USA Inbound Acquisitions & Investments Blog : Inbound Investment Lawyer & Attorney : Sullivan & Worcester Law Firm : Mergers & Acquisitions, Cross Border Investments

Does 2010 mean a renewal of inbound M&A activity? We have put the question to well-qualified investment bankers to get professional views. Brian McDonald, a Managing Director in the M&A Group of Houlihan Lokey, an international investment bank, has some very positive views. Brian has been a banker for over 20 years, advising both publicly traded and privately held companies in various industries. He has advised on numerous cross-border transactions.

USAInbounddeals: Commentators have pointed out that the level of M&A activity in the United States for mid-market businesses was lower in 2009 that it had been for several years. Are you forecasting an increase in M&A activity involving mid-size U.S. businesses for the remainder of 2010 or 2011 over 2009’s activity level? Can you suggest what the reasons for any increase might be? 

Brian McDonald: At Houlihan Lokey, we expect to see an increase in activity in 2010 and beyond, and we have already seen an increase in deal backlog. There is both pent up supply and pent up demand for transactions due to the lull in activity during the recent period of market disruption. Now that equity valuations have stabilized and the financing markets have begun to recover, we expect an uptick in M&A activity as buyers and sellers return to the market.

After the recent volatility in the equity markets, shareholders of family owned businesses are much more cognizant of the risks inherent in holding a significant portion of their net worth in illiquid stock of a single, small private company. Many such shareholders are now considering a sale, even though valuations are down from their pre-crisis highs. Also, long-term capital gains tax rates are expected to increase from 15% currently to at least 20% or 25% in 2011, providing an additional incentive for sellers to sell now rather than later. 

Private equity sponsors with older vintage portfolio companies need to sell those companies to return cash to their limited partners, so the current stabilization in valuations provides an opportunity to market those transactions. Corporates are also rationalizing their portfolios and exploring divestitures to either deleverage or to redeploy capital in their core businesses. 

Buyers also have a strong rationale to transact. Many large corporates have built up significant cash reserves by cutting expenses, reducing capital expenditures and reducing dividends. In 2009, many corporates were able to increase earnings even as revenues declined, because they reduced expenses significantly. This cannot be easily repeated in 2010. And since the economy is not expected to grow rapidly, these corporates will try to grow by using their cash reserves to make acquisitions. 

USAInbounddeals: If you believe that an increase will occur, are you predicting an increase in the activity level of foreign-based buyers (including their existing U.S. businesses) in the U.S. market? Are you willing to estimate how significant this increase might be? 

Brian McDonald: In recent years, foreign buyers have increasingly been active in the U.S. middle market. We believe that their demand for U.S. businesses will further increase in 2010 for a couple of reasons. First, the U.S. economy is expected to recover from its recession sooner and more rapidly than Europe. Therefore, European buyers will likely continue to look to the U.S. for growth acquisitions. Also, the recent sustained appreciation of the Euro relative to the dollar appears to be headed towards a reversal, particularly with the fiscal crisis in Greece. If European buyers conclude that their window for buying U.S. assets at “sale” prices will soon be closing, they may decide to jump in before the window closes. 

Asian buyers, particularly Japanese and Chinese buyers, have also been active, but less consistently. We expect buyers from these countries to continue to appear in select middle market transactions.

USAInbounddeals: Do you believe that specific U.S. industries are more likely to see increased interest from foreign investors or buyers? What might those industries be? 

Brian McDonald: We have seen the most foreign buyer interest in the industrial sector, real estate, and infrastructure services and materials.

USAInbounddeals: Are sell-side clients actively asking you to seek out foreign buyer interest? 

Brian McDonald: Yes. Sell-side clients often seek foreign buyers for several reasons. Most importantly, sellers want to maximize value and they recognize that foreign buyers can often pay more due to a strong currency or unique strategic considerations. If a foreign buyer views a U.S. business as a way to establish a platform in the U.S. or gain access to U.S. distribution channels, they may place a significantly higher value on the acquisition than a U.S. acquirer would.

Another reason sellers like foreign buyers is that they often represent the least disruptive buyer for the employees. If the buyer does not already have a U.S. business with which to integrate the acquisition, the buyer will typically retain most employees.

USAInbounddeals: Are you aware of any concerns in the M&A marketplace that the U.S. government’s screening of inbound deals makes them more difficult to complete?

Brian McDonald: Yes. Companies that service the defense sector or that sell directly to the government are often reluctant to include buyers from sensitive countries on their buyers list. Even if the seller is willing to invite a foreign buyer into the sale process, some buyers are reluctant to participate if they are concerned that the U.S. government may reject the transaction due to national security concerns. We have even seen this behavior by private equity funds that have significant limited partner equity from countries in the Middle East, for example.

This article is intended for informational purposes only and reflects the opinion of Brian McDonald, a Managing Director in the M&A Group of Houlihan Lokey. The material presented reflects information known to the author at the time this article was written, and this information is subject to change. 

About Houlihan Lokey

Houlihan Lokey provides a wide range of advisory services in the areas of mergers and acquisitions, financing, financial restructuring, and valuation. The firm was ranked the No. 1 M&A advisor for U.S. transactions under $3 billion in 2009 and the No. 1 U.S. fairness opinion advisor over the past 10 years by Thomson Reuters. In addition, the firm advised on more than 500 restructuring transactions valued in excess of $1.25 trillion over the past 10 years. Notable engagements cover numerous sectors and virtually all of the largest U.S. corporate bankruptcies, including Lehman Brothers, General Motors, WorldCom and Enron. The firm has more than 800 employees in 14 offices in the United States, Europe and Asia. Each year Houlihan Lokey serves more than 1,000 clients ranging from closely held companies to Global 500 corporations.

For more information on Houlihan Lokey, visit www.HL.com.

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Kraft Foods’ acquisition of Cadbury PLC has led at least one prominent British policymaker and one prominent business leader to consider whether Britain should take steps they believe will discourage short-term investment in its companies and encourage long-term investment, as if the two can be distinguished.  They are suggesting that legal and regulatory changes may be necessary to offset the market’s focus on short-term trading in favor of what they perceive as Britain’s need to retain the benefits of long-term investment. They appear to be advocating these changes without regard to the detrimental effects that their protectionist actions will have on worldwide foreign direct investment (FDI), including that originating in Britain. 

In an opinion piece published in the Financial Times in mid-January, Peter Mandelson, Britain’s Secretary of State for Business, Innovation and Skills, asked what steps might be taken to better align the interests of short-term and long-term investors and the interests of the owners and managers of publicly listed companies. He argued that financial markets often separate financial assets from real assets, with the consequence that the trading of financial assets leads to insufficient recognition of the importance of real assets. Lord Mandelson convened a roundtable discussion with investors, fund managers and company executives to establish a dialogue between investors and management of the companies in which they invest. The implication is that the lack of alignment between these groups too often results in a takeover of a real asset which in turn leads to the loss of the business itself to Britain. Additionally, the inability to assemble a pool of “patient capital” may be at odds with Britain’s needs for new technologies and infrastructure investment.

Lord Mandelson made clear that he was displeased with the failure of mergers and acquisitions strategies to create additional long-term value during the past 20 years. Although acknowledging that M&A can create economies of scale and technology synergies, he advocated openness by acquirors with respect to their intentions and robust criticism by shareholders. It is difficult to disagree with his analysis of the problem.  The recommendations for cure are quite another matter. 

