10/08/17

Offshore China money has no desire to move back, maybe ever: Morrison & Foerster

DEALSTREETASIA -- At a time when China’s capital control measures have been blamed for a slowdown in investment flow in the region, international law firm Morrison & Foerster LLP has a converse view of the situation. “We have actually managed to successfully close a number of those (deals). And I know there are deals in the pipeline that these large Chinese institutional investors are looking at this year and next year. So, clearly from where they see, they think they will be able to do those deals and capital controls have not really impacted,” says Singapore-based Shirin Tang, a partner at the law firm.

 In an interaction with DEALSTREETASIA, Tang and Hong Kong-based Jason R Nelms, also a partner at Morrison & Foerster, discussed China’s capital controls and the way it has impacted fund formation and M&A in the region. They also share their perspectives on the increased competition for investments with the advent of sovereign funds, insurance firms and family businesses who are largely behaving like a typical private equity (PE) firm.

According to data released by China’s Ministry of Commerce, Chinese outbound investment was seen shrinking 46 per cent to $48.19 billion in the first half of this year. This had come after years of encouragement by Chinese regulators to make overseas investments. The government tightened enforcement of capital controls; government departments are required to sign off on all foreign acquisitions over $10 billion or $1 billion for businesses that were not the buyer’s core business.

Meanwhile, with regard to Southeast Asia, Tang said that the region was seeing businesses building rather than exiting. “Last 3-4 years Southeast Asia has been dull but this year we are seeing increased activity. Japanese corporates are investing. Those have all been building than exiting,” she added. Edited excerpts: The investment scene has been dominated by tech deals in recent days.

As a law firm engaged in these deals, how do you see the Chinese deals in the non-tech space. In terms of M&A, apart from the tech space, what is your view on the deal flow this year or next year?

Shirin Tang – It is good that you have both of us here so we can both share different perspectives. Jason has Chinese fund investors while I do straight M&As.

Jason R Nelms – I think capital controls have been a big driver. There has been a tremendous demand among Chinese investors for outbound investment which gave rise to the capital controls and in a sense, it further increases demand. So on the fund formation side, we have seen increase in funds being formed outside of China — offshore funds in the Cayman Islands, for example. Chinese investors want to invest outside of China. It could be US — tech and real estate are big ones and strategies like pan-Asia is another one. Of course, demand needs to limit to investors who have money offshore in USD or other currencies. This has been a very evolving story, the capital controls being tighter and tighter. And I guess, the corollary is that we are seeing a lot of investment interest around the world.

Does it make it more difficult when there is a Chinese interest or bidder? Does it take away the China premium or are the companies more wary? There have been examples where clinching deals with Chinese bidders taking a far longer time to close or not closing at all which sets everybody back?

Tang: That is a great observation. Setting aside tech, your question was, are there more M&As? I have seen both and I have seen the same set of data which said that in the first six months, everything fell off. I have seen straight M&As with Chinese and HK listed companies listing into SEA and they have been unable to fund and they walked away from the deal like in the consumer sector. But I have also seen large Chinese institutional investors that do these big headline making real estate or other investments where we have had to restructure if they are doing a co-investment deal. Some of these large real estate portfolios come in like co-investors and so everyone is supposed to close on the same day and some places where they are not able to entirely fund capital commitment amount they have to restructure. But, we have actually managed to successfully close a number of those. And I know there are deals in the pipeline that these large Chinese institutional investors are looking at this year and next year. So, clearly from where they see it, they will be able to do those deals and capital controls have not really impacted. It is easy for people to say capital controls are going to stall everything but that is not the case. If you look at the Chinese press, what they say is that they are trying to stop irrational investments. They are really trying to stop people from moving money out and parking it.

Nelms: One thing we have seen is that as hard as it is to get an approval to make outbound investment in a portfolio company, it is more difficult to get an approval to make investment into an investment fund. And one of the reason is when the Chinese regulators see a fund they do not see an actual investment. They don’t see a rational investment. And one good reason why the regulators are concerned is that we actually see some investors who say, “I will invest in your fund outbound in USD and you give my return back cash into my account straight.” So, it is one that has become a theoretical strategy to control and the regulators are all over that.

 As a law firm do you also see some smart strategies? What are some of the creative ways you are seeing when Chinese investors want to do a deal?

Nelms: We are seeing a lot more outbound than inbound (investments). So, money that is already offshore, there is no desire to move it back, maybe ever. Certainly people are looking for ways to offset this and make it cost efficient but money is largely moving in one direction.

Tang: I don’t know any creative ways. Like Jason said, now there is a focus on keeping whatever money you have offshore that way. In the past, it was more fluid but now you are more afraid that you could not remit and move it outside.

 How has it impacted PE firms in China? Are they afraid they may not be able to exit as they cannot bring the money out? Second, how does it impact the frenzy of PE investments in China as one could exit or turnaround quickly?

Nelms:  We do see exits have been a big issue. On the fund formation side, we are seeing that peripherally, but we are also seeing that it has created opportunities for funds. So a lot of times a fund might be formed to buy assets from another fund. Also, valuations are so high apart from the capital controls. There are a lot of concerns around how to exit and with such high valuations. So, we are seeing a lot of sales, fund selling to fund, a lot of new strategies. For example, on the real estate side, we see funds that are in the business of developing real estate assets, and we see other funds springing up in the business of acquiring those assets and creating portfolios of stabilized real estate assets. This gives rise to another thing which is the open-ended real estate funds — a private equity fund that allows an investors to subscribe at a time or redeem at a time like a hedge fund. The portfolio of the companies would be the buildings and property that will be leased off to tenants that are paying rent. Investors in Asia are interested in this opportunity. I think this is something that we see in a high valuation scenario where we create strategies where one group is able to enter and the other group is able to exit and redeploy its capital.

