Chinese outbound M&A set to change course in 2018

A push for greater regulatory clarity combined with the One Belt, One Road initiative could pave the way for an increased focus on overseas dealmaking in 2018

At first glance, it would appear that Chinese buyers lost their appetite for foreign dealmaking in 2017. Corporations and private equity funds operating in Asia's largest economy were responsible for 361 outbound deals worth US$125.14 billion over the year, with value decreasing by 37.2 percent compared to 2016.

Turning tides

But context is crucial: 2016 was a record year for Chinese outbound M&A. Activity was inflated after Beijing relaxed its regulation surrounding outbound investments—a decision it reversed toward the end of 2016. While this had a dampening effect on dealmaking, 2017 was still the second-most active year for Chinese buyers overseas on record.

Chinese companies investing over US$300 million overseas have subsequently been required to report such deals to the National Development and Reform Commission (NDRC), which is empowered to cancel reported deals under certain circumstances. Efforts to regulate activity were reportedly concentrated on deals valued at upwards of US$10 billion and any US$1 billion-plus transactions that did not appear to fit with acquirers' core activities. The effects of this regulation are reflected in the coupling of a moderate dip in 2017 deal volume with a dramatic drop in value.

Transatlantic headwinds

Compounding the dampening effects of tightened NDRC oversight was a pushback in the US from the Committee on Foreign Investment in the United States (CFIUS), which became notably more risk-averse in 2017 under the Trump administration. Chinese investments into the semiconductor space as well as other sensitive technologies were heavily scrutinized, and reports of abandoned transactions because of "unresolved national security concerns" identified by the government body increased.

Transactions that failed to clear in 2017 included the US$1.3 billion bid for Lattice Semiconductor Corp. by Canyon Bridge Capital Partners, a US-headquartered private equity firm, and Chinese smartphone manufacturer TCL Industries' play for the mobile hotspot business of Inseego Corp.

At the same time, deal value from Chinese firms investing in US assets plummeted 81% from a record US$56.7 billion in 2016 to US$10.7 billion in 2017, while volume dropped by 15 percent. Indeed, not one deal with a US target featured in the top ten Chinese outbound deals of 2017. This compares with five in 2016, the largest being the US$10 billion acquisition of aircraft leasing business CIT Commercial Air unit by Avolon, a subsidiary of Bohai Capital Holding, a listed Chinese leasing company.

Changing course

China’s ambitious Silk Road Economic Belt and the 21st-century Maritime Silk Road initiative, also known as One Belt, One Road (OBOR), aims to connect Asia with the rest of the globe via a vast logistics and transportation network, encompassing roads, ports, railways, airports and even transnational electric grids and fiber optic lines. According to sources at the 19th National Congress of the Communist Party of China held in October 2017, the Chinese government will continue to encourage overseas expansion, with sectors linked to the OBOR effort set to benefit the most.

Investment is essential for Beijing to realize the initiative—a sign that Chinese outbound M&A will return to growth in 2018. Further, after years of rapid expansion, growth in the country's industrial base is slowing resulting in demand to invest in overseas technologies in order to harness them domestically to make efficiency gains.

The need to upgrade the industrial and technological base in order to maintain economic growth will therefore persist for the foreseeable future. An effective route to achieving this goal is accessing foreign companies' market knowledge and innovation through deals and patriating it for use in China. The use of this strategy was reflected in last year's M&A data, with the industrials & chemicals sector claiming the greatest share of deals (25.8 percent), followed by the technology, media and telecommunications sector (18 percent).

Regulation: a mixed bag

Heightened regulatory scrutiny in Beijing appears at odds with the ambitions of the One Belt, One Road project. While new regulations that took effect on March 1 streamline approval requirements for overseas deals that cross the US$300 million threshold, the new law also expanded the list of “sensitive” areas in which deals may be reviewed at the NDRC’s discretion.

Large overseas transactions in telecommunications, massive land development, and electric mains and power grids still must be reported, but no longer require the NDRC’s blessing. But overseas deals above US$300 million involving arms, multinational water resource exploitation and news media now require NDRC approval to proceed.

Outbound investment in properties, hotels, cinemas, entertainment, sports clubs and equity investment funds is also restricted under the March 1 regulations, as is investment in “sensitive countries”—those that are at war, do not have diplomatic ties with China, or are subject to investment restrictions by international treaties or agreements China has signed. The new rules also increase the scope of regulatory oversight by covering transactions made by non-Chinese entities controlled by Chinese investors.

The impetus is to curb "irrational" outbound investment, with acquisitions of assets in industries such as real estate, hotels and entertainment curbed because these are seen as speculative, overpriced plays.

There are also concerns that acquirers are taking on excessive liabilities to fund transactions, with the China Banking Regulatory Commission (CBRC) in January saying that one of its targets is to reduce corporate debt. China’s spectacular economic growth over the last 20 years has been fuelled by the rapid expansion of credit, and there are fears that excessive leverage could lead to problems if left unchecked.

Horizon scanning

The latest regulatory developments warrant careful attention. Investors should keep abreast of issued notices from the NDRC. Now that the state planning agency has published its sensitive sector watchlist, deals are likely to become more selective and will show a closer strategic alignment to acquirers' core activities. Chinese buyers are also expected to exercise more prudence in their use of credit, as regulators in the world's second-largest economy prioritize financial sector risk reduction.

Greater clarity around which sectors will come under scrutiny in the year ahead, and under what circumstances, is a welcome development for dealmakers and may point to a more rational but buoyant 2018 for China outbound deals.

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