Asia's evolving private equity landscape

Linklaters partners discuss recent regulatory developments in the Asian private equity sector.

The following discussion with a number of Linklaters partners examines recent regulatory developments in the Asian private equity sector and key challenges to come in China, India, Indonesia, Japan and Korea.


What significant developments have taken place in the China market over the past few years?

Betty Yap: Two notices issued by the State Administration of Foreign Exchange (SAFE) in January and April 2005 brought many private equity transactions to a halt and it was with some relief when they were repealed and replaced by a new SAFE notice, which came into effect on 1 November 2005.

The previous notices required enterprises with foreign investment in China to issue a representation to SAFE, as part of their foreign exchange registration exercise. They needed to confirm whether any Chinese individuals or entities had ownership or control, either directly or indirectly, in the foreign investors of these enterprises. This created uncertainty for one of the most common private equity structures in China - private equity investments in overseas companies, which operate businesses and assets in China and are controlled by Chinese individuals or entities.

The notices were designed to prevent unauthorised transfers of assets offshore by Chinese persons. But they created uncertainty about SAFE's reaction (and the implications) if the existence of such Chinese interests were disclosed to it. It was by no means clear whether any specific SAFE approval was required in addition to the usual approval required from the Ministry of Commerce.

The November 2005 SAFE notice clarified the position. Any offshore private equity structure involving Chinese interests needs to be registered with SAFE, although it should now be clear that SAFE doesnÆt have any substantive approval role in the adoption of these structures.

In legalistic terms, the new notice is applicable to any offshore special purchase vehicle set up directly, or controlled indirectly, by Chinese persons (including natural persons) for the purpose of conducting equity financing outside China using the Chinese persons' assets within China.

The notice requires prior notification of the existence of these Chinese interests. In addition, it lays down a requirement that these Chinese persons must repatriate their foreign earnings back to China within 180 days.

With these latest regulations, much of the previous uncertainty seems to have been removed, although the notification requirements and the mandatory repatriation have lessened the attraction of structuring cross-border private equity transactions for Chinese persons.

On December 31, there was also a new spurt of legislative activity with the joint issue of new administrative measures by a number of PRC government departments including the Ministry of Commerce and the China Securities Regulatory Commission (CSRC). The government announced that foreign strategic investors will be able to acquire A shares in PRC listed companies that have completed their share desegregation reform.

These announcements comprised the detailed administrative provisions that were first contemplated in a notice promulgated in October 2005. For the first time, this provided for non-Qualified Foreign Insitutional Investors (QFIIs) to acquire A shares in PRC listed companies.

Of note to private equity firms is that the eligibility requirements for ôforeign strategic investorsö do not exclude them. They largely cover good standing and size requirements. These include a requirement that a foreign investor or its parent company must have offshore assets of not less than $100 million, or that the offshore assets managed by the investor or its parent company must be not less than $500 million.

Eligible private equity investors are, therefore, able to participate in this new initiative, although there are a number of trading and other restrictions including a minimum investment of a 10% shareholding and a lock-up period of three years, which makes short-term trades difficult.

Where do you see the key challenges and opportunities in China?

Thomas Ng: A new PRC Company Law and a new PRC Securities Law were introduced on 27 October 2005, and became effective on 1 January 2006. Some key restrictions in previous laws were removed, which provide opportunities to devise more flexible investment structures for private equity investors.

One new feature of the PRC Company Law particularly relevant to private equity investors is the ability for a PRC joint stock company to have different classes of shares with different rights attached. Indeed, new domestic venture capital rules issued recently now specifically refer to the possibility of preference shares.

Another new feature is a PRC joint stock companyÆs ability to repurchase up to 5% of its own shares in order to award shares to its employees. This opens up the possibility of establishing a workable employee stock incentive scheme onshore.

With these latest legislative developments, we not only expect an increase in private equity investment activities in China, but also a higher level of complexity in these transactions during 2006.


International private equity investment in India kicked off a decade ago following the governmentÆs economic liberalisation programme. However, initial interest was limited to the IT and telecoms sectors. Success in these sectors has encouraged private equity houses to look at other sectors such as textiles, pharmaceuticals, auto components and real estate.