More recently, Roger Carr, the chairman of Cadbury who resigned on February 3, called for an overhaul of M&A regulation in the UK. Mr Carr is arguing that his country’s regulatory scheme for takeovers works against the long-term interests of British businesses. According to news reports, he cited takeover practices as predatory and stated that the current rules reward short-term traders at the expense of owners with longer-term views. He suggested that the rules had resulted in too many UK business being sold off to foreigners, and that the sale of a domestic business to a foreign business was a loss to the UK. His sentiments were plainly protectionist and sounded like those of a sore loser. He seems to have said little about those UK companies who have walked the globe, acquiring businesses for strategic and other reasons or those UK businesses, such as Cadbury itself, who build plants outside of the UK to enhance profits.  

The thrust of the comments of both Lord Mandelson and Mr. Carr is that differentiation should be made between those who will hold their shares for the long term and those who will not. However, a requirement that shareholders be locked in or locked up means that investors give up their ability to sell their shares when the situation warrants. This stratagem shifts risk to shareholders, who will expect and in fact be entitled to a greater reward. These types of restrictions have existed in the past and have often allowed management to be less accountable to owners, since the owners cannot exercise their right to show their ultimate displeasure—by exiting their investment. 

Ultimately, however, changes in risk allocation and the balance of management/owner power in one geographic market can disadvantage companies in that market in terms of global capital allocation. If investment in British companies is stickier than in U.S. or Australian companies, then British companies may well lose value in comparison with their non-British peers. Given choices, FDI will always seek investment opportunities that are less encumbered. 

Then again, Lord Mandelson and Mr. Carr may believe that it is Britain’s best interest to erect a wall around its industry, buying some time to create Britain’s future. Deflecting foreign ownership will, however, likely lead to retaliation. It would not be surprising if other countries were to preclude British business from investing in or acquiring their businesses. Worse yet, it could lead to rounds of similar restrictions on investment in other developed countries and then to trade restrictions. This could have a disastrous effect on FDI and the strong world economy that has been developing since 1945, despite the shocks of 2008. Lord Mandelson and Mr. Carr could better serve their countrymen by leading UK businesses to build stockholder loyalty through the creation of true stockholder value and to be strong competitors in the world economy. 

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FDI promises to grow in importance to both developed and the developing economies in the new year. The world economy as a whole has not fully recovered from the slowdown of the past three years. What recovery has occurred has been selective, leading to stronger economies in some cases and leaving weaker economies in others. The imbalance suggests that opportunities for cross-border investments and M&A activities will abound and that those businesses, funds and individuals that have available capital will likely pursue them.

Heightened FDI activity will raise issues in the media, in academia and elsewhere. The issues that will garner the greatest attention are likely to be:

• Protectionism. If there is a sudden, large upturn in FDI into developed economies, will more inbound transactions be challenged by regulatory authorities? At the end of 2009, the Obama administration prevented the acquisition of FirstGold by a Chinese acquirer on national security grounds. Will this be interpreted as protectionism disguised? CFIUS has rarely outright blocked deals in the past, so a moderate increase in number of challenged deals may well be interpreted as a change in political attitude. Complicating the assessment is that foreign buyers will likely be shopping for natural resources business and high technology firms – both of which may have assets that are inordinately valuable and difficult to find elsewhere. These values may raise the stakes to investee nations when control of these assets is shifted offshore.
• Credit Squeeze. Buyers and investors with strong credit lines will likely be very attractive to targets who are starved for debt and equity capital. Distressed assets are in strong supply and can often be revitalized with infusions from capital from new owners with adequate capital supplies. Will buyers and investors remain disciplined and limit their capital at risk, or will there be “shopping sprees” as holdout sellers give up, price spreads narrow and well-endowed players run the table?
• FDI Extends the Service Sector. Economies that have built their capacities and economic fortunes on exports of manufactured goods with price advantages will seek to compete more aggressively by incorporating more of the value chain into their enterprises. They may wish to acquire design capability and marketing interface directly with their ultimate customers. Confronted with the question of “buy or build,” some businesses will look to acquire or invest in businesses that provide those services. This means businesses whose assets go home at night. From an operational perspective, this will raise issues of conflicting corporate cultures. Return on investments into service companies can also be more difficult to measure than investments in hard assets. The range of results on these deals will likely be broader than in other investments.
• Developed Assets More Desirable. For investors in the U.S. and Europe, assets – both hard and soft – that are developed and therefore require minimal additional expenditure, are likely to be more desirable than those requiring considerable additional investment. Consequently, in both developed and developing economies, greenfield investments may have a difficult time competing for investment capital. For outbound investors in China – where capital appears to be less constrained and risk tolerance may be greater – greenfield investments in the energy and agricultural sectors will remain top priorities. There may be a strong divergence that is building, with those economies and businesses in need of significant capital infusions turning away from investors in the developed nations and looking almost exclusively to investors in emerging economies.
• What Direction for Global M&A? The year 2009 brought a large number of strategic cross-border mergers and acquisitions, many with high profiles. The trend toward consolidation within industries will accelerate – the Kraft/Cadbury transaction being the poster child for these deals. Absent from the space at this time are the financial players, such as the private equity funds who have relied on leverage to complete their acquisitions and generate their returns. Will private equity and other private investors step back into the ring before credit has become more available, or will financial deals continue to lag strategic deals? The lack of clarity ahead for many businesses also adds uncertainty regarding valuation and pricing. With these factors taken all together, the return of robust cross-border M&A transactions does not seem imminent.

If we gain information on these FDI issues in the next six months, then the last half of 2010 may appear to be more predictable, especially if it is more in line with past trends. Given the change in direction that 2008 and 2009 brought compared to the immediately preceding years, any predictions – at any point – may deny the reality that volatility persists, even in FDI.

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Earlier this month the United Nations Conference on Trade and Development released two significant new publications. On December 1, UNCTAD released its inital Global Investment Trends Monitor. The publication reported data on global foreign direct investment (FDI) for the second and third quarters of 2009. On December 4, the UNCTAD Secretariat published its first Investment Policy Monitor. The aim of the Monitor is to provide the international investment community with current developments in foreign investment policies at both the national and international levels.

UNCTAD intends to publish its Investment Trends Monitor quarterly to provide the international investment community with regular assessments of global FDI. UNCTAD has developed its own index to measure FDI, based on FDI data for 67 economies that comprise 90% of FDI flows. The Investment Trends Monitor recorded an increase in global FDI from Q1 to Q2 of 2009. Specifically, the index rose 65% to 115 on a quarter-over-quarter basis. The increase was the first posted in five consecutive quarters. The G20 countries alone produced a 38% increase, according to the Index, but the increase affected only certain countries in the G20. Increases in the emerging economies were more limited. The Monitor warns that a full global recovery might not yet be underway, citing two reasons. First, cross-border global M&A was flat during the first three quarters of 2009. Second, the number of international, greenfield investment projects declined for the fifth consecutive quarter. The publication predicts that FDI flows for the third quarter will not show material improvement and will remain significantly below the year-earlier levels, but offers the optimistic prediction that “the overall environment for international investment is slowly improving.”

