Two years in, and the regulatory scrutiny on cross-border Chinese institutions is only intensifying.
Last month, authorities in China expanded their surveillance to bring into their purview one of the most popular circumvention routes used by mainland Chinese companies of late to invest overseas: via their offshore subsidiaries. Starting March 1, the offshore subsidiaries of all Chinese investors, including financial enterprises and individuals, need the approval of The National Development and Reform Commission (NDRC), China’s state planner, before closing any overseas transaction.
“We are advising clients to take a conservative view and go to the NDRC to ask for approvals for every deal”
In case the deal is what NDRC calls a ‘non-sensitive’ project, only a filing is to be made if the investment amount exceeds $300 million. But for ‘sensitive projects,’ irrespective of the size, a filing alone is not sufficient and companies need to obtain an approval. Additionally, the NDRC Order 11 also applies to Chinese firms sponsoring or investing in an offshore private equity investment fund, which was not under the regulatory ambit until now.
Chinese insurance companies and other financial institutions have increasingly been using their Hong Kong subsidiaries’ balance sheets to fund acquisitions, either in entirety or to meet the initial deposit obligation until the State Administration of Foreign Exchange (SAFE) approves their foreign currency conversion. One example was China Life Insurance’s $350 million acquisition of a single-tenant property portfolio from US manager ElmTree last May. China Life used its offshore investment arm in Hong Kong to pay for the deal, a company spokesperson had earlier confirmed to PERE.
In theory, these latest requirements are just additions to an already existing list of items Chinese investors need to check off before they sign a non-binding agreement. However, as things currently stand, several cross-border investors, their advisors and legal experts have told PERE they are confused and uncertain about how this circular should be interpreted.
Until the NDRC issues further guidance or until market participants have had more experience dealing with the regulators, investors will be “crossing the river by feeling the stones,” law firm Morrison & Foerster said in a note published in March.
The biggest unanswered question is what the regulators deem as a sensitive sector. While real estate and hospitality come under what has been termed as a ‘restricted sector,’ there is ambiguity about their definitions. For example, what if an investor is looking to acquire an operating platform such as an asset-light hotel management company instead of a hotel asset – is that to be considered sensitive? That is one question asked by Paul Guan, partner at global law firm Paul Hastings.
“We are advising clients to take a conservative view and go to the NDRC to ask for approvals for every deal. Instead of trying to circumvent rules, it is better to talk to regulators,” he says.
Even though the official filing process is simple, the outcome takes time. Institutions are required to file for an approval through an online application system, and it takes 20 business days for a decision to be made. In the case of a complicated deal that involves other Chinese regulatory bodies, the waiting period increases to 70 days.
There are also times when the investor neither gets a rejection nor an approval, in which case it may feel emboldened to take the risk and sign a deal, landing in regulatory trouble much later, a Beijing-based real estate investment manager told PERE.
Adding to the confusion is the number of regulatory bodies in China involved in these approval processes. SAFE is responsible for granting foreign currency quotas, in liaison with the Ministry of Commerce. The insurance investor community also has the China Insurance Regulatory Commission acting as a watchdog.
“There was always an issue with NDRC trying to grab the power to control foreign investments,” explains one Shanghai-based lawyer. “Investors were always confused about whether to go to NDRC first or to SAFE to approve its capital conversion. With Notice 11, it is clear that SAFE is not allowed to process any capital conversion unless the firm has obtained clearance from NDRC.”
Deployment and exits at stake
What started off as government-led measures to stem capital outflows and prevent a reckless depletion of China’s foreign reserves have widened in scope over the past two years to reign in speculative overseas deals by highly-leveraged domestic conglomerates.
“Even if one is following the books right now to remit money overseas, banks are asking more questions and the transfer process is slower than it used to be”
This has materially impacted the volume of Chinese cross-border investments. There was a staggering 75 percent drop in mainland Chinese capital deployed in US real estate deals in 2017, according to research by Cushman & Wakefield. From $18.3 billion worth of Chinese investments into the US in 2016, last year saw only $4.5 billion. Furthermore, the real estate consultancy expects outbound activity to cool by 30-40 percent this year, according to its Chinese investor intentions survey published in February.
