Private Equity Direct - Feb 2011 - PRC Changes the Rules of Engagement for Foreign Investors
The gap between opportunity and availability is shrinking in China as recent regulations put out a broader welcome mat for Western investment in this emerging marketplace. The timing could not be more propitious for this new center of world power and influence. In the wake of the financial crisis, as some private equity executives are finding it difficult to raise funds in the United States and Europe, they are instead now looking to China for new investment opportunities.
Private equity powerhouse The Carlyle Group announced earlier this year that it was granted a business license for its Fosun-Carlyle Equity Investment Fund—the first license issued in China since regulations went into effect on March 1 allowing Renminbi (RMB) based funds. The initial $100 million from Carlyle's Asia Growth Fund and Fosun Group, which describes itself as the largest privately owned investment conglomerate in China, is expected to begin investing in China immediately. Rival Blackstone Group has also pushed for investment in China and claims it will also raise capital for its first local Yuan fund in Shanghai.
The interest in China stems in part from new laws that indicate the government is both moving to ease restrictions on foreign investors while promoting the establishment of partnerships as the preferred mechanism for doing so. "You used to need a joint venture [if you wanted to invest in China], but now there's a notion of partnership," says Tony Upson, director of assurance and advisory in Beijing for PKF International, a network of firms which provide business advice and accountancy services. "Partnerships are widely used in the private equity industry which opens up a new range of possibilities for people looking to start [PE] funds in China."
In 2008, underscoring its desire for both foreign and domestic investor interest, the Chinese government abolished the preferential tax treatment for foreign-owned enterprises throughout all industries. Formerly, foreign-owned corporations enjoyed a preferential tax rate of 15 to 24 percent in China. However, because foreign investors were limited to special economic or technological development zones, the new 25 percent tax rate between resident and non-resident is preferable as foreign investors seek to expand their presence in more industries. The more level playing ground allows for a better regulated and transparent investment environment as rules and regulations continue to evolve.
"Clearly China has built up a regulatory regime far better than it was," says John Frisbie, president of the U.S.-China Business Council. However, Frisbie notes that there are some restrictions due to the government's long-standing efforts to promote "national champions" as a means of protecting economic security. National champions are usually state-owned enterprises (SOEs) and the State-Owned Assets Supervision and Administration Commission (SASAC) was established in 2003 as a holding company for approximately 190 large Chinese enterprises. The Chinese government wanted to help the best of the SOEs become business strongholds.
China's "national champion" policies have potential foreign private-equity investors cautiously predicting the advantages of investing in China. Often, investors find, the potential benefits outweigh any negative factors. "Few people realize that three-quarters of what goes into investment in China is not as a joint investor, but is wholly owned by the company—that's a big change from say, 30 years ago," Frisbie says. What bears watching, he adds, is "whether this trend to protect national champions will continue to get stricter or not."
Accounting regulations, particularly in the hinterland, continue to be a source of concern, however, and a focus of the Chinese government. According to the December 2009 issue of Thomson Reuters' World Trade Executive: "Further improving and maintaining the quality of accounting and auditing practices outside major cities of China poses an important challenge for the Chinese authorities." The report indicated that Chinese accounting law provisions instruct companies to follow a systematic approach when maintaining books of accounts and preparing financial statements.
Accounting standards in China are not necessarily aligned with International Financial Reporting Standards (IFRS) and tax reporting differences are not the only challenge for companies or investors doing business in China. Bill Reinsch, president of the U.S. National Foreign Trade Council, notes that in some cases, companies' efforts to invest in local projects in a province can be rejected—even if already approved by the province. It is not uncommon for the central government to overrule provinces, often with little explanation. "Here was a case where the federal government was overruling what the provinces were willing to do because they [federal government] wanted to maintain indigenous [ownership,]" Reinsch says. Despite potential confusion and the sometimes vague distinction between who governs projects within a province—whether local or federal—the economic growth rate, immense amount of opportunities and the onslaught of entrepreneurships can be reasons to ignore the potential complications.
The International Monetary Funds' Reports on the Observance of Standards and Codes (ROSCs) indicated that while strides are being made, there are equally high hurdles yet to clear. Some preparers of financial statements are able to manipulate accounting policies in order to avoid certain tax liabilities. "There are still some issues as not everyone is following accounting rules very strictly yet," Upson says. "Some listed companies and large enterprises continue to use the old Chinese standards." Upson also notes that in many cases, many private companies still adhere to older tax standards as well.
Addressing the many changes occurring in the PRC, Steven D. Bortnick, a partner at Pepper Hamilton, and John I. Forry, a principal with EisnerAmper LLP, point to a number of new laws and regulations enacted in recent years that are intended to promote foreign investment and curtail market abuses. For example, a Chinese Anti-Monopoly Law was instituted in August 2008, followed by an Anti-Monopoly Commission of the State Council, a month later.
The PRC has published a catalogue that indicates what businesses the government forbids, restricts or encourages for foreign investment. In 2007, the government added amendments indicating certain industries as preferable for foreign investment, such as high technology, advanced manufacturing, energy-saving, and environmentally friendly industries. The catalogue also indicated that companies seeking to use non-renewable natural resources are restricted or forbidden, as are certain business sectors, most notably news websites and search engines, which are deemed to be a threat to the economy.
"Another area to watch," says EisnerAmper's Forry, "is potential challenges by PRC tax authorities to the use, by foreign funds and other international investors, of tax treaties and offshore holding companies to reduce local taxes on holding or disposing of PRC investments."
Despite these challenges, there are rules promoting investors' abilities to raise funds from Chinese investors without foreign exchange controls or foreign investment approval requirements, according to Mayer Brown JSM, a global law firm advising on both regional and international transactions in Asia, the Americas and Europe.
Not everyone is optimistic as some of the Chinese government's restrictions are viewed as a hindrance to doing business abroad. Reinsch is reluctant to concede that the opportunities in China easily outweigh potential hurdles. "In general, my members are losing interest—it's getting more complicated [to invest in China]," Reinsch says. "China's economic policies are moving in an anti-market direction."
To improve the regulatory environment for outside investors, the World Bank recommends that the PRC make financial statements more transparent and available to the public, support access to updated IFRS and International Standard of Auditing (ISA) rules and improve overall education and training of personnel.
Upson warns foreign investors in China that, above all else, "avoid making assumptions." He insists that asking questions is the best mechanism to avoid misunderstandings and possible legal ramifications. "Even if the company in which you are interested is unlisted, you may want to consider using an audit firm that is qualified to audit listed companies, as it will be subject to more robust regulatory oversight," Upson writes. Despite these setbacks, the momentum behind China's market is too strong to ignore. "There are new regulations out and the way that they're set up has been relaxed," Upson says. "The government is obviously trying to make life a bit easier."
Private Equity Direct - February 2011 Issue