Asia has perhaps the richest and most diverse cultural, linguistic and political environment in the world. This diversity provides a wealth of opportunities for the expanding private equity community, but also some formidable challenges.
Some private equity firms have responded to this diversity by focusing on Asia’s more developed markets, or on those where they have specific, in-house expertise. Others believe that, despite the challenges of adapting the private equity model to diverse jurisdictions, the value to be gained from such an approach outweighs the structural and political risks.
Private equity continues to grow in Asia, although its form and character is likely to change considerably over the coming years as it adapts to the diverse requirements of Asia.
This article highlights some of the recent trends and developments that our lawyers, working across Asia, have observed during the past 12 months.
We also discuss the specific regulatory challenges, opportunities, deal structures and risks in: China, India, Japan, Korea and Thailand.
Trends
Over the past 12 months we have seen increased protection of strategic industries in China; well-publicised rebuffs for Macquarie and Newbridge in their attempt to acquire PCCW in Hong Kong; and significant regulatory and legal hurdles for Lone Star in its proposed sale of KEB in Korea.
These high-profile setbacks have not dented the inexorable growth of the private equity market across Asia. Deal flow in China and India continues to increase, albeit mostly at the smaller end of the mergers and acquisitions (M&A) market.
Activity in Australia, Japan and in the broadband sector in Taiwan has been particularly prolific. Sponsors continue to expand their teams and their regional footprints. Investment and commercial banks continue to grow their leverage finance teams.
As the number of players and the funds available increase, we are seeing changes in the nature of Asian M&A. Despite the PCCW transaction, there is still strong interest in financing take-private transactions in both Hong Kong and Singapore. These are deals which can offer high levels of transparency on asset quality, significant deal size, acceptable levels of deal certainty, clarity of execution and the opportunities to leverage fully.
In the private M&A market it is now rare to see any disposal which is not structured as a competitive auction aimed at both sponsors and trade buyers. This has handed considerable bargaining power to vendors, with deal terms becoming increasingly vendor-friendly. Despite the frailty of accounts in some jurisdictions, locked-box structures are becoming more common.
Meeting the Challenge
The ability to leverage, the robustness of local legal and regulatory frameworks, and political, linguistic and cultural differences, all combine to create dramatically different risks and opportunities across the region.
For those who wish to profit from such diversity, the ability to understand and to price jurisdictional risk is paramount. For most sponsors, running a lean operation, this will increasingly mean augmenting their own resources and expertise with those of their legal and accountancy advisors.
In areas where law and regulation can be a moving target, there are strong arguments for turning to advisors such as the global accountancy and law firms which have long operating histories in Asia as well as familiarity with US and other fund structures and international execution standards. Whilst some rely on a multitude of local advisors, all agree that it is no longer enough to have only some parts of the puzzle.
The bidder which has the benefit of international expertise, seamlessly combined with strong, commercially based guidance on the local legal, regulatory and political landscape, will be best placed to price its risk most keenly. The current war for talent amongst the major advisory firms in almost every major jurisdiction in Asia demonstrates that the lawyers and accountants are as aware of the need to expand their Asia-wide coverage as their clients.
Even in those jurisdictions with more developed and accessible regulatory and political frameworks, the requirement for advisors to be able to provide in-depth regional coverage is increasing. Nobody wants to attempt a take-private unless they are supported by strong public M&A advisors in the relevant jurisdiction. And no one wants to see their IPO exit prevented or delayed because the original acquisition structure failed to take account the requirements of the local listing rules.
As the market grows, expect the financing product to become more sophisticated, with increasingly stretched capital structures becoming a feature. As well as single-tranche senior debt structures, we are starting to see subordinated (mezzanine, second lien, PIK) and high-yield take-out components on Asia-Pacific deals. This requires legal advisors with familiarity with the US and European markets, who can draw upon expertise in the latest loan, bond and hybrid financing products, and who have international (English and US) as well as local law capability.
Over the past 12 months, private equity has continued to be active in China with a number of developments of particular note.
The new M&A rules which came into effect in September 2006 introduced new government approval requirements for “round-trip” restructuring of Chinese targets, Chinese interests in overseas holding companies and their eventual listings outside of China. This has created exit concerns in the market.
These changes introduced by the new M&A rules compounded the effect of the existing requirements for PRC nationals holding interests in overseas companies which seek capital raising outside of China to complete verification and registration procedures with the local foreign exchange bureaus.
The new M&A rules have also introduced new review procedures for foreign acquisition of important Chinese brands and household names, potentially creating more obstacles for private equity investment in strategic targets or regulated industries or where there are anti-trust concerns or other sensitivities.