“Nobody wants to be out there right now making a headline,” says Priyaranjan Kumar, regional executive director for capital markets at Cushman & Wakefield. “The next three quarters, at least, we are not expecting Chinese investors to bid for pure real estate assets.”
It is not just outbound deals that are stuck in limbo. Managers selling assets in mainland China are facing more scrutiny by local banks for remitting capital. Several managers use an offshore holding structure in Hong Kong or elsewhere to invest capital from their funds into China. The proceeds from the sale then need to be converted into US dollars or other currencies. One manager that runs a pan-Asia real estate fund told PERE that around 400 million yuan from one of its exits has been stuck in an onshore bank for two months and there is still no word on when it will be transferred.
Hong Kong-headquartered investment manager Arch Capital Management has had similar experiences.
“Even if one is following the books right now to remit money overseas, banks are asking more questions and the transfer process is slower than it used to be,” says Richard Yue, chief executive and co-founder at Arch Capital Management. “The banks want to make sure there is no hidden entity behind the receiving party.”
In one instance, it took Arch Capital Management over the year-end and Chinese New Year holidays to complete an exit because of the time taken by the Chinese bank to arrange the transfer.
But despite the lengthy process, the firm continues to have a strong pipeline of potential investment opportunities in China. Yue feels the fundamentals of the underlying property market in China are attractive and tighter controls in the country’s financial system are better for the stability of market in the long run. But for now he suggests managers factor in potentially lengthier transfers in their underwriting as a consequence of these capital controls.
Opportunity in distress
Even though these curbs are expected to continue, some industry observers insist there is no blanket ban on all overseas deals and certain kinds of transactions are still being approved, even encouraged.
“Long-term investments in the senior housing sector are being encouraged by the government,” Allan He, senior partner at Beijing-headquartered investment manager Cindat Capital Management, said at PERE’s annual summit in Asia in March. “This is because they recognize that this is an opportunity for investors to enjoy a stable cashflow and also put the operational expertise and operating models to use back in China.”
He said that the firm has been actively pursuing senior housing and healthcare deals over the past six months. Indeed, according to a Bloomberg article, the firm is planning to spend $2 billion this year on homes for the elderly in the US. “On the surface, one is seeing regulation and a lot of control,” he said at the PERE conference in response to a question on how capital controls have impacted its pace of outbound deals. “But, so far, our investor base has not been much affected because they already have dollars in offshore banks.”
Logistics is another sector that some say is being encouraged for strategic reasons, if the investment falls in line with China’s ambitious 65-nation Belt and Road initiative. China’s own state fund China Investment Corporation, for instance, was behind one of the biggest European logistics deals last year when it paid €12.25 billion to acquire Blackstone’s pan-European logistics platform, Logicor.
As the regional head of a large global institutional investor pointed out to PERE, this is a major reason why “almost everyone is trying to peg on the Belt and Road initiative to get regulatory approvals.”
Chinese investors’ run-ins with their authorities is also creating potential buying opportunities for Western managers. One of China’s most acquisitive investors, HNA Group, has reversed its ambitious buying spree and has been actively trimming its portfolio. According to Real Capital Analytics, the group has disposed of around $5.5 billion of overseas real estate and hotel company stakes since the start of this year. Such deals will open the door for private credit lenders like the New York-based Mack Real Estate Credit Strategies to provide debt capital to opportunistic investors bidding for assets.
However, Peter Sotoloff, managing partner and chief investment officer at the firm, does not believe these exits will all be distressed in nature. “They [Chinese firms] are so far being thoughtful in how they are monetizing these assets. Except for the development sites that have a higher execution risk, these sales are not creating a windfall of distressed real estate opportunities,” he says.
China’s crackdown on outbound deals comes at a momentous time for the country. Last month, its congress passed a major constitutional amendment allowing for the removal of presidential term limits. This means that President Xi Jinping, whose tenure was set to expire in 2022, could remain president for life. This news was followed by the nomination of Yi Gang as the country’s new central bank governor.
President Xi has already made a public resolution to tackle financial risks arising from overleveraged institutions. Until this stance shifts, Chinese cross-border investors should be prepared to face a bumpy ride.