The Investment Policy Monitor assesses the national policy frameworks reflecting attitudes toward FDI. The report notes that during 2009 the majority of the 51 changes analyzed were for the “liberalization, facilitation and promotion” of inbound FDI. The report interprets this majority to mean that countries continue to believe that FDI is a means to finance their economic recoveries and promote their economic growth. The remainder of the changes included prohibition of foreign participation in certain industries, modifications to screening requirements and tightenings of regimes on investments that may relate to national security. The analysis differentiates between changes in the G20 countries and in non-G20 countries. The Investment Policy Monitor also follows changes in the general legal framework relevant to foreign investors in taxation regimes, state aid and stimulus packages. The report notes that between July and November 2009, 34 countries undertook measures related to foreign investment and 31 enacted state aid or stimulus packages or otherwise enhanced earlier such initiatives. Also included are new international investment agreements (including bilateral investment treaties) and double taxation treaties. All together, 82 economies were direct parties to new agreements in 2009.

Both publications include useful hard data and metrics and, for that reason alone, should prove exceedingly useful in the months ahead as FDI participates in and generates the expected global recovery.

UNCTAD was established in 1964 with the goal of promoting sustainable development while integrating developing countries into the world economy.

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A relatively small proposed investment in Firstgold Corp. of Lovelock, Nevada, a development stage mining company, has lead to a flurry of press coverage of the refusal by the U.S. Treasury’s Committee on Foreign Investment in the United States (CFIUS) to permit the deal. 

The proposed investor is Northwest Non-Ferrous International Investment Company Limited of Xi’an, China. Firstgold is a small-cap, financially-challenged gold mining business with four tracts in Nevada, but little operating history—in its own words, “a junior mining and exploration company.” The deal size has not been disclosed and may be less than $10 million. The deal structure involves three parts—the acquisition of senior secured debt from a disgruntled private investor, an additional loan to Firstgold and a purchase of a control equity stake, making Northwest both Firstgold’s parent and secured lender. The deal was first announced in July 2009. The parties did not make their CFIUS filing until late September.

After both a review and an investigation, CFIUS is recommending that the President disapprove the transaction. According to CNNMoney’s report, CFIUS apparently based its rejection on the proximity of one of Firstgold’s properties to Fallon Naval Air Station and offered several mitigation possibilities, none of which Firstgold accepted. The company states that the air base is 50 miles away. 

There is other speculation that the investor would use Firstgold’s gold assets—even if undeveloped at this point—to add to China’s hoard of gold, now totaling a staggering estimated $1.95 trillion. China’s gold reserves exceed Switzerland’s. 

Other news reports and blogs covering the development include:

• Reuters
• Northern Miner
  
• Exec Digital
• As well as Firstgold’s own release

This blog, in its October 1 post, alerted readers to the possibility of an unfavorable CFIUS outcome. We noted that management did not seem to approach the CFIUS filing with seriousness and as recently as October had predicted that its CFIUS filing would not be problematic.

The furor surrounding this development has an interesting footnote. The California Gold Rush of 1848-52 began with the discovery on gold on Mexican soil, specifically on land owned by a Swiss farmer, John Sutter—and ultimately led to the annexation of California by the United States. So there may well be historical precedent for the concerns of CFIUS. 

Updated  On December 22, Northwest withdrew from the transaction, Reuters announced.  Therefore, President Obama will not have to take direct action to disapprove the deal. 

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Will President Obama’s recent trip to China product any inbound FDI results for the U.S.? According to the U.S.-China joint statement, the November 16-18 trip produced significant agreements in five key areas of bilateral interest. There were tangential, but not explicit, mentions of FDI into the U.S. either by way of mergers and acquisitions or Greenfield investments.

Judging from the tenor and substance of the joint statement, the meetings further developed the mutual confidence and trust that are the predicates for a favorable investment climate. The five key areas of agreement were:

• The importance and productivity of regular high-level exchanges to the growth of the overall U.S.-China relationship
• The building of a bilateral strategic relationship that is positive, cooperative and comprehensive
• Strengthened dialogue and cooperation on macro-economic policies leading to global recovery
• Shared responsibility to cooperatively address regional and global security challenges
• Vigorous responses to issues of climate change, energy and environment

The joint statement implicitly references the importance of FDI at several points. There was express recognition of the importance of the U.S.-China Strategic and Economic Dialogue. “Both sides believed that the first round of the Dialogue held in Washington, D.C., in July this year was a fruitful one and agreed to honor in good faith the commitments made and hold the second round in Beijing in the summer of 2010.” The bottom line is that the U.S.-China FDI relationship appears well and growing and on track to produce results. Those results may not be evident until later next year. 

Further, while addressing the need to support the global recovery, the statement made clear that both sides are committed to open trade and to jointly fight protectionism and to resolve bilateral trade and investment disputes. The joint statement articulated the explicit promise of the U.S. and China “to expedite negotiation on a bilateral investment treaty.”

Prior to the release of the joint statement, reports had appeared in the Chinese press, notably the South China Morning Post, that a specific agreement would be reached to promote acquisitions of small and mid-size U.S. financial institutions by Chinese lenders. No such agreement or memorandum of understanding appears to have emerged from Obama’s visit.

A recent transaction involving a proposed takeover by China’s Minsheng Bank of failed California-based bank, UCBH Holdings, illustrates the formidable difficulties to be overcome if U.S. regulators intend to encourage Chinese lenders to invest in U.S. banks. Minsheng Bank had acquired a 9.9% interest in UCBH in 2007 and recently raised US$3.86 billion in its initial public offering in China. According to a report in The Wall Street Journal, Minsheng Bank also sought to acquire United Commercial Bank before U.S. authorities closed the San Francisco-based lender earlier this month. 

UCBH operated the United Commercial Bank, with several branches in California and also in other key Chinese American areas, such as New York, Boston, Seattle, Atlanta and Houston. United Commercial suffered commercial lending losses from loans to developers and home builders during the housing boom. A financial scandal led to a management shake-up. 

The Federal Reserve rejected China Minsheng's proposal to buy United Commercial Bank because of regulatory restrictions on foreign investment in U.S. banks and instead closed the bank. Soon after the closure, East West Bank, based in Pasadena, California, took over United Commercial Bank's roughly $7.5 billion in deposits, as well as $10.2 billion in assets. The Los Angeles Times reports that its takeover of UCBH will greatly expand its reach of East West, which has concentrated on Southern California and the San Francisco Bay Area. Interestingly, East West has a full-service branches in Hong Kong. 

The plain result of the regulatory actions is that a domestic bank with no interest in UCBH was permitted to acquire the business, while a foreign bank that always was a part owner of UCBH was not. The broader implication seems to be that any federal policy determined to promote inbound FDI will have to be based on a full and complete alignment of regulatory agencies at all levels. Otherwise, well-intentioned policies will be incapable of being executed. 

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The proposed business combination between India’s Bharti Airtel and South Africa’s MTN Group collapsed at the beginning of last month. Local and international politics appear to have played a substantial role in its demise. Therefore, some important questions should be posed. To what extent was the collapse a result of nationalism or protectionism masquerading as a different public policy? Is the withdrawal of that deal evidence of a wider global trend that may make foreign direct investment (FDI) more difficult to execute? As government stimulus programs end, will governments—U.S. and otherwise—use their power to shield companies that have been nursed through the downturn from foreign takeovers? 

Bharti is Asia’s leading integrated telecom services provider, with operations in India and Sri Lanka. MTN is South Africa’s leading mobile and fixed-line telecom company, with over 100 million subscribers and operations in over 20 countries in Africa and the Middle East. Their proposed combination was negotiated from the end of May to the end of September and had a value of approximately $24 billion. Bharti would have received a 49% stake in MTN, while MTN and its shareholders would have received a 36% stake in Bharti. The combined enterprise would have been the world’s third largest telecom company. 

