How to tame China’s M&A market

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China's M&A trading environment has been continuously optimised in recent years, and the country has emerged as a genuine world player in global M&A markets. The pace of M&A in China has accelerated, and obstacles are being continuously overcome. These include over-complicated approval processes, difficulties in financing, imperfect service systems and institutional mechanisms and difficulties in cross-regional, cross-ownership M&A structures. Some unreasonable regulations have been cancelled to solve outstanding issues hampering M&A. Nowadays, China's policy for M&A transactions gives PRC companies a flexible trading space while respecting corporate needs, allowing companies to make independent decisions and voluntarily participate in M&A.

According to data from the Wind China M&A database, in 2018 there were 11,531 domestic M&A transactions (with buyer and target both domestic companies) while outbound transactions (where the buyer is domestic and target is an overseas company) saw a 15.1% increase year-on-year in number of deals. The transaction value of outbound deals was RMB2.77 trillion ($412 billion), a slight decrease of 4.31% year-on-year.

Among these transactions, there were 4,917 deals of less than RMB100 million, basically the same as the previous year, while transaction volume in this category decreased by 4.72%; and 78 transactions valued at more than RMB5 billion each, with a a year-on-year decrease of 8.24%. In 2018, there were 376 outbound M&A, marking a 13.4% year-on-year decrease, with a total transaction value of RMB331 billion, representing a 29.97% year-on-year decrease.

Both private and public M&A transactions are common in China. In some cases, private M&A transactions are used to raise bridge financing before merging a company into the structure of a listed company, which means that a single transaction can cross from being a private to a public deal.

Compliance, financing considerations and leverage ratios have been one of the most significant factors influencing deal structures recently in China. With the issuance of the Guiding Opinions on Regulating the Asset Management Business of Financial Institutions in April 2018 (the new restrictions of leverage ratios), ultimate investors and the use of non-self-owned funds, where private equity participates in deal financing, new obstacles were set up in relation to the financing in M&A transactions.

M&A sponsors usually set up private funds with financial investors to complete M&A transactions. According to a recent statement by the chairman of the PRC Securities Regulatory Commission, private equity funds are encouraged to purchase shares of listed companies and participate in M&A of listed companies via non-public offerings, transfer by agreements and block trades. It is foreseeable that financial investors may play a more important role in the Chinese M&A market in the future through private equity funds.

Looking at M&A recent deals in the market an emerging trend is that post-deal integration is becoming more and more important; a deal's success can rest on implementing a proper governance structure and distinguishing between critical and noncritical function integration. Increasingly, companies will opt for scope deals (those in which the target is a related but distinct business, enabling the acquirer to enter a new market, product line or channel) as opposed to scale deals (those that involve a high degree of business overlap between the target and acquirer, fueling a company's expansion in its existing business). Scope deals are tricky to implement and often require companies to go beyond the traditional merger integration playbook–for example, selectively integrating only where it matters most.

There is no single law or regulation governing M&A in China and a transaction may involve many laws and regulations. PRC Company Law may be relevant when designing the corporate structure of the target company. PRC Securities Law and its supporting regulations may come into play in a public M&A transaction. Contract Law may govern a transaction when an asset purchase is part of the deal. Employment Law and Employment Contract Law may come into play when employees need to be transferred as part of a transaction. Tax law is always relevant, while foreign exchange policy and regulation is important when financing crosses borders. An competition law declaration may be required if a deal value triggers a regulatory requirement.

M&A and the restructuring of listed companies are greatly affected by policy level decisions. Although the senior officials of the China Securities Regulatory Commission have clearly stated that they will promote the further marketization of M&A, this does not mean that the threshold for M&A has been lowered, especially when it involves major assets restructuring of listed companies or the issuance of shares to purchase assets.

The supervision of the M&A and corporate reorganisation market was significantly scaled up in the first half of 2018. In the second half of 2018, regulatory authorities loosened the policy on listed company M&A by launching a 'quick review program' and revising thresholds on the price of the assets purchased and use of funds raised.

On December 26 2018, the National People's Congress issued the Foreign Investment Law (Draft), which may impact potential cross-border M&A when foreign companies invest in companies in China. The biggest change the draft law may bring is on the corporate governance of foreign invested companies. At present, Sino-foreign joint-ventures and Sino-foreign cooperative enterprises are required to establish a board of directors in accordance with regulations with the board of directors as the highest authority of the company. The Foreign Investment Enterprise Law (Draft) however does not make special provisions on the governance structure of foreign-invested enterprises, which means that the two types of Sino-foreign enterprises may only need to design their governance structure in accordance with the relevant provisions of the Company Law or the Partnership Enterprise Law and no longer be subject to special regulations.

