Driven by a combination of potentially attractive returns as well as regulatory liberalisation, investors are looking at increasingly sophisticated investment structures. Are the regulators in Asia's key markets keeping pace?
The following discussion with a number of Linklaters partners examines recent developments in the regulatory environment and looks ahead to the challenges to come in China, India, Indonesia, Japan and Korea.
What have been the significant developments in the China market over the past few years?
Betty Yap: Two notices issued by the State Administration of Foreign Exchange (SAFE) in January and April of this year brought many private equity transactions to a halt and it is with some relief that they have now been repealed and replaced by a new SAFE notice, which came into effect on 1 November 2005.
The previous notices required enterprises with foreign investment in China to issue a representation to SAFE, as part of their foreign exchange registration exercise, confirming whether any Chinese individuals or entities have ownership or control, whether directly or indirectly, in the foreign investors of these enterprises. This created uncertainty for private equity investments in overseas companies which operate businesses and assets in China and which are controlled by Chinese individuals or entities - a common structure in the market. While these notices were drafted with the intention of preventing unauthorised transfers of assets offshore by Chinese persons, they gave rise to uncertainty as to SAFE's reaction (and the implications) if the existence of such Chinese interests is disclosed to SAFE, and whether any specific SAFE approval would be required in addition to the usual approval required from the Ministry of Commerce.
The new SAFE notice clarifies the position. Any offshore structure involving Chinese interests contemplated by private equity investors will need to be registered with SAFE, it should now be clear that SAFE does not have any substantive approval role in the adoption of these structures. The new notice is applicable to any offshore special purchase vehicle set up directly, or controlled indirectly, by Chinese persons (including natural persons) for the purpose of conducting equity financing outside China using the Chinese persons' assets within China.
The notice requires prior notification of the existence of these Chinese interests. In addition, it lays down the requirement that these Chinese persons must repatriate their foreign earnings back to China within 180 days. With these latest regulations, much of the previous uncertainty would seem to have been removed - although the notification requirements and the mandatory repatriation have lessened the attraction of structuring cross-border private equity transactions for Chinese persons.
Where do you see the key challenges and opportunities in China?
A new PRC Company Law and a new PRC Securities Law were introduced on 27 October 2005, and will become effective on 1 January 2006. Some key restrictions in previous laws have been removed, which provides opportunities to devise more flexible investment structures for private equity investors.
One new feature of the PRC Company Law that is particularly relevant to private equity investors is the ability for a PRC joint stock company to have different classes of shares with different rights attached. Indeed, new domestic venture capital rules issued recently now specifically refer to the possibility of preference shares.
Another new feature is the ability for a PRC joint stock company to repurchase up to 5% of its own shares for the purpose of awarding shares to its employees, which opens up the possibility of establishing a workable employee stock incentive scheme onshore.
With these latest legislative developments, we expect an increase in not just private equity investment activities in China but also a higher level of complexity in these transactions in the coming year.
As one of the world's fastest growing economies, India has a large number of cash hungry companies. International private equity investment in India kicked off a decade ago following the economic liberalisation programmes instituted by the then government. However, initial private equity interest in India was limited to the IT and telecoms sectors. Success in these sectors has encouraged private equity houses to look at other sectors such as textiles, pharmaceuticals, auto components and real estate.
What has sparked the recent interest in private equity in India?
Sandeep Katwala: Private equity interest in India has recently increased due to the increasing ability of foreign investors to successfully exit from their investments which was always a concern in the past.
Recent buy-outs of private equity investments in companies such as Daksh and DHL have also changed this perception. The Indian stock markets are at an all time high and private equity investors are now increasingly able to exit companies through listing on the stock market. Examples include private equity investors in Biocon, UTI, and Mphasis using the stock market as a means of exit.
What are the key aspects of the Indian regulatory and legal structure affecting private equity investors?