The ominous notes for FDI come from reports in Dealbook and elsewhere that the South African government failed to approve the transaction because of protectionism and nation-building policies. This outcome was not necessarily predictable because both the Indian and South African governments have supported increased trade among developing countries in sub-Saharan Africa and South Asia. That “South–South” trade is intended to offset growing Chinese economic influence in the region.

Dealbook also reported that interventions by both Indian and South African governments imposed conditions that led to the end of the deal. The South African government required that MTN keep South African management in place and maintain a listing on the Johannesburg stock exchange in addition to its listing on the Mumbai exchange. Indian financial regulators were unwilling to waive their rules against dual listings. 

The South African blog SAgoodnews pointed out that there is a long history of dual listed companies and saw no reason why that requirement should have been terminal for the transaction. The blog also dismisses arguments that national political and labor pressures were at fault.

The Indian blog Trak.in News asserts that the Indian government had backed the deal at the highest level, with Prime Minister Manmohan Singh expressly giving the combination his support. The blog also suggests that the real issue was whether the national character of the combined business would be Indian of South African. South Africa’s insistence on the dual listing was a cover for this point. On the other side, the Indian authorities believed, but seem not to have stated, that the dual listing would effectively set a conversion rate for the rupee that could differ from the official rate of exchange. 

Both companies’ share prices rose after termination was announced. Stock analysts who had trepidations were pleased to see the transaction crater. It therefore is possible that, in addition to political agendas, there were financial issues underlying the headline events. Investors may not have been as supportive of the transaction as were the managements of Bharti and MTN. 

After September 30, both governments issued the usual palliatives, saying that they remain open for business and underscoring the importance of FDI. Rather than helping business decide whether to pursue cross-border deals in emerging economies, however, these positions and unarticulated rationales only obscure the facts. The recovery from the worldwide turndown is in its early stages. Obfuscations and half-truths do not bring recovery any nearer, as they only add uncertainty where business strategists would prefer to deal with articulated policies and certainties. 

What is true for developing economies such as South Africa and India is also true for the United States. Efforts to generate inbound investment must be very transparent and free from hidden conditions. Actual decisions and measures must align with policy pronouncements. In an environment in which the U.S. is hotly competing with other countries for inbound FDI, the U.S. government cannot afford to be less than utterly committed to inbound investors. Anything less will lead those investors to look for greener pastures—a lesson that South Africa may yet learn. 

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If imitation is the sincerest form of flattery, then the architects of the Foreign Investment and National Security Act of 2007 (FINSA) and its regulatory agency CFIUS can be proud. The Canadian government is revising its Investment Canada regulatory scheme. The result resembles the regulatory system here south of the Canadian border.

Recent Canadian statutory enactments and proposed regulations introduced a new national security review mechanism into the screening process. In 2007, FINSA amended the then-existing U.S. statute, known as Exon-Florio, to specify that national security was to be the sole focus of U.S. regulation. The new Canadian structure authorizes the government to review, block or limit inbound investments by non-Canadians based on national security concerns. One commentator has noted that although the legislation does not define “national security,” it remains to be seen whether the regulators will also consider issues of economic security under the national security umbrella.

Under the new regime, Canada’s national security process starts with a preliminary review of the transaction. If the initial review indicates that there are national security concerns arising from the proposed deal, then the Cabinet reviews and determines whether a full review is required. The review applies the standard, “injurious to national security.” If the transaction fails that standard, then the government may order the transaction blocked, restricted or, if closed, unwound. The maximum length of the review is approximately 3 ½ months. Once the time for review has expired, the Canadian regulators cannot challenge a reviewable foreign investment on national security grounds.

Under the legislation the government retains the authority to initiate a review of non-reviewable transactions, including minority investments, at any time within 45 days after completion.

Recent statutory changes will significantly modify the monetary thresholds for review of inbound transactions. If and when the proposed regulatory changes are made, the threshold will be applied to the enterprise value of the target, not the book value of its assets as is currently the case. The threshold itself is set at enterprise value of Cdn $600 million and will increase to Cdn $1 billion over the next four years.

FINSA and CFIUS are, of course, not the only national security-based regulatory schemes in place today. China, France, Germany, Japan, Poland, Russia and the United Kingdom, among others, based their regulatory reviews of inbound deals on national security grounds.

Canada is frequently mentioned together with Australia as the leading developed, resource-rich nations that are targeted for foreign investment by China and others aggressively looking to source commodities. Australia, by contrast, recently revamped its FDI regulatory scheme to limit the range of deals subject to review. Like Canada, it raised the threshold for review. That change and others are reviewed by our recent August 13 posting in this blog.

Unlike Canada, Australia did not adopt a regulatory scheme that specifically vets national security issues.

For a discussion of the role of national security in the CFIUS review process, please access the white paper located on our firm’s Web site.

Howard Burshtein of Torkin Manes LLP, Toronto, Ontario, contributed to this post.

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We wanted to alert you to a recent development that may be of interest to the FDI community. On July 1, 2009, the Civilian Agency Acquisition Council and the Defense Acquisition Regulations Council issued an interim rule prohibiting the award of U.S. government contracts using appropriated funds to any foreign incorporated entity that is treated as an inverted domestic corporation or to any subsidiary of one. The rule implements Section 743 of Division D of the Omnibus Appropriations Act, 2009 (Public Law No. 111-8). The Department of Homeland Security (“DHS”) has had a similar rule since December 2003, but the new interim rule applies to all federal agencies.

Briefly put, an inverted domestic corporation is one that (1) used to be incorporated in the United States or used to be a partnership in the United States but now (2) is incorporated in a foreign country or is a subsidiary whose parent corporation is incorporated in a foreign country. Congress enacted Section 743 – as well as an earlier tax statute – to discourage would-be corporate expatriates from trying to avoid United States taxes on business income generated in foreign countries by incorporating in “tax havens” such as Bermuda, Barbados and the Cayman Islands.

Section 743 borrows the definition of “inverted domestic corporation” from the DHS statute, which in turn is related to the tax statute. The long three-part definition defines an “inverted domestic corporation” as a foreign incorporated entity that, pursuant to a plan (or a series of related transactions):

1. Directly or indirectly acquires substantially all of the properties held directly or indirectly by a domestic corporation or substantially all of the properties constituting a trade or business of a domestic partnership
2. Acquires at least 80 percent of the stock (by vote or value) of the entity held (a) in the case of an acquisition with respect to a domestic corporation, by former shareholders of the domestic corporation by reason of holding stock in the domestic corporation, or (b) in the case of an acquisition with respect to a domestic partnership, by former partners of the domestic partnership by reason of holding a capital or profits interest in the domestic partnership, and
3. After the acquisition, the expanded affiliated group that includes the entity does not have substantial business activities in the foreign country in which or under the law of which the entity is created or organized when compared to the total business activities of such expanded affiliated group.

Under the regulatory scheme, an offeror for a U.S. government contract must represent that it is not an inverted domestic corporation or a subsidiary of an inverted domestic corporation. If the offeror cannot affirmatively make such a representation, then the offeror cannot submit an offer absent a secretarial-level waiver that contracting with the inverted domestic corporation or its subsidiary is in the interest of national security.

Because of the complexity of the definition of “inverted domestic corporation,” companies that could be considered inverted domestic corporations should consult legal counsel.
 