WhatÆs sparked the recent interest in private equity in India?

Sandeep Katwala: Private equity interest in India has recently increased because foreign investors have been increasingly able to successfully exit from their investments. This was always a concern in the past.

WeÆve seen buy-outs of private equity investments in companies such as Daksh and DHL. The Indian stock markets are also at an all time high and private equity investors have been increasingly able to exit companies through IPOs. Examples of private equity investors using the stock market to exit include Biocon, UTI, and Mphasis.

What key aspects of the Indian regulatory and legal structure affect private equity investors?

Since economic liberalisation began in 1991, India has had four changes of government. Notwithstanding this, liberalization has been continuous and steady, although slow. Under the current foreign investment regime, the requirement of prior regulatory approvals has been dispensed with for foreign investment in many sectors.

Sectors of the economy where foreign investment was prohibited or severely restricted such as real estate, print media, FM radio, telecoms and airlines continue to be further liberalized.

Similarly, requirements concerning approvals for share transfers between residents and foreign investors have been considerably relaxed. Another significant change in government policy has been the removal of restrictions on foreign investors investing in more than one company in the same or allied fields.

This restriction, popularly referred to as the "Press Note 18" restriction, was cause for considerable discomfort among foreign investors seeking to invest in India. This is because it required the investor to seek permission from the existing joint venture partners before making investments in the same or allied field. Now the restriction (set out in "Press Note 1" of 2005) is limited to investment in more than one company in the same sector.

Since a large number of Indian companies are listed, foreign investors can also use the portfolio investment route to purchase equity in such companies. The portfolio investment route is almost completely free from foreign investor regulatory oversight, subject to regulations that apply equally to Indian investors, such as the SEBI Takeover Code.

In addition, Indian regulatory authorities have adopted a more investment friendly approach when dealing with applications in sectors where prior approvals are required.

Indian law allows for up to one third of the directors of an Indian company to be nominee directors, ie, not elected at a shareholders' meeting. Private equity investors in Indian companies can avail themselves of this provision to nominate directors to monitor and keep control of the investee company. Often these nominee directors have veto powers over important decisions such as significant M&A activity, distributions and borrowings.

Over the years, lawyers, bankers and accountants working on Indian transactions have perfected structures and investment vehicles, which give optimal tax benefits while minimising regulatory issues. This acquired knowledge from initial deals is a valuable asset that new investors can now benefit from.

Linklaters has a dedicated India group, comprising a number of dual-qualified lawyers who are specifically tasked with monitoring and developing the firm's involvement in the Indian market. The group (comprising partners and lawyers from London, Hong Kong and Singapore) supports members of the firm across practice groups, where necessary, to add their specific experience and knowledge of India to transaction teams.


The government's bank privatization programme, which began in 2002, has widely been seen as a resounding success with banks such as Permata Bank and Bank Danamon attracting significant foreign investment. The largest transactions of recent years have been dominated by heavyweight regional institutional investors such as Temasek and Khazanah - the investment arms of the Singapore and Malaysian governments.

What significant developments has the Indonesian market witnessed over the past few years?

Richard Good: The dominance of regional investors largely reflects concerns those outside the region have with the Indonesian market. Principal concerns include: bureaucracy; a weak regulatory environment; the enforceability of contracts and reservations about the quality and experience of management.

Formulating an effective exit strategy has also been difficult. The Indonesian stock market's performance has made IPO exits unattractive and the other obvious exit mechanism of a trade sale itself poses risks in a market that, until recently, has not attracted significant numbers of trade buyers.

Where do you see the key challenges and opportunities?

The political environment is looking more stable than it's been for some time, the economy is generally improving and FDI levels are increasing. Much was made in 2005 of proposed new legal and regulatory changes to encourage foreign investment.

This included proposals to introduce a more streamlined process for approving foreign investments and a new investment law, which promised to offer equal treatment for foreign and domestic interests. As yet no significant changes have been enacted.