In March this year, the PRC government announced significant changes aimed at the unification of the tax laws governing domestic enterprises and foreign invested enterprises. These changes will become effective from 1 January 2008, gradually phasing out tax concessions for foreign invested enterprises and creating a level playing field. There has also been increasing regulation of transfer pricing and an increasing focus on tax avoidance.
Predictions
In the coming months we expect to see increasing competition in the private equity space in China as the number and types of private equity investors proliferate, and the pool of Chinese targets that are not subject to the new government approval requirements for restructuring and overseas listings, diminishes.
As a result, and as more opportunities emerge onshore, there may be an increasing interest in onshore investment structures, including interest in establishing or investing in an onshore private equity fund.
The choice of jurisdictions with a double-tax treaty with China that is most favourable and appropriate for the investment will be important if withholding tax on dividend income repatriated from China is fully enforced, and restructuring and re-domiciling issues may also surface.
Finally, investment structures will continue to evolve to deal with accounting, legal and regulatory issues as they develop. A recent example is the RMB-denominated USD-settled convertible instrument into which a number of investments have now been structured since the beginning of this year to deal with the accounting treatment of embedded derivatives under IAS 39.
The last few years have seen a significant increase in private equity activity into India. This reflects the general positive outlook towards the country and the bullish, if occasionally volatile, stock markets.
But the more subtle reasons for the increase must include the recent examples of successful exits – a key consideration for any private equity investor – and the ever-liberalising regime for foreign investment into India, both in terms of the areas in which investment is permitted and the amount of foreign holdings. There are now only a handful of industry sectors in which foreign investment is not permitted or where less than 100% foreign investment is permitted, and the increasingly simplified licensing and consenting regime means that regulatory barriers to entry and exit are few.
Deal sizes have however remained modest. Investments as large as Blackstone’s US$366 million in Emcure Pharmaceuticals and US$275 million in the Eenadu group are few, but the deal flow in the small- to mid-cap segment is huge.
In terms of participants, both the traditional private equity houses and investment banks – through their proprietary desks – operate in the market. Domestic players such as IDFC Private Equity are also becoming more active. Investments are being made at the pre-IPO stage and there is also a significant amount of private investment in public equity (PIPE) activity.
The recent trend is for investments to be made through different structures and using a combination of instruments. There is a wide array of simple equity instruments/investments, convertible bonds, FCDs (fully convertible debentures) as well as preference shares. This variety is designed to ensure the maximum possible return within the Indian regulatory framework, whilst balancing downside protection and investor control.
The Indian regulatory framework, however, does not as yet lend itself to the traditional private equity take-private or management buyouts (MBOs), at least in the listed space. The main barriers to such transactions are:
- the difficulty of raising any in-country acquisition debt or being able to do a successful debt push-down into the target in India. This is caused by the rules on foreign currency borrowings which regulate the commercial terms as well as the use of proceeds (most significantly in the context of acquisition finance). Foreign currency loans cannot be used to acquire shares. Domestic debt is also limited as retail banks in India are not permitted to lend for the purposes of funding share acquisitions, which restricts the lender pool to non-banking financial companies operating in India. Linklaters continues to explore structures that will facilitate the leveraged buyout (LBO) market in India;
- that a vast majority of Indian companies tend to be family owned and controlled; and
- the absence of any compulsory minority squeeze-out mechanism. A take-private transaction would have to rely on what can be fairly expensive delisting procedures and possibly a time-consuming court-approved scheme of arrangement to ensure that 100% control is obtained.
In the pre-IPO space, investors need to be mindful of the pre- and post-IPO lock-in restrictions imposed under the listing rules of SEBI (the Securities and Exchange Board of India), when they are considering the timing of their exit. They also need to carefully consider the investment instrument: convertibles can be tricky in the context of the lock-in rules.
Similarly, downside protection has to be carefully structured so as to comply with the general foreign exchange rules and the relevant trigger has to operate within the prescriptive listing procedure. An advisor that has experience and in-depth knowledge of all parts of this puzzle is therefore crucial, so that the entry can be structured in a manner that will maximise the chance of a successful exit.
While there are still some gaps in the regulatory framework, private equity houses the world over continue to be eager to get a foothold in this market, given the current valuation and the potential for high returns in an exit.
Recent themes
The Japanese economy has continued to improve after more than a decade of stagnation so sponsor investments have entered a new phase. Whereas the early 2000s saw distressed companies such as Shinsei and Aozora bought for a knock-down price, now the emphasis is increasingly on buying profitable businesses.