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Forget about Dubai Ports, forget about Huawei Technologies. There is a new crisis boiling over in foreign direct investment. A Russian billionaire may become the owner of a dearly beloved, U.S. professional basketball team and acquire a controlling interest in the team’s proposed arena in New York City.

On Wednesday of this week, the New Jersey Nets announced that, pending approval from the owners of other National Basketball Association teams and subject to a favorable outcome of litigation surrounding the construction of its new arena, Mikhail Prokhorov’s Onexim Group has agreed in principle to invest $200 million to acquire an 80% interest in the team, a 45% interest in the team’s unbuilt sports arena and the right to acquire a 20% stake in Atlantic Yards, the adjacent real estate project being developed by the team’s current owner, Forest City Ratner Companies. According to the release, the deal will ensure the completion of the proposed Brooklyn, NY-based arena, the relocation of the Nets to Brooklyn and the completion of Atlantic Yards. The tentative date for closing the deal is the first quarter of 2010. 

Mikhail Prokhorev is a high-profile, self-made Russian investor. Many blogs, including Keith Gessen of The New Yorker and Ethan Trex of Mental Floss, catalogue his controversial history. His six-foot-seven height and the fact that he has played basketball make Mr. Prokhorev one of those figures that invite focused interest, even if past media coverage wasn’t enough. And there is the matter of his reported $9.5 billion net worth, making him Russia’s richest man. In his statement, Mr. Prokhorev said, “I have a long-standing passion for basketball and pursuing interests that forward the development of the sport in Russia.”

Forest City’s Bruce Ratner added his own rationale for the deal, stating that he was thrilled that ”[S]mart global investors appreciate the exciting economic potential of Brooklyn. We are one step closer to achieving our goals of creating much needed jobs and economic development for Brooklyn and the city.”

Notwithstanding the promised benefits of the agreement, critics were quick to attack. NoLandGrab, a local opposition group, argues that there must be shady side deals that were undisclosed. Develop Don’t Destroy Brooklyn is adamantly opposed as well, asking

Putting aside legal questions, what are the ethics and policy principles of subsidizing the 40th richest man in the world with city, local and federal financial gifts, as well as a highly controversial use of eminent domain?

The New York Observer reports that Congressman Bill Pascrell Jr., who represents a district that is adjacent to the Arena where the Nets now play, has asked the NBA Commissioner to investigate the deal. Mr. Pascrell has raised questions about a foreign corporation’s benefiting from tax incentives being employed to support the arena. 

So all the elements now are in place for another epic battle over FDI. What will play out here—in the cosmopolitan metropolis of New York, in the legendary Borough of Brooklyn—is the same drama that unfolds in many American towns and villages when the concept of FDI materializes into the real-life acquisition of a local treasure. The forced migration of a sports team is almost always a deep and searing wound. Thousands of fans still mourn the losses of the New York Giants and the Brooklyn Dodgers to California, even though they happened 50 years ago.

The questions proliferate. Will the players or coaches be Russian? If they buy this franchise, will they buy others? Will Americans lose their jobs, even though they are high-paying jobs that most Americans can only dream of? Will foreign ownership change basketball, even though the team in question has never achieved a spectacular record? Will America lose control over one of its institutions, now treasured more in the anticipation of loss than ever before? Arguing that foreigners will benefit somehow from U.S. tax benefits is usually a start to a “we/they” analysis of the situation. Ultimately, someone will ask whether there can be some adverse affect on our national security? 

It’s a good bet that somewhere someone is toiling away, trying to figure out how review by the Committee on Foreign Investment in the United States (CFIUS) can be invoked. Forest City’s hometown paper, The Cleveland Leader, is already advocating that CFIUS must review the deal. 

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The global economy is struggling with some success to recover from the turmoil of the last two years. Attorneys, investment bankers and other professionals now are trying to predict where global mergers and acquisition activity will begin to increase. What markets are likely to first benefit from the return of global FDI?

Earlier this year, the United Nations Conference on Trade and Development (UNCTAD) released its World Investment Prospects Survey for 2009-2011 (WIPS). WIPS provides an outlook on future trends in FDI by the largest multinational business enterprises. WIPS compiled the results obtained from a sample of 241 company executives of the large non-financial multinationals and from 20 direct interviews. 

WIPS predicted the top 15 countries that will receive FDI for 2009 - 2011:

1. China
2. United States
3. India
4. Brazil
5. Russian Federation
6. United Kingdom
7. Germany
8. Australia
9. Indonesia
10. Canada
11. Vietnam
12. Mexico
13. Poland
14. France

The United States improved its position by one step over last year’s survey, replacing India in the number 2 slot. Brazil moved past Russia, achieving the 3^rd place position.

The reasons underlying the selection of these countries were predictable and included:

• market size
• market growth
• availability of less expensive labor
• access to natural resources
• quality of the business environment

Of even greater interest, however, is the distribution of the responses from the survey participants. First, the top 15 countries accounted for 74% of the total responses. This is close to the 80/20 phenomenon seen in other measure of voluntary market participant choices—such as favorite websites or favorite books—in which 80% of the respondents pick the same 20% or less of available choices. Second, as shown in the accompanying chart from WIPS, China, the United States and India appear to have more favorable responses than do the other twelve nations. This type of sharp drop off from highest to lowest in frequency of choice is referred as a power law curve. The power law curve is an algebraic graph plotting data in which the N position has 1/N^th of the first position’s rank. This distribution occurs where the responses represent free choices and is at odds with a normal bell curve distribution.* 

Then, what are those attributes that make a country attractive to FDI. WIPS recites:

• “For market growth, developing and transition economies are generally favored, such as China, India, Brazil, the Russian Federation, Indonesia, Vietnam, Poland and Thailand.
• For market size, the largest economies are favored, either developed ones such as the United States, Germany and Canada, or emerging ones such as China, the Russian Federation and Brazil.
• For access to regional markets, countries that are integrated into large markets, or which are close to large and growing economies, are favored, such as Mexico, Germany, Vietnam and Poland.
• For presence of suppliers, mostly developed countries are favored, such as the United Kingdom, Germany and France, and, to a slightly lesser extent, some developing countries such as India.
• For their business environment (including government effectiveness, stability and quality of infrastructures), developed countries such as the United States, Germany and Australia are favored. France is frequently mentioned for the quality of its infrastructure.
• For skills and talent, developed countries such as the United States, Germany, the United Kingdom and France are favored, but also some developing countries, such as India and Thailand.
• Cheap labor is cited for favoring developing countries, mostly in Asia, such as China, India, Vietnam, Indonesia and Thailand.
• For access to natural resources, countries well endowed with them, such as Canada, Australia and Indonesia, are favored.
• Access to capital markets is frequently mentioned as an asset for the United States, the United Kingdom and Canada. 
• Incentives is frequently mentioned for Australia, Vietnam and Brazil.” 

WIPS concludes on an optimistic note, expressing the view of its respondents that a progressive recovery will start slowly in 2010 and gain momentum in 2011. The basis for the optimism is that the growing internationalization of business enterprises will lead to a new wave of international investment projects as the recovery takes hold. When and if that occurs, these key factors are likely to play a major role in deciding where FDI is targeted. 

Implicit in these findings, and in the power curve as well, is a warning for the United States. The United States could fall behind its competitors for any one or more reasons – a slower recovery, unfavorable tax policies, protectionist trade practices or restrictive regulation of which investments, to name just four. The power curve is a slippery slope. If the U.S. falls to 4th or 5th place, it will fail to receive substantial amounts of FDI and may be unable to require the 1st or 2nd position for years to come.