On valuations, how big a concern is it? Is it in some sectors or overall?

Tang: I think, from where I see, it depends on the industry. So there are certain industries like tech where valuations are very high. If you look at it, there is a broader phenomenon where some of these unicorns have not made a dollar. So, they have to literally be the last one standing before they monetize. But now there are investors — strategic and financial — who are naming that bet. Whether that is too high, I don’t know. They clearly think there is money to be made. In Southeast Asia, Indonesia is one market where valuations are high. Indonesian families are not too hungry to sell, so it’s hard to persuade them to sell and there is a lot of dry powder. Coming back to your earlier question on Chinese capital controls, one other thing I wanted to say is that the big thing in the way now is national security filing in the US. Chinese institutional investors have come forward and said that we wish the US was more welcoming and we have so much money to invest. That is something which we are seeing in our deals now. There is an actual demonstrated stringent process when it comes to Chinese investors.

Do you see that spreading to other jurisdictions where other countries may not want Chinese capital in certain strategic sectors? The US is a clear example but do you think there may be others?

Tang: There has been no sign of that in terms of legislation. A lot of countries have the security screening process. US has been the outspoken one but I think there have been others like Australia where there has been not much noise.

Nelms: Other thing is that there has not been legislation and a lot of it has not been driven by law. A lot of this is because of the way winds are blowing right now, so it is very difficult to predict. As administrations change and economies change, there is a big point of uncertainty.

Tang: It will be interesting to see because of the amount of investment by Chinese investors in sensitive sectors even in Southeast Asia.

Specific to SEA, apart from tech, what are the other sectors where you are seeing a lot of interest for outbound Chinese investment?

Nelms: One area we talk of is venture capital fund raising. It continues to be quite hot. A lot of managers forming new funds are still oversubscribed. They have more investors that want to invest than they have available capital and that allows them to demand very strong terms for themselves. US, Silicon valley continues to be a hot area, even though the valuations are so high because there is no real place for people to invest. From a fund raising perspective you have money flowing in that you could expect would be successfully deployed. So this is a story we are watching. It will be difficult to tell how it will be in 12 to 18 months but right now it continues to be strong.

According to data, there is a lot of dry powder. Do you see the competition increasing because we have lot of corporates, LPs and family offices. How do you see deal making in that scenario?

Nelms: We have seen a lot of investors who we thought are passive investors like sovereigns, pension funds and family offices. Historically they have invested in funds passively now they more and more want to have an active role in the funds. They also are doing co-investments more so having a long term objective of not having a fund investment at all. Of course, this has already increased valuations. We know this is cyclical. As much as the dry power there is, as economies rise and fall, these funds have a fixed end. So, inevitably there will be a new round of investing and some of dry powder will fall away without ever getting invested.

 Tang: It is convergence and integration. It used to be that private equity used to compete with private equity for the same kinds of deals. Now we have a convergence where private equity is competing with sovereigns and then you have strategics behaving like PE. It has changed the way we do deals. In a competitive situation, there used to be a thing that this is the advantages that a strategic brings and other advantages. Now there has been a convergence. Large tech companies like in Japan and China, they are investing in very large valuations that typically you would find in among the large institutional investors. But they are behaving like a hybrid of a strategic and a financial investor. They want strategic returns but they also want a strategic synergies and integration and that is creating more dry powder. That is like having a valuation of $2.5 billion for a firm at a time when it is having to compete with others in this region but people are willing to make that bet.

What are the challenges that the LPs have in this scenario? Do you think there are a lot of people competing for cash from an LP?

Nelms: We are. If you look back historically 2010 to 2012 we saw a very good fundraising market. And then a bit of a downturn in 2014. So, 2016 is sort of a next wave. Out of the managers who did well at that time, they are having a lot more easy time raising. Also, a lot of high profile fund managers who are raising their own funds are doing well. It is the people in the middle who are having a problem.

Also, there are a lot more people now. Asia is relatively new for the fund formation business. So, with each cycle we are seeing exponential increase in sophistication in the number of people who understand that business. It is a very competitive environment. Some of the funds that target 500 million can raise a billion others have a target of a billion and they look super on paper but they end up not raising at all. A big driver here is Chinese investors looking to invest outbound. The sovereigns, the corporates and more recent the insurance firms, some high net-worth investors. We see a lot of managers who are Chinese who are close to Chinese investors are forming a new fund to seek that money. Al lot of fund of funds too where the manager will say, you want access to these big venture funds and you cannot do it directly but I can put your money across these companies, sort of matchmaking between China and the overseas.

How do foreign managers compete with the locals who come with their own set of local expertise, and what does this hold for a large global PE player which is investing in the same region as the local player?

Nelms: There is always a discussion when it comes to investing into China. How can the foreign manager compete with the local managers and how do they compete with the foreign fund who already have access to US and the Europe? I think a lot of these Chinese managers are not replacing but adding a necessary step in the distribution chain. They have access to China money because of the language, the culture or something else and they are helping to place the deals and there is an increasing demand for these ‘middlemen’ to use that term.

 China outbound is a recent story and people are focused on it. So, we see greater allocations for Asia. People are very focused on India and South Korea. Southeast Asia is great story. We are also seeing increased competition between local and international managers.

Exits have always been an issue. What has been the trend in Southeast Asia?

Tang: What we are seeing in Southeast Asia is they have been building rather than exiting in Southeast Asia. There has been a whole spate of elections in each country and there has been a lot of unrest. Last 3-4 years, Southeast Asia has been dull but this year we are seeing increased activity. Japanese corporates are investing. Those have all been building than exiting. In a few years, may be exit won’t be a problem here anymore.