Since economic liberalisation began in 1991, India has had four changes of government. In this period, parties across the spectrum have been in power but the liberalisation policies, while slow, have been continuous and steady. Under the current foreign investment regime, the requirement of prior regulatory approvals has now been dispensed with for foreign investment in many sectors.
Sectors of the economy where foreign investment was prohibited or severely restricted such as real estate, print media, FM radio, telecoms and airlines continue to be further liberalised.
Similarly, the requirement for approvals for transfer of shares between residents and foreign investors has been considerably relaxed. Another significant change in government policy has been the removal of the restriction on foreign investors investing in more than one company in the 'same or allied' fields.
This restriction, popularly referred to as the "Press Note 18" restriction, was cause for considerable discomfort among foreign investors seeking to invest in India as it required the investor to seek permission from existing joint venture partners before making investments in the same or allied field. Now the restriction (set out in "Press Note 1" of 2005) is limited to investment in more than one company in the same sector.
Since a large number of Indian companies are listed, foreign investors can also use the portfolio investment route to purchase equity in such companies. The portfolio investment route is almost completely free from foreign investor regulatory oversight, subject to regulations that apply equally to Indian investors, such as the SEBI Takeover Code. In addition, Indian regulatory authorities have adopted a more investment friendly approach while dealing with applications in sectors where prior approvals are required.
Indian law allows for up to one third of the directors of an Indian company to be nominee directors, ie, not elected at a shareholders' meeting. Private equity investors in Indian companies can avail themselves of this provision to nominate directors to monitor and keep control of the investee company. Often these nominee directors have veto powers over important decisions such as significant M&A activity, distributions and borrowings.
Over the years lawyers, bankers and accountants working on Indian transactions have perfected structures and investment vehicles which give optimal tax benefits while minimising regulatory issues. This acquired knowledge from initial deals is a valuable asset that new investors can now benefit from.
Linklaters has a dedicated India group, comprising a number of dual-qualified lawyers who are specifically tasked with monitoring and developing the firm's involvement in the Indian market. The group (comprising partners and lawyers from London, Hong Kong and Singapore) supports members of the firm across practice groups, where necessary, to add their specific experience and knowledge of India to transaction teams.
The government's bank privatisation programme, which began in 2002, was widely seen as a resounding success with banks such as Permata Bank and Bank Danamon attracting significant foreign investment. The largest transactions of recent years have been dominated by heavyweight regional institutional investors like Temasek and Khazanah, the investment arms of the Singapore and Malaysian governments respectively.
What have been the significant developments in the Indonesian market over the past few years?
Richard Good: The dominance of regional investors largely reflects the concerns that those outside the region have with the Indonesian market. Bureaucracy, a weak regulatory environment, concern about the enforceability of contracts and reservations about the quality and experience of management are the principal concerns for international investors.
Formulating an effective exit strategy has also been difficult - the Indonesian stock market's performance makes an IPO exit unattractive and the other obvious exit mechanism of a trade sale itself poses risks in a market that, until recently, has not attracted significant numbers of trade buyers.
Where do you see the key challenges and opportunities in Indonesia?
The political environment is looking more stable than it's been for some time, the economy is generally improving and FDI levels are increasing. Much has been made this year of the proposed new legal and regulatory changes which it is said will encourage foreign investment, including a more streamlined process for approving foreign investments and a new investment law which promises to offer equal treatment for foreign and domestic interests, but as yet no significant changes have been enacted.
Indonesia has a long way to go to compete with its neighbours for private equity funds and although the signs are positive and the government has publicly declared its commitment to reversing the trend of declining foreign investment and creating an environment that is more conducive to international investors, there is concern that without substantive reforms soon, Indonesia could continue to lose ground.
That said, Indonesia continues to be a market of under-exploited potential within the region and one that can, as was shown with the bank privatisation programme and a number of the recent foreign investments in the telecommunications sector, generate significant returns for international investors. We've also seen increasing interest in South East Asia this year from investors in the Middle East and it's likely that Indonesia and Malaysia in particular will benefit from this going forward.