*For a compelling discussion of the power law curve and its application in the context of social media, see Clay Shirkey's Here Comes Everybody: The Power of Organizing Without Organizations.

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Investment bankers, lawyers and other professionals often overlook the importance of other third parties in facilitating inbound FDI transactions. A prime example is the increasingly critical role that the economic development community may be able to play in bringing inbound mergers and acquisitions to the United States to stimulate recovery. 

Worldwide, there are over 7,000 economic development organizations (EDOs) and investment promotion agencies (IPAs) operating on behalf of cities, towns, regions and countries. There are over 4,500 members of the International Economic Development Council (IEDC) in the U.S. Since the economic turndown has resulted in significant businesses closures and job losses, U.S.-based agencies now may be looking to continued foreign investment to restart their economies.  Their search for inbound investment leads to rivalry and competition because demand for investment greatly exceeds supply. 

Economic development efforts are at an inflection point. Until 2008 or this year, EDOs have been seeking “greenfield investment”— the startup of a new business or the relocation of a existing business to their area. The worldwide economic crisis has, however, led to business consolidation. 

In a business consolidation phase, expansion is unlikely to take place. Instead, business combinations — mergers, consolidations or takeovers — occur. The aim is to spread greater business activity over lower expenses.

Lower expenses, however, often mean job losses, reduced requirements from vendors and fewer outflows in general. These effects are not the effects that EDOs desire to create. EDOs advocate for more jobs, more business for local vendors and increased outflows from new business into their community. So it becomes challenging for EDOs to advocate mergers, takeovers or other business combinations when the result may be to exacerbate conditions that already are bad. 

But, in a downturn, if businesses already are devastated, business combinations that take advantage of companies already shuttered or whose fate is clear unless repositioned can have salutary effects. It’s a question of public perception. That’s where marketing and education come in.

So the EDO agenda now has two goals. First, win public support for all forms of inbound investments, including business combinations with inbound buyers. Second, continue convincing inbound buyers of the significant benefits to be gained from owning and operating businesses in the U.S. 

The Strengthening Brand America Project aims to have U.S. EDOs place a higher priority on FDI attraction as a strategy for accelerated economic recovery. Founded by Edward Burghard, the Project is a community of practice targeted to EDO professionals. The Project’s goal is to facilitate the transfer of private sector product and corporate branding principles to the public sector.

The Project has succeeded in making publicly available data for inbound capital investment on a state-by-state basis for 2003 through 2008. fDi Intelligence, a specialist division of Financial Times, harvested and analyzed the data. The data gives an excellent perspective on the comparative successes of state-level EDO campaigns. For the five-year period:

• the top 10 states picked up more than 45% of the inbound investment
• the results vary considerably from $57,320 million for top-rated Texas to $287 million for bottom-rated Vermont
• among the bottom 80% of states, no state received more than 2.9% of the incoming funds

Results for 2009 are likely to differ significantly because the total incoming amount will be significantly less.

The overall challenge looms large—to replace these meaningful amounts of inbound capital investment with inbound M&A. With the support of the Strengthening Brand America Project and the data it provides, states and localities have superior tools to take on the task ahead. 

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A comment to this blog received last month questioned whether regulatory screening of inbound mergers and acquisitions by the United States conflicts with U.S. bilateral investment treaties (BITs).

BITs generally promise that the host country will treat all inbound investors equally with investors from the host country. The rationale is clear -- based on the treaty provisions FDI will flow into the host country and will be protected. BITs promise investors fair and equitable treatment for their investments, equal treatment with the host’s own nationals and “most favored nation” treatment, as well as a guarantee of full compensation should appropriation occur. BITs also establish an agreed-on tribunal for resolving disputes under the treaty.

The objective of BITs is to generate FDI. The general model of BIT currently used by the U.S. extends equal treatment with U.S. investors not only to businesses once established but also to the period prior to the actual creation of the investment, that is, while there is an agreement to acquire or invest. On the other hand, the purpose of a regulatory screening regime, such as the Committee on Foreign Investment in the United States (CFIUS), is to filter inbound mergers and investments so that foreign ownership does not impair the ability of the U.S. to defend itself. The policy is rooted in national security, not economic security or the protection of U.S.-based businesses against external competition. CFIUS implements its policy during the pre-investment phase.

The resolution to this apparent conflict between policies and the answer to our commenter’s question is found in the BIT itself. The current U.S. model form has the following provision, entitled “Essential Security,” that describes certain “Non-Precluded Measures” that the treaty permits the U.S. or the other treaty party to take:

Nothing in this Treaty shall be construed . . . to preclude a Party from applying measures that it considers necessary for the fulfillment of its obligations with respect to the maintenance or restoration of international peace or security, or the protection of its own essential security interests.

In laymen’s terms, as long as the CFIUS review is undertaken to protect essential security interests, it trumps the BIT’s provisions.

A few interesting facts about BITs, all extracted from a comprehensive and detailed overview of the topic authored by Lisa E. Sachs and Karl P. Sauvant of the Vale Columbia Center on Sustainable International Investment:

• the number of BITs worldwide have literally exploded over the past half century from one in 1959 to 2,573 in 2006, with more than 2,000 of these having been signed since 1989
• by the end of 2006, 177 countries had entered into one or more BITs
•  the economies with the most BITs are Germany (135), China (119) and Switzerland (114)
• the U.S. is not listed among the 10 countries who are parties to the greatest number of BITs, although it is the country that has entered into the greatest number (148) of double taxation treaties

The Sachs/Sauvant overview is essential and interesting reading for anyone seeking an informed perspective on the interplay BITs and FDI.

Thanks to my partner Jim Silkenat for his assistance in preparing this post.

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Intuitively, FDI into the U.S. should be increasing. An increasing chorus of economists is declaring that the recession at or near to an end. Asset prices remain low. IPO’s in the stock markets have begun to stir, raising hopes for exits from investments and for capital to recast balance sheets. The anecdotal evidence is that FDI continues to stream toward other developed economies such as Australia, and transitional economies, such as China and Brazil. Is the U.S. likely or not likely to be an early beneficiary of FDI flows as the world economy recovers?

OCO Global develops strategies for economic development organizations and investment promotion agencies worldwide. Led by its CEO, Mark O’Connell, earlier this year OCO’s editorial team published “A New Investment Paradigm,” a forecast of near-term market directions for FDI.

The findings of OCO’s report include:

• a prediction for a bounce in M&A from companies that normally would have expanded through greenfield investments
• firms from emerging markets have entered the world FDI market in force and are formidable competitors; these firms will use M&A as the pathway for investing in host economies; for example, Indian FDI into the U.S. could triple over the five years ending 2014
• OFDI from China nearly doubled and the trend is likely to continue, following the government’s promotion of a “go global” policy, particularly in service industries
• the vast majority of recorded OFDI from China has been from large state-owned enterprises (SOE’s); future OFDC is more likely to originate within its private sectors
• less than 5% of China’s OFDI has been directed at North America; there are at least two rationales for this relatively small percentage:
  • a lack of readiness by Chinese businesses to compete with large U.S. companies on their home turf; and
  • a fear of U.S. protectionism hiding behind a regulatory screen
• in China, the availability of foreign exchange reserves combined with credit availability makes OFDI affordable and inviting, particularly if targets with existing market share and recognized brands are cheap

One could connect the dots among these factors and conclude:

• the greater availability of credit to offshore businesses -- plus a strategic need to bolt on the right target -- gives inbound acquirers significant advantage
• the “buy versus build” scale may have tipped to the “buy” side for multi-national enterprises and investors
• low visibility of revenue growth for U.S. based companies may hold down valuation multiples, making acquisitions more affordable
• the need for capital, especially capital that increases employment and capital expenditures, may make inbound acquisitions more palatable -- even desirable -- in parts of the U.S.
• as more foreign buyer become truly privately-owned, and fewer are SOE’s, U.S. businesses and their constituencies (i.e., labor, localities, vendors) may become less averse to inbound deals

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Last week Wayne Swan, Australia’s Treasurer, announced significant reforms to Australia's foreign direct investment (FDI) screening framework. The reforms will invite addition mergers and acquisition activity, with a view to supporting economic growth and positioning Australia for a more competitive recovery beyond the global recession. 

