you start to think life is too short," Shoesmith says.
It's similar when CEOs think they're about to close a joint venture. "A partner takes you out to dinner and you think you're near a deal, but you're no where close," he continues. "And then suddenly, the partner is having trouble coming up with the money."
The first rule of thumb is to cultivate patience -- and plenty of it. Even multinational companies such as IBM, which have deep pockets and a long presence in the country, have had to move very slowly, doing just a handful of transactions over several years.
"It takes an incredibly long time to build out an ecosystem of relationships," Mendoza says.
Having patience is just the beginning. Dealmakers also have to be willing to spend big bucks, whether it's for the sky-high cost of quality translation work or when haggling over deal valuations. Bottom line, it isn't cheap to go to China.
"Expense is a huge consideration for us," says one U.S. corporate development executive who has now done four deals in China. "If you're doing a $1 million to $3 million investment in a startup and it's generating $500,000 in legal fees, it doesn't work."
Translation costs alone can account for huge chunks of the legal bill. Lawyers agree it's expensive but say such costs are hard to avoid.
"Over the course of months, the parties may be continuously negotiating and revising transaction documents in both languages, and often, these revisions to deal documents are done 'real-time' in connection with the bi-lingual negotiations process," Wang explains. "Legal translations are not so simple when you consider the different grammatical structures between the languages."
Another challenge is agreeing to a valuation. In China, U.S. buyers will commonly find that a seller will value itself at a higher Ebitda multiple than the suitor is willing to spend. Relative differences in stock market valuations can play a big role here. For instance, where the domestic Chinese stock market might place a cash flow multiple of 10, on average, for companies in a particular industry, a stock market elsewhere may put the average at 8.5. So while a U.S. investor may size up the prospect of a future exit on its own exchange, the local Chinese entrepreneur is envisioning one on his, and so a valuation war ensues.
Then there's due diligence challenges, given that Chinese companies have very different accounting practices to comply with than U.S. companies do. Weeding out rampant corruption, something many regard as a fact of life in Chinese business dealings, hardly helps when investors are trying to figure out if they're buying a legitimate business or something that will cause them a big legal headache.
"When you raise FCPA issues, it comes in two varieties," one lawyer says of conversations he has with U.S. middle-market companies. "First, they may say it's a really serious problem but we can't spend a lot of money on an FCPA audit. Or, they say they put out a message to employees that [corruption] won't be tolerated."
Some companies worried about an FCPA investigation can spend big bucks for pretty lame advice.
"We knew a distributor for a U.S. company doing work in Taiwan who had a water cooler conversation, where he became concerned his distributor was involved in corruption," the lawyer recalls. "So he called a law firm and they charged him $100,000 [for the investigation], then had a phone conversation where their advice was basically to stop doing business in China."
Rather than walking away, which most would agree is unrealistic, the lawyer says U.S. companies should find more creative ways to deal with corruption problems. For instance, instead of giving in to a culture of bribing or walking away all together, he says, companies can charge lower prices for goods and services.
One way or another, U.S. corporations will need to figure out a game plan because the international regulatory ring fence is starting to tighten. Two years ago, for example, Chinese regulators including Mofcom signed a memorandum of understanding with the Federal Trade Commission to better monitor corruption and related issues. The Securities and Exchange Commission is also cracking down with the help of other governments, and American companies are starting to feel the heat.
"We're very concerned about FCPA," says one Silicon Valley executive. "We have FCPA in-house expertise and we've included a new component in the due diligence exercise that focuses on just this issue."
Of course, that's exactly what the SEC wants to hear. In an interview with Deal Pipeline, Kara Brockmeyer, chief of the SEC's national specialized FCPA Unit said: "There's closer cooperation internationally now than we've ever had. It's not just the U.S. that's focused on this anymore. And this is something U.S. companies are recognizing -- it's a game changer."
John E. Sorkin joined Ropes & Gray LLP's mergers and acquisitions practice as a partner in New York. For other updates launch today's Movers & shakers slideshow.
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