The rising stock market has helped IPO exits such as Aozora (Cerberus) and USJ (Goldman Sachs PIA).
Potential buyers still outnumber sellers. Japanese companies are becoming more willing to consider M&A but the process is slow. The rising stock market and economy paradoxically have taken some pressure off management to restructure ailing companies.
As a consequence of the vendor scarcity, auctions are becoming more common and valuations are rising. In the hot sector of real estate we saw literally dozens of bidders emerge when ANA decided to sell off a 13-hotel portfolio in order to concentrate on its core airline business. The price more than doubled during the auction period, with Morgan Stanley eventually winning with a US$2.4 billion bid.
As we forecast in our last report, MBOs have increased dramatically with around 80 in 2006, including Skylark (US$2.4 billion) and World (US$1.8 billion). The total value of sponsor-backed MBOs has increased ten-fold in two years. Some MBOs were controversial, as discussed below.
Non-Japanese funds have often decided they have a higher chance of clinching a sale if they partner with a Japanese fund. We saw several joint purchases including CVC and Nomura (Skylark), Bain and JIP (SunTelephone) and Carlyle and Unison (Toshiba Ceramics).
As we predicted, we saw more hostile takeover bids in 2006. The most surprising in some ways was Oji Paper’s bid for Hokuetsu Paper. This was surprising not for its industrial logic, as it was an obvious combination in an overcrowded industry with global competition, but for the fact that it was reportedly the first hostile battle between blue-chip Japanese companies. Even more unusual was that it was a Japanese broker, Nomura, which advised the aggressor, whereas the defence advice was provided by a foreign bank, Credit Suisse. That bid, as with all the other hostile bids in 2006, was defeated by a white knight defence.
Regulatory developments
A tax trap emerged on squeeze-outs. On 1 October 2006, Japanese tax law changed so that a 100% takeover of a company may trigger a revaluation of the target’s assets with any deemed gain being subject to a tax charge. Squeeze-out practice has therefore changed since 1 October 2006, with the traditional “liquidation” method being replaced by the “fractional share” route, although neither is yet definitely approved by either the court or the tax authorities. On 1 May 2007 a new method of squeeze-out, the cash-out merger, also became available. This is an area where law is uncertain, practice is changing and a mistake is potentially very costly, so expert advice is essential.
The new cash-out merger allows squeeze-outs with as little as two-thirds of the votes exercised in a general meeting. This is low by international standards. If this right is abused, for example by squeezing out at an undervalue, we would expect shareholder challenge.
The regulator discovered its teeth. In separate events Horie, founder of livedoor, was sentenced to jail (he has appealed), three partners from Big 4 audit firm Chuo Aoyama received suspended sentences and criminal charges were brought against fund manager Murakami, amongst others. Some funds, including Murakami’s, decided to move their bases offshore, to Singapore or Hong Kong, with the Japanese regulatory regime apparently influencing the decision.
Some MBOs were controversial. Critics noted that World downgraded its profit forecast ahead of its MBO, then more than doubled it three weeks afterwards. Similar criticism attached to Rex Holdings for its pre-MBO profit warning. The government responded to concerns by amending the law in December 2006 to require greater disclosure, including the steps taken to avoid conflicts. However the real problem is Japan’s lack of truly independent directors, without whom it is hard to provide an easy legislative fix to the inherent conflict which exists in any MBO. Meanwhile a group of over 100 shareholders of Rex Holdings has taken the company to court over the allegedly unfair buyout price.
Large shareholding disclosure requirements were tightened up following the livedoor and other scandals. Institutional investors previously reported changes in their listed company holdings of over 5% on a quarterly basis. Since 1 January 2007 they must report twice monthly or even more rapidly if they intend to exert “significant influence” over management.
In a series of steps merger control became more sophisticated, with the HHI test replacing the old simplistic market share tests. Some mergers which would have been prohibited before would now be allowed and vice versa. Some eyebrows were raised when Japan’s biggest noodle-maker Nissin acted as white knight to the fourth biggest, Myojo Foods, in order to save it from a hostile takeover bid, despite the combined group now having over 50% of Japan’s instant noodle market.
Predictions
We make the following predictions:
- The Japanese economy will continue to strengthen, with the proviso that there is a significant risk that the government will increase consumption tax after the 2007 elections (the last time they did this it killed the nascent 1997 recovery).
- M&A will increase, especially take-privates and other MBOs.
- TOB (tender offer bid) premiums, which have been historically low or even negative, will increase.
- Foreign triangular mergers are permitted for the first time in May 2007, but this will not by itself unleash a wave of new M&A because the principle “cash is king” will continue to apply for cross-border deals.
