China is now the world’s third largest overseas foreign investor, behind only the United States and Japan. With the inception of China’s “Go Global Campaign” in the early 2000s, in just 10 years Chinese Overseas Foreign Direct Investment (OFDI) has grown from a mere trickle to an estimated $120 billion in 2014. Within two years, it is estimated that Chinese outbound foreign investment will exceed inbound investment in China. Some Chinese government agencies estimate that total OFDI from China will exceed two trillion U.S. dollars by 2020.
Contrary to popular belief, taking on Chinese investment is rarely easy money.
The structure of PRC OFDI has also changed rapidly. Early investments were dominated by state owned enterprises, with most of those investments funded by Chinese state owned banks. That investment was focused primarily on Asia and Africa and it was designed primarily to secure key raw materials and secondarily to focus on developing secure trading and manufacturing networks in those regions.
This structure of investment meant that until quite recently U.S. businesses saw very little investment from China. In just the last several years however, this situation has changed. Chinese investment into the United States, however, has been quite different from China’s pattern with the rest of the world. Investment in the U.S. has been primarily from private businesses, mostly funded from outside China’s banking system, and not primarily focused on securing raw materials.
The major new trend that I and the other China lawyers at my firm are seeing (both from here in China and back in the United States) is rapidly increasing participation by Chinese SMEs in US investments. Though the motives for these investments vary widely, investments by Chinese SMEs are — surprisingly — not primarily focused on investment returns. Instead, the SME investments are usually designed to provide the PRC entity with some other advantage.
We typically see two common motivations for China SME investment into the U.S., depending on the type of industry. For companies in traditional export industries such as furniture, shoes, clothing and housewares, the Chinese SME is usually looking for a secure market for its products. For technology companies, the Chinese SME is looking for privileged access to technology that it will be able to exploit in China.
The structure of the Chinese SME transactions is also quite different from the norm. Most foreign investment by Chinese state owned entities has been in big ticket M&A transactions where the Chinese purchaser takes a 100% or controlling interest in the acquired entity. Chinese SMEs have preferred to take a more conservative route by usually buying only a minority ownership interest in the U.S. company. The China SME then couples this minority investment with an additional agreement to secure the benefit on which they are actually focused. For the traditional exporters, this will typically be a long-term contract with their Chinese factory. For the technology investors, this will typically be a favorable long-term license for a key technology.
The U.S. side must take care to negotiate these types of Chinese investment with great care. In a typical minority investment, the minority investor primarily focuses on minority investor protections, such as super majority decision rules or anti-dilution requirements. Chinese investors typically ignore these issues and are willing to fund the venture with minimal documentation. This then looks like “easy money” to the U.S. side, which too often leads them to make fundamentally bad decisions.
In the traditional manufacturing type of venture, the common mistake is for the American company to agree to a long-term supply contract with the Chinese factory that is financially unattractive to the U.S. parent company. In the technology ventures, the common mistake is for the American company to enter into a license agreement that results in their giving away key technology to the Chinese investor. When we point out these mistakes to the U.S. side (my client), their response is almost always, “But the Chinese side is a co-owner of the U.S. parent company so I know that it will not make any decisions that could harm the U.S. parent. So there really is no reason for us to be concerned about getting trapped into a bad manufacturing agreement or license.”
These American-side explanations are based on the wrongly held belief that the Chinese side is investing for US returns and they almost never prove true. The Chinese investor is almost never concerned with the success of the U.S. parent; it is concerned only with the short-term benefit(s) that will accrue to the Chinese company. The Chinese side does not even care about financially destroying the U.S. company. It is therefore critically important that the “side” agreements in this type of transaction be drafted to provide maximum protection for the U.S. parent and its U.S. investors. This is seldom done, with predictable results. I know this both because we get called in to represent American companies in these transactions and because we get called to try to fix these deals after the American companies realize their true nature.