Indonesia has a long way to go to compete with its neighbours for private equity funds. The signs are positive and the government has publicly declared its commitment to reversing the trend of declining foreign investment and creating an environment more conducive to international investors. But there is concern that without substantive reforms soon, Indonesia could continue to lose ground.

That said, Indonesia continues to be a market of under-exploited potential within the region and one that can, as was shown with the bank privatization programme and a number of the recent foreign investments in the telecommunications sector, generate significant returns for international investors. We've also seen increasing interest in South East Asia this year from investors in the Middle East and it's likely that Indonesia and Malaysia in particular will benefit from this going forward.


The past few years have seen radical changes in Japan, both in the volume of private equity funds looking to invest in Japan and in the M&A landscape.

What significant developments have there been in the Japanese private equity market over the past few years?

Casper Lawson: The market is almost unrecognisable from five years ago. A decade or so after the Japanese economic bubble burst in 1990, only a few brave funds were making large countercyclical bets on Japan business, which was seen as being in an endless recessionary trap. But those that did invest have seen some spectacular returns.

Most publicly, Ripplewood's investment in the failed Long Term Credit Bank (LTCB), which it floated in 2004 as the renamed Shinsei (literally new birth), drew the world's attention to the potential gains to be made in Japan. Many of those who were still doubters were converted when Ripplewood bought and sold Japan Telecom within 10 months for a disclosed gross IRR of 479%.

There was a hiccup in early 2005 when the Japanese government introduced legislation threatening a 20% withholding tax on foreign private equity gains, a result of the political unhappiness at the Shinsei gains having been made tax-free in Japan, despite the Japanese tax-payer having pumped around $70 billion into the failing LTCB.

The tax proposals caused indignant complaints and dire warnings about the collapse of FDI, but the tax changes went ahead anyway and the collapse didnÆt happen. On the contrary, more and more private equity money has been targeted at Japan. The main effect of the 20% withholding tax has been to make foreign funds increasingly careful to avoid establishing a permanent establishment in Japan, which is too easily done by accident and a costly mistake.

A few funds packed up and went home, citing the difficulty of finding suitable investment targets. But the overall funds flow has been clearly inward, with European and US giants like Permira and KKR setting up offices in Tokyo within the past couple of months.

How has the M&A landscape changed in Japan?

On the M&A front the changes have been no less dramatic. M&A has moved from the business pages to the front pages, with a series of hostile takeover attempts in 2005, which followed the breakdown since 2001 of the keiretsu (cross-shareholding) system. Most visibly, internet company Livedoor had a tilt at radio company Nippon Broadcasting System, rapidly accumulating over 35% of its shares in a form of market raid. This caused a flurry of angst amongst the establishment but engendered a surprisingly large degree of support from the general public, particularly the younger element, who liked the idea of a new media company shaking up corporate Japan.

The takeover attempt has had knock-on effects in several areas and equilibrium has not yet been restored. Several Japanese companies have installed poison pills for the first time in Japan.

Others have focused on increasing shareholder value, by distributing surplus cash piles or divesting non-core assets. The whole takeover regime badly needs an overhaul, but itÆs currently being done in a piecemeal fashion, with different regulators arguing, for example, both for and against the introduction of golden shares.

Some would say this uncertainty creates opportunity. Certainly, while some funds, notably M&A Consulting (an activist investor fund run by ex-bureaucrat Murakami-san), focus on shaking up management to work harder at creating value for shareholders, other funds make a virtue of eschewing ever taking hostile interests and instead position themselves as white knights to save management from actual or perceived hostile bids.

Interestingly, despite (or perhaps as a result of) foreigners coming under strong establishment criticism during the Livedoor bid, somewhat bizarrely since both bidder and target were Japanese, most of the hostile activity has been from Japanese firms while foreign private equity funds have generally avoided openly making hostile moves.

What do you see as the future of the Japanese private equity market?

Views are divided. Optimists are encouraged by increasing deregulation, for which the Japanese government deserves more praise than it usually gets. This includes a major rewrite of company law coming into effect in around May 2006, which will remove a large number of mandatory company law rules and permit shareholders to have a much wider selection of rights in relation to capital, management and distributions.