The past few years have seen radical changes in Japan, both in the volume of private equity funds looking to invest in Japan and in the M&A landscape. Casper Lawson discusses these changes and their impact on the market in Japan.
What have been the significant developments in the Japanese private equity market over the past few years?
Casper Lawson: The market is almost unrecognisable from five years ago. A decade or so after the Japanese economic bubble burst in 1990, only a few brave funds were making large countercyclical bets on Japan business, which was seen as being in an endless recessionary trap. But those that did invest have seen some spectacular returns. Most publicly, Ripplewood's investment in the failed Long Term Credit Bank (LTCB) which it floated in 2004 as the renamed Shinsei (literally, "new birth"), drew the world's attention to the potential gains to be made in Japan. Many of those who were still doubters were converted when Ripplewood bought and sold Japan Telecom within 10 months for a disclosed gross IRR of 479%.
There was a hiccup in early 2005 when the Japanese government introduced legislation threatening a 20% withholding tax on foreign private equity gains, a result of the political unhappiness at the Shinsei gains having been made tax-free in Japan, despite the Japanese tax-payer having pumped around US$70 billion into the failing LTCB.
The tax proposals caused indignant complaints and dire warnings of the collapse of FDI, but the tax changes went ahead anyway and the collapse did not happen. On the contrary, more and more private equity money has been targeted at Japan. The main effect of the 20% withholding tax has been to make foreign funds increasingly careful to avoid establishing a permanent establishment in Japan, which is too easily done by accident and a costly mistake.
A few funds packed up and went home, citing the difficulty of finding suitable investment targets. But the overall funds flow has been clearly inward, with European and US giants like Permira and KKR setting up offices in Tokyo within the past couple of months.
How has the M&A landscape changed in Japan?
On the M&A front the changes have been no less dramatic. M&A has moved from the business pages to the front pages, with a series of hostile takeover attempts in 2005, which followed the breakdown since 2001 of the keiretsu (cross-shareholding) system. Most visibly, an internet company called livedoor had a tilt at the radio company Nippon Broadcasting System, rapidly accumulating over 35% of its shares in a form of market raid and causing a flurry of angst amongst the establishment but a surprisingly large degree of support from the general public, particularly the younger element, who liked the idea of a new media company shaking up corporate Japan.
The takeover attempt has had knock-on effects in several areas and equilibrium has not yet been restored. Several Japanese companies have installed poison pills for the first time in Japan. Others have focused on increasing shareholder value, by distributing surplus cash piles or divesting non-core assets. The whole takeover regime badly needs an overhaul, but it is currently being done in a piecemeal fashion, with different regulators arguing, for example, both for and against the introduction of golden shares.
Some would say this uncertainty creates opportunity. Certainly, while some funds, notably M&A Consulting (an activist investor fund run by ex-bureaucrat Murakami-san), focus on shaking up management to work harder at creating value for shareholders, other funds make a virtue of eschewing ever taking hostile interests and instead position themselves as White Knights to save management from actual or perceived hostile bids.
Interestingly, despite (or perhaps as a result of) foreigners coming under strong establishment criticism during the livedoor bid, somewhat bizarrely since both bidder and target were Japanese, most of the hostile activity has been from Japanese firms while foreign private equity funds have generally avoided openly making hostile moves.
What do you see as the future of the Japanese private equity market?
Views are divided. Optimists are encouraged by increasing deregulation (for which the Japanese government deserves more praise than it usually gets) including a major rewrite of company law coming into effect in around May 2006, which will remove a large number of mandatory company law rules and permit shareholders to have a much wider selection of rights in relation to capital, management and distributions.