M&A transactions are subject to different approvals or filings to the relevant government authorities in China. Approvals from the State Administration of Industry and Commerce, Ministry of Commerce and foreign exchange filings are most common process in a M&A transaction. Depending on the nature of the transaction, the order of the required approvals and filings is subject to change. In many cases, the participating parties may overlook changes to the approval processes when structuring payment terms and the corporate transaction.

The most frequently overlooked area is tax planning. Through advanced design and arrangement, the corporate tax burden can be reasonably reduced within the scope permitted by the tax law and this can reasonably reduce M&A costs and maximise transaction benefits. The parties should not only consider the tax burdern of a transaction itself but also the tax arrangement between the target company and the parties participating in the transaction. Considering reasonable and effective commercial arrangements, parties to a transaction can rationally plan the transaction structure through certain tax planning, and find a feasible solutions to improve a transaction's efficiency.

Obtaining a certain percentage of equity is the key to gaining control of a listed company. Generally speaking, the acquirer should be the largest shareholder of the listed company and hold at least 20% of the shares after the completion of a control acquisition of a listed company. Of course, in an actual transaction, a company or person may obtain the control of a public company in a variety of ways other than owning 20% of the shares.

The purchase price, the purchase price payment method, the offer validity/commitment period, the change of the offer and the cancellation of the offer are usually attached to a public takeover offer.

Current laws and regulations stipulate that liquidated damages must not exceed 30%. In practice, break fees are generally agreed at about 20% of the transaction price. However, these break fees are subject to change according to the situation of the target company, negotiation leverage and the price tag on the transaction.

As regards consideration mechanisms in private M&A deals, locked-box mechanisms, completion accounts and earn-outs are all common tools for consideration used in M&A transactions. In some cases, a locked-box mechanism is combined with an earn-outs calculation, by requiring the equity seller to bear certain operational risks, in order to protect the buyers' interests. In terms of protection mechanisms, escrow accounts are commonly used in M&A transactions in China, while indemnity insurance is only used in big M&A deals.

Different mechanisms have their advantages and disadvantages. The parties in a M&A transaction may choose the appropriate consideration mechanism based on the nature of the transaction, the needs of both parties and the negotiation leverage.

Participants in a private takeover may agree on different conditions based on the nature of the transaction, the needs of both parties and the negotiation leverage.

It is not common to provide for a foreign governing law in private M&A share purchase agreements, unless both parties are foreign enterprises and prefer foreign jurisdictions or the target company is located in a foreign jurisdiction.

There are many ways for a company to exit after an M&A transaction. IPOs, share transfers, shares buy-backs and liquidation are all feasible and common exit plans for investors in China. Before the execution of M&A transaction documents, parties usually have a specific goal on the future of the target company. In addition, these exit options must be carefully and clearly listed out in the transaction document to prevent any dispute in the future.

The capital markets are the most direct reflection of the current financial situation. In the context of the trade war between the US and China, the global economic situation is uncertain. China's domestic real estate market is facing a turning point, and the stock market continues to be sluggish. At this moment in time however, asset price valuations are relatively low, which means the environment for M&A should be encouraging. We expect that the demand for legal services in the Chinese M&A market in 2019 will be huge.

About the author
		Carl Li Senior partner, Allbright Law Offices Shanghai, China T: +86 13816681760 E: carl.li@allbrightlaw.com W: www.allbrightlaw.com Carl Li is one of the senior partners in Allbright Law Offices. Carl's practice areas include M&A, private equity (PE) funds, foreign direct investment (FDI) and compliance. In the area of M&A, Carl has provided comprehensive legal support to the Chinese businesses of multiple renowned transnational companies in relation to global reorganisations, separations and mergers. He has facilitated the equity mergers and asset acquisitions of multiple foreign enterprises and public companies in China. Moreover, Carl has represented a number of foreign enterprises and private enterprises in the sale of their main businesses and assets to investors. In the PE sector, Carl has assisted various well-known funds in establishing domestic and overseas private funds, constructing compliance regulations, completing filings with the Asset Management Association of China, facilitating product launching and fundraising and providing beginning-to-end service to the funds' project investment. In FDI, Carl acts as the legal counsel to dozens of high-profile foreign enterprises in China, providing comprehensive legal support on the establishment of new projects or capital increases, as well as providing long-term support on daily operations, covering compliance issues related to HR, business and EHS.