There are concerns that the current economic turndown may lead countries to restrict inbound mergers and acquisitions. Australia nevertheless has taken commendable steps. Swan’s steps -- clearly anti-protectionist and pro-globalization -- reflect his assessment of the best interests of Australia’s economy. The reforms upsize the investment screening thresholds, set as fixed dollar amounts.

According to Mr. Swan’s press release, Australia’s government has recognized that the health of its economy is linked to the global economy. The government seeks to eliminate certain impediments to further FDI by removing itself from uncontroversial business transactions. The announcement makes clear that “Foreign investment is vital to Australia’s future growth and prosperity.” Reasons underlying this linkage are that FDI:

• creates jobs
• increases innovation
• promotes healthy competition

The current regulatory regime has six thresholds. The proposed regulations:

• replace the four lowest thresholds with one threshold of AUD 219 million
• replace those threshold that apply to U.S. investors with one threshold of AUD 953 million
• index the threshold amounts annually against the GDP price deflator
• eliminate the notice requirement that applies when foreign investors (other than U.S. investors) make a greenfield investment of more than AUD 10,000,000

Directly on the heels of Mr. Swan’s announcement, Yanzhou Coal Mining Co. reportedly launched its cash bid to acquire Felix Resources Ltd., based in Brisbane. Talks between the companies had begun over a year ago. According to Dealbook, Yanzhou’s bid is valued at more than AUD 3.5 billion. The offer may well test Australia’s liberalized outlook. 

To put the matter in context, China's direct investments in Australia reportedly grew from US $1.4 billion in Q1 2008 to US $13 billion in Q1 2009, a staggering 830% increase.

Dr. Peter Drysdale, emeritus professor at the Australian National University, buttresses Swan’s rationale. Dr. Drysdale, a noted Australian economist, speaks out against protectionism and in favor of cooperative, bilateral frameworks. He has told Xinhua, the official press agency of the government of the PRC  that “Anxiety over the growth of foreign investment in resources by China is unfounded.” Dr. Drysdale’s premise is that increased international cooperation brings benefits to both the investor and the host country. Outbound investments secure stakes in projects that can provide long-term supplies to China’s rapidly growing markets and also bring management know-how and technology to China. The host country receives capital, know-how and access to markets. The Australian government has clearly heard Dr. Drysdale’s appeal to put market solutions ahead of regulatory solutions. 

The Australian Government’s reform is particularly courageous in light of the current controversy over China’s July 5 detention of four Rio Tinto Ltd. employees, one of whom is an Australian national. Yesterday, there were reports that Shanghai prosecutors had approved the arrest of the employees. There is a predictable home-base backlash against FDI from China into Australia arising from China’s steps to deal with alleged thefts of secrets, particularly data with great value to China’s steel manufacturers, as well as bribery of non-governmental officials. 

Our July 16 post to this blog discussed the U.S. State Department’s support for inbound FDI into the U.S. As the Australians are proving, however, actions are louder than words.

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The Committee on Foreign Investment in the United States (CFIUS) figured prominently in the high level discussions held last week in Washington between representatives of the People’s Republic of China and the U.S. government.

According to the “The First U.S.-China Strategic and Economic Dialogue Economic Track Joint Fact Sheet,” the U.S. committed unequivocally that the CFIUS screening process would be non-discriminatory:

In addition, the United States confirms that the Committee on Foreign Investment in the United States (CFIUS) process ensures the consistent and fair treatment of all foreign investment without prejudice to the place of origin. The U.S. reaffirms its commitment to the open and non-discriminatory principles for recipients of sovereign wealth fund investment as identified by the Organization for Economic Cooperation and Development.

Two days of meetings were held among U.S. Secretary of State Hilary Rodham Clinton and U.S. Secretary of the Treasury Tim Geithner, as special representatives of President Obama, and Chinese Vice Premier Wang Qishan and State Councilor Dai Bingguo, as special representatives of President Hu Jintao.

Underscoring the importance of the meetings to the U.S. economy, President Obama addressed the opening session of the Dialogue. Twelve U.S. cabinet secretaries and heads of executive agencies also attended. The Fool’s Mountain blog carries an extended excerpt from the President’s address. There is no question but that the White House is taking substantive steps to acknowledge the importance of China’s investor status to the improvement of the U.S. economy.

Secretary Geithner’s closing statement, released on July 28, reflected the high profile that CFIUS has in these discussions. He reaffirmed U.S. commitments “to open and rules-based trade and investment” and to avoiding protectionist measures. In return, China agreed to increase its thresholds for “foreign direct investments that must obtain central government approval.” The accompanying release clarifies that China’s commitment means less regulation of inbound investment into China, particularly by its opening service markets to private investment.

The Administration seems determined to confront and allay the misgivings that Chinese investors and businesses have about the U.S. regulatory screening process. The prior experiences of Huawei Technologies and CNOOC are often cited to substantiate doubts, without equal time given to those transactions that proceeded without incident. In the conventional view of Chinese investors and businesses, any overall effort to increase investment from China requires clarity from CFIUS as to what U.S. industries, if any, are off limits. Congress has given CFIUS the gatekeeper role for inbound FDI. To keep CFIUS as far away from politics as possible, CFIUS must keep its profile low, remain nimble in its dealings and maintain intact its process for dealing with filed notices on a case-by-case basis. Pronouncements that characterize specific industries as in bounds or out of bounds will only attract the degree of attention that has been hostile to FDI in the past. Although foreign investors may genuinely desire more definitive guidance, that guidance may be better obtained from experienced U.S. advisors rather than backing CFIUS into unwelcome positions.

The net result of the meeting and the dialogue may well be that offshore buyers and investors — Chinese and other — see their way clear to proceeding with U.S.-targeted deals. This will be welcome news for private equity, venture and buyout funds with portfolio companies in need of cash. It will also be welcome news for M&A advisory firms, especially those who have built relationships in the developing world.

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Is it reasonable for U.S. businesses to expect mergers and acquisitions activity and investments from Chinese businesses? Our posts of July 10 and 13 highlighted a policy brief on China’s Changing Outbound Foreign Direct Investment Profile published by the Peterson Institute for International Economic and written by Daniel H. Rosen and Thilo Hanemann. Dr. Rosen agreed to respond to questions that we posed regarding China’s approach to mergers and acquisitions and other direct investments in the U.S.  Part I of our interview follows.