- Japanese companies will increasingly invest in other countries, giving opportunities to private equity funds to partner with them as they move into unfamiliar territory.
- There will be a few more hostile takeover attempts, many more AWSs (poison pills) installed and, we hope, some judicial clarification of whether AWSs are effective.
- Shareholder activism will increase, emboldened by a recent proxy fight by Ichigo against a proposed steel company merger at minimum premium, which was reportedly the first time in Japan that shareholders vetoed a merger approved by the companies’ boards.
- There will be increasing focus on the ‘elephant in the room’, which is the ongoing privatisation of the post office. As approximately US$1,600 billion of low-yielding deposits held for customers of the world’s largest financial institution start to be converted into higher-yielding mutual funds and similar investments, the effects on the country’s financial landscape are likely to be significant and unpredictable. But change and uncertainty bring opportunities to the bold and clear-sighted.
Over the past 12 months, the market in Korea for private equity deals, as with all of the jurisdictions mentioned above, has continued to evolve.
Until recently, the market has been dominated by multi-billion auction sales processes by creditors, courts or the government. As the “hang over” from the currency crisis comes to an end, such processes are tailing off and “middle-market” deals have come to the forefront.
In these auction processes, domestic corporates have emerged as active and confident buyers, often backed with financing from domestic and international lenders flush with liquidity or domestic pension or government related funds. Another feature of the market has been the beginnings of private equity funds partnering with domestic corporates.
We are also seeing local private equity funds such as Vogo and MBK Partners becoming an established part of the financial sponsor landscape. This has been coupled with the balance of activity shifting towards Asia-focused private equity funds.
On the regulatory and legal front, there have been some developments that have clarified certain aspect relating to the use of leverage and the imposition of capital gains tax for non-Korean investors. While the clarifications may be viewed as steps in the right direction, the market would most welcome further positive clarifications and transparent application of relevant laws. This is particularly true in a regulatory enforcement environment with respect to alleged white collar and tax-related crimes which many would characterise as being more aggressive and arguably less transparent.
Finally, through the year the headlines of the international business press pointed to the “anti-foreign capital” sentiment running through Korean society. It can be said that we are witnessing the emergence of a less positive populist view of the impact private equity funds have on the Korean economy. To some degree, however, this is not out of line with the debate which continues globally about the role private equity should play in the economy.
Predictions
We expect these trends to largely continue for the foreseeable future. In addition, we expect the following developments to impact the market for private equity transactions:
- The expected enactment of the Consolidated Capital Markets Law. Although the proposed law, if enacted, would not become effective before January 2009, it would mean that financial institutions in Korea might acquire/dispose of assets to benefit from the change in law. It might also mean changes to the activities of financial institutions in Korea with respect to the private equity industry.
- The ongoing review of corporate law in Korea, which will have longer-term effects.
- A focus on outbound investment by Korean corporates.
- The presidential elections in Korea towards the end of 2007.
- Structural changes in certain industries if the Korea–US Free Trade Agreement is ratified.
Despite the political turmoil, the past 12 months have seen a significant increase in private equity interest in the Thai market.
Of notable attraction to private equity firms have been several depressed financial institutions and commercial banks. Perceived consolidation in the insurance sector has also seen some nibbling interest but, as yet, there is little movement beyond this.
Without doubt the most active private equity transaction in Thailand over the past year has involved the significant investment by Newbridge in BankThai Public Company Limited, a matter in which our Bangkok office has acted as legal advisor to Newbridge.
As private equity investment in Thai corporates and financial institutions is relatively embryonic, the M&A activity that has taken place to-date has had to comply with current Thai laws. In particular, restrictions on foreigners participating in certain business sectors, such as those contained within the Foreign Business Act, have needed to be considered. In addition to this, Thai law also has significant restrictions under other laws, such as those found within the Commercial Banking Act, which would otherwise curtail the usual transaction structure private equity firms like to see elsewhere.
Notwithstanding these issues, keen interest in the Thai market continues to grow with signs that private equity firms will likely extend their interest from the activity of the past 12 months. In particular, the blooming technology sector in Thailand has caught the eye of a number of private equity firms who, historically, are more familiar with these types of industries.
Predictions
We expect to see growth in private equity activity in the Thai market continue for the foreseeable future. In particular, continued private equity interest in the Thai finance sector is highly likely following the Thai government’s recent acceptance, relaxation and support of foreign ownership in Thai commercial banks, as seen in the Bank of Ayudhya Public Company Limited and BankThai Public Company Limited transactions.
This article was first published by FinanceAsia on 1 May 2007.
This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts at Linklaters, or contact the editors.
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