The rise of an entrepreneurial class of manager and the increasing focus on shareholder value are also positive developments. The fact that M&A, as a percentage of GDP, is only around one-third that of other large economies such as the US, UK or France, shows that M&A could continue its strong growth for many years to come. Foreigners have been buying strongly into the Japanese stock market, increasing their holdings from around 6% of Tokyo Stock Exchange listed companies a dozen years ago to around a quarter now; and, since traditionally foreigners and funds are less likely than strategic trade investors to hold for the long term, this creates more possible targets for buy-outs. Finally, club deals are starting to appear which, coupled with cheap yen-denominated debt, gives greater fire-power to investors and increases the number of potential buy-out candidates.
Conversely, pessimists point to the undeniably large increase in money to be invested, not yet matched by a large increase in willing sellers. The rising stock market could, paradoxically, reduce the pressure on companies to restructure and divest non-core assets. We have seen false dawns before and the current enthusiasm for investment in Japan could be killed by any number of factors, such as government clamping down on the economy too severely, which killed the nascent 1997 recovery.
Who are right: the optimists or the pessimists? I believe both views have some truth and make some predictions:
- M&A will continue: the restructuring genie is out of the bottle and Japan will not return to its static ways of the 1990s.
- This will continue to create opportunities for private equity funds, many of which will make attractive returns.
- The easy pickings (with the luxury of 20-20 hindsight) of five years ago leading to triple digit returns are gone; funds will increasingly have to add value to realise value.
- Take-privates, especially MBOs, will increase; as will club deals.
- Although foreign funds have made the headlines, especially doing the larger deals, domestic funds will increasingly be visible, as we can see with Advantage Partners leading the bid for the multi-billion dollar food and cosmetics company Kanebo.
- Japan will still be Japan and money, while important, will not be everything. Successful funds will continue to have to be patient and the best deals may take months or even years of careful wooing before a target feels comfortable with the proposed investment.
Since the Asian financial crisis, the Korean government has made a number of radical legal reforms to encourage foreign investment.
What have been the significant developments in the Korean market over the past few years?
Sanghoon Lee: Since the Asian financial crisis, the Korean government has essentially liberalised barriers to entry. Laws that once restricted foreign investors from establishing or acquiring businesses or funds and purchasing publicly traded shares and other securities, have been amended or abolished to allow foreign investment with no prior government approvals or minimal reporting obligations.
As a result, it has opened Korea's economy to foreign participation, and foreign investors have participated in Korea's continuing restructuring process, which has led to an increasing trend in private equity and M&A, capital markets, and bank financing activities in Korea.
In many ways, the financial crisis and the Korean government's response has led to one of the most developed private equity/M&A markets in Asia - certainly among markets of any significant size. This can be seen in terms of both absolute and relative volumes of activity. Also, if you look at the role that financial sponsors have played in the progress of certain industries in Korea (eg the banking industry) or the types of transactions being undertaken, it is difficult to find another market in Asia where the activities of financial sponsors have had such an impact or where you see such complex structures (includingeg, leveraged deals).
In addition, many financial sponsors have experienced the full cycle - from investment to management to exit. More recently Korea has introduced regulations to permit the establishment of domestic private equity funds. A few fairly large funds have been established and it will be interesting to see if the additional competition results in an even stronger, more sophisticated market.
While much progress has been made in restructuring the economy and companies since the financial crisis, there are still a large number of assets/companies held in the hands of creditors. For many of these creditors, a trade sale may be an attractive route to rehabilitate these assets/companies.
Where do you see the key challenges and opportunities in Korea?
There is greater competition for deals in Korea, especially with the entry into the market of domestic funds as well as global funds that previously did not focus on Korea. This has led to concerns that valuations may have increased and that financial sponsors have to compromise on certain aspects of the documentation and execution of deals.
There is also a continuing concern that the regulations have not kept up with the many developments in the market. For example, investors feel hampered by the rigidity of tender offer rules and the limitations they face in doing leveraged deals. There are some who would also say that the relatively greater role of the government in Asian transactions (both behind the scenes and in the approval process) can complicate transactions. As such, it is helpful to have management teams with a track record in the local area and counsel who is familiar with the regulatory environment.