Dr. Rosen is an economic adviser specializing in China’s commercial development and writes and speaks extensively on US-China economic relations. He is the Principal of Rhodium Group, a specialized practice helping decision-makers analyze and understand commercial, economic and policy trends in Greater China. He is a graduate of the Graduate School of Foreign Service at Georgetown University and the Department of Asian Studies at the University of Texas, Austin. He is a Member of the Council on Foreign Relations and the National Committee on U.S.-China Relations. He is the author of Behind the Open Door: Foreign Enterprises in the Chinese Marketplace. 

Your recent policy brief addressing China’s changing outbound foreign direct investment (OFDI) makes a strong case for an expectation of increased OFDI.  In fact, you write that China’s OFDI is at an inflection point and that the geographical distribution of OFDI will shift toward the OECD countries. Do you expect OFDI into the United States to accelerate? 

Rosen: Yes.  Wherever Chinese producers are already OEMs or producers in value chains that lead to the US, they should be expected to move up and down those value chains toward US assets.

What are the characteristics of those American businesses that would be most attractive as investments for Chinese strategic investors?  

Rosen: Complementarily to Chinese capabilities, low price, non-union.

How important is the price level for those businesses?  Are distressed U.S. assets attractive to Chinese investors as an investment class?

Rosen: Price is important to Chinese firms, but not if it reflects extremely complicated situations.  China has little ability to work-out regulatory, labor or legal complexities, and so will tend to avoid them, or else have to rely on co-investors to deal with them. 

At various times in the past, both strategic and financial buyers have acquired or invested in U.S. companies.  How close are we to a time when Chinese financial buyers, as opposed to strategic buyers, will acquire U.S. businesses? 

Rosen: I think Chinese investment will be weighted toward strategic buyers who can generate value through expanded scope for a long while.  Financial investors from China have little ability to add value in the US.

You have written about the imperative for China’s firms to capture a greater share of the production chain.  The 2005 Lenovo transaction with IBM was a precursor of this type of transaction.  Do Chinese businesses and the Chinese government perceive the Lenovo transaction as a model to be followed?

Rosen: Lenovo is still considered an exceptional case, involving exceptional entrepreneurship.  Even still, it is not considered a home run in terms of performance.  It is a healthy example of the real, normal business challenges that will arise in even better Chinese forays abroad.

Part II of the interview with Dr. Rosen will be posted on August 3, 2009.

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How much merger and acquisition and other investment activity is directed into the United States? Is the level of foreign direct investment into U.S. businesses increasing or decreasing?

The Commerce Department’s Bureau of Economic Analysis has released three reports that provide measurements. The first, by Thomas Anderson, addresses new investments made to acquire or establish U.S. business in 2008. The chart included in this post shows annual outlays measured by this report. 

Significant findings contained in the report include:

• Foreign direct investors made outlays of $260.4 billion of outlays in 2008 to acquire or establish U.S. businesses. This level is the third highest on record.
•  46% of these outlays were for large-sized transactions ($5 billion or more), double the percentage of large-sized transactions for 2007.
•   2008’s level of these outlays was a 3% increase over 2007’s level of $252 billion. The rate of increase for 2007 over 2006 was 52%.
• Outlays for manufacturing businesses accounted for the majority of spending in 2008, with outlays for financial services businesses a distant second.
•  European investors made 61% of the outlays; Asia and Pacific made 17%. Outlays from Canada and the Middle East fell to 10% and 5% of the total.
•  Of the $260.4 billion total, 93% of the outlays were made to acquire existing businesses, with the balance to start up new businesses.

In April, the BEA had released its report on U.S. international transactions for 2008. Net financial inflows for foreign direct investment into the U.S. were $325.3 billion, an increase of 37% over 2007’s level. These inflows included financing of both existing and new U.S. affiliates and also reflected sell-offs and other subtractions and additions. They also excluded domestic-sourced funds that are used to make new investments. 

Earlier this month, BEA revised the $325.3 billion number for 2008 FDI downward by $5.5 billion to $319.7 billion. Because of a substantial upward revision to FDI reported for 2007, the new 2008 level represented a 16% year-over-year increase.

BEA has discontinued its survey that measures new foreign direct investment. Therefore, there will be no future reports on new FDI comparable to the first report referred to above in this post. Future surveys will collect related information on greenfield investments by foreign direct investors and their U.S. affiliates. BEA will also collect extensive data on FDI in the U.S. through its quarterly and annual surveys.

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Chinese regulatory authorities have taken an important initiative to encourage outbound FDI from China. U.S. private equity funds and other owners of businesses desiring investment should take note of these changes. These developments also are significant for investment bankers and other intermediaries, as the steps should enhance their ability to broker strategic arrangements. 

In June, China’s State Administration of Foreign Exchange (SAFE) announced that new regulations loosening its control on outbound investment procedures would take effect on August 1. SAFE will also modify its controls over foreign exchange management of domestic companies with overseas investments. The announced policy purposes of the modifications are to:

• stabilize external demand for domestic products;
• increase the efficient use of funds by Chinese enterprises; and
• support the “go global move” of enterprises “of diverse ownership” to stimulate exports.

The major changes that SAFE announced are:

•  “qualified enterprises of diverse ownerships” now can make overseas loans;
• sources of funds for overseas ownership are expanded and can include self-owned foreign exchange and foreign exchange purchased with Chinese currency;
• streamlining of procedures for overseas lending, which will be decentralized; and
•  improvements to statistical monitoring of, and risk prevention for, overseas lending.

In a related development, a former assistant professor of economics at an Indiana university has been promoted to chief of SAFE. The appointee, Yi Gang, is also a vice governor of the Peoples Bank of China. Mr. Yi taught at Indiana University-Purdue University Indianapolis from 1986 to 1994.

The changes announced by SAFE are likely connected to China’s accumulation of foreign exchange. The Financial Times reported on July 15 that China’s foreign reserve position had increased beyond $2.1 trillion. The merge results from capital inflows to take advantage of faster economic growth and inflating asset prices. These trends arise from the view that China’s economic recovery will be sustained, with GDP growth for the second quarter of 2009 expected to approximate 8%.

The Contrarian Investor’ Journal has opined that the next logical step will be towards the eventual float of the RMB, cautioning that the float will not happen imminently.  

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Earlier this month the U.S. State Department clarified its position on the importance of inbound foreign direct investment (FDI) to the U.S. economy. State released a fact sheet on July 1 entitled "The State Department, Open Investment, and American Jobs."  The fact sheet underscores the importance of FDI to economic growth and job creation in the U.S.

The fact sheet credits the Committee on Foreign Investment in the United States (CFIUS) with concluding action on over 150 transactions in 2008. This represents an increase of at least 9% over the 138 transactions that CFIUS reviewed in 2007. Of the 2008 transactions, 92% were mergers and acquisitions of U.S. businesses. The balance was likely to have been joint ventures or loan transactions. The State Department points out that, as a result of its membership on CFIUS, it has a direct role in the rulings that the panel makes.

Without doubt, inbound acquisitions and investments are quantitatively significant. In 2006, U.S. inbound FDI totaled $236.7 billion, or 1.8% of GDP. U.S. affiliates of foreign firms spent $395.8 billion on U.S. payrolls and $34.3 billion on U.S. R&D.

Because of these direct economic effects, the State Department wants its message to be crystal clear:

The United States has a significant stake, as both the world’s largest source and recipient of foreign direct investment, in working with our economic partners both multilaterally and bilaterally to implement policies that facilitate global investment flows.

State’s pronouncements and their forceful delivery add to the expectation that inbound FDI will assist in pulling the U.S. economy out of its current slump.

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