The rise of an entrepreneurial class of manager and the increasing focus on shareholder value are also positive developments. The fact that M&A, as a percentage of GDP, is only around one-third that of other large economies such as the US, UK or France, shows that M&A could continue its strong growth for many years to come.

Foreigners have been buying strongly into the Japanese stock market, increasing their holdings from around 6% of Tokyo Stock Exchange listed companies a dozen years ago to around 25% now. Since foreigners and funds are traditionally less likely to hold for the long term than strategic trade investors, this creates more possible targets for buy-outs.

Finally, club deals are starting to appear which, coupled with cheap yen-denominated debt, gives greater fire-power to investors and increases the number of potential buy-out candidates.

Conversely, pessimists point to the undeniably large increase in money to be invested, not yet matched by a large increase in willing sellers. The rising stock market could, paradoxically, reduce the pressure on companies to restructure and divest non-core assets. WeÆve seen false dawns before and the current enthusiasm for investment in Japan could be killed by any number of factors, such as government clamping down on the economy too severely, which killed the nascent 1997 recovery.

Who are right: the optimists or the pessimists? I believe both views have some truth and make some predictions:

- M&A will continue: the restructuring genie is out of the bottle and Japan will not return to its static ways of the 1990s.
- This will continue to create opportunities for private equity funds, many of which will make attractive returns.
- The easy pickings (with the luxury of 20-20 hindsight) of five years ago leading to triple digit returns are gone; funds will increasingly have to add value to realise value.
- Take-privates, especially MBOs, will increase; as will club deals.
- Although foreign funds have made the headlines, especially doing the larger deals, domestic funds will increasingly be visible, as we can see with Advantage Partners leading the bid for the multi-billion dollar food and cosmetics company Kanebo.
- Japan will still be Japan and money, while important, will not be everything. Successful funds will continue to have to be patient and the best deals may take months or even years of careful wooing before a target feels comfortable with the proposed investment.


Since the Asian financial crisis, the Korean government has made a number of radical legal reforms to encourage foreign investment. Private equity investors such as the Carlyle group has been well rewarded.

What significant developments have taken place in the Korean market over the past few years?

Sanghoon Lee: Since the Asian financial crisis, the Korean government has essentially liberalized barriers to entry. Laws that once restricted foreign investors from establishing or acquiring businesses or funds and purchasing publicly traded shares and other securities, have been amended or abolished. They now need no prior government approvals and have minimal reporting obligations.

As a result, Korea's economy has been opened up to foreign participation, and foreign investors have participated in the countryÆs continuing restructuring process. In many ways, the financial crisis and the Korean government's response has created one of the most developed private equity/M&A markets in Asia - certainly among markets of any significant size.

This can be seen in terms of both absolute and relative volumes of activity. Also, if you look at the role financial sponsors have played in the progress of certain industries in Korea such as banking, or the types of transactions being undertaken, itÆs difficult to find another Asian market where financial sponsor activity has had such an impact, or where you see such complex structures including leveraged deals.

In addition, many financial sponsors have experienced the full cycle - from investment to management and exit. More recently Korea has introduced regulations to permit the establishment of domestic private equity funds. A few fairly large funds have been established and it will be interesting to see if the additional competition results in an even stronger, more sophisticated market.

While much progress has been made in restructuring the economy and companies since the financial crisis, there are still a large number of assets/companies held in the hands of creditors. For many of these creditors, a trade sale may be an attractive route to rehabilitate these assets/companies.

What key challenges and opportunities do you see in Korea?

ThereÆs greater competition for deals in Korea, especially with the entry of domestic funds, as well as global funds that previously didnÆt focus on Korea. This has led to concerns that valuations may have increased and that financial sponsors have to compromise on certain aspects of the documentation and execution of deals.

There is also a continuing concern that the regulations have not kept up with the marketÆs many developments. For example, investors feel hampered by the rigidity of tender offer rules and the limitations they face in doing leveraged deals.

There are some whoÆd also say that the relatively greater role of the government in Asian transactions - both behind the scenes and in the approval process - can complicate transactions. As such, itÆs helpful to have management teams with a track record in the local area and counsel who are familiar with the regulatory environment.

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