Deep Background
February 10, 2021

The Information Advantage on China Investments: Steering Around Risk

It’s possible to get better information in China, if you know what to look for, and know how to appropriately acquire it.

By: Randal Phillips and Jingyi Li Blank

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“China’s Economy Surges, and So Does Its Currency,” reads a recent New York Times headline.  It’s no secret that investments into China are growing; consider just some of the more recent developments: 

In September 2020, Citigroup became the first U.S. financial institution licensed to wholly own a China stock brokerage under the new Phase I trade agreement.  Others in line to open in China include American Express, Blackrock, JP Morgan and Vanguard.

Just one month later in October, the head of the world’s largest hedge fund, Bridgewater’s Ray Dalio, went onto CNBC to declare that “almost everyone is underweight on China.” He’s especially bullish on Chinese bonds.  

In December 2020, the Chinese detergent maker Blue Moon Holdings listed on the Hong Kong stock exchange.  The company raised approximately US$ 1.2 billion in its initial public offering.  The company’s stock price increased 37 percent in less than two weeks.  Six cornerstone investors led by Veritas Asset Management, the British investment fund, took US$ 235 million in the Blue Moon deal that accounts for nearly 21 percent of the IPO, according to press articles.

You might believe all this is happening because of the expectation of improving U.S.-China relations with an incoming Biden administration. “Not true,” says Randal Phillips, head of the Asia practice for Mintz Group.  “Investments in China are growing,” says Phillips, “but that is driven by market opportunity, not calming superpower relations.  Get-tough China policies now enjoy wide bipartisan support in the U.S., and Xi favors a hard line against the U.S. as well. There’s no going back to the softer Obama years.”

The Mintz Group team in Asia led by Randal and Jingyi are affected by this situation everyday in their work for clients – we team up to help investors – we have deep reach in China, and we understand financial and investment risks so we provide better info tailored to client needs.

Investments have Risks, and China Investments have China-specific Risks

Anyone who’s read an IPO prospectus is familiar with the daunting litany of risks disclosed therein.  So, imagine you’re perusing a hypothetical IPO for “China InvestCo” and got to the Risk Factors section.  It might include things similar to this:

  • The Blue Moon prospectus stated that “Our brands and products may be subject to counterfeiting, imitation, and/or infringement by third parties.  We rely on intellectual property laws in the PRC and other jurisdictions to protect our brands and trademarks … Failure to detect or prevent fraudulent or illegal activities or other misconduct by our employees, customers, distributors, suppliers or other third parties may have a material adverse effect on our business … including, but not limited to, those in violation of anti-corruption or anti-bribery laws … While we seek to improve our risk management and internal control systems on a continuous basis, we cannot assure you that these systems are sufficiently effective in ensuring, among other things, accurate reporting of our financial results and the prevention of fraud.”
  • The draft prospectus of the Ant Group IPO stated that “The financial services industry is subject to evolving and extensive regulation … We and our partners are subject to a broad range of laws and regulations, and future laws and regulations may impose additional requirements and other obligations that could materially and adversely affect our business, financial condition and results of operations … These laws, rules and regulations are highly complex, continuously evolving and could change or be reinterpreted to be burdensome or difficult to comply with … In recent years, there has been a deterioration in the relationship between China and the United States which has resulted in intense potential conflicts between the two countries in trade, technology, finance and other areas, and this has led to greater uncertainties in the geopolitical situations in other parts of the world affecting China and Chinese companies.  For example, export controls, economic and trade sanctions have been threatened and/or imposed by the U.S. government on a number of Chinese technology companies.”
  • The June 2020 prospectus supplement for JD.com stated that “Registered public accounting firms in China, including auditors of our consolidated financial statements in our prior annual reports on Form 20-F filed with the SEC, are not inspected by the U.S. Public Company Accounting Oversight Board, which deprives us and our investors of the benefits of such inspection … It may be difficult for overseas regulators to conduct investigation or collect evidence within China.”

All these bad things have happened to foreign investors in China…and much more.  For years we have helped our clients navigate all of these issues and others.  The importance of due diligence and having the best experts on the ground in China to steer you around pitfalls cannot be overstated.  

Why do investors continue to invest in China in record numbers?  Because there are rewards to be reaped if due diligence is done well.  

Understand Your Investment from China’s Perspective

China’s big opportunities come with equally big risks.  From trademark protection to due diligence to regulatory compliance, a whole new set of rules apply.  Over the last couple years and particularly in the last few months, our investor clients have been uniquely interested in the geopolitical and regulatory risk to their China investments.  A few guiding principles we have shared with them are as follows.

1. Map Your Position in the Framework

In some ways, China is more clear than almost any other government in stating its vision, strategy and policies.  Recently in October 2020, the Communist Party of China proposed major social and economic development targets for the 14th Five-Year Plan (2021-2025), a regular occurrence every five years, and Chinese President Xi Jinping made an explanatory speech at the meeting.  

The government spells out controversial (to foreigners) policies as well.  The Made in China 2025 (MiC) national strategic plan, enacted in 2015, is key to President Xi’s transformation of China from a low-cost manufacturing supplier to a global high-tech powerhouse.  To quote the Council on Foreign Relations, MiC “aims to use government subsidies, mobilize state-owned enterprises, and pursue intellectual property acquisition to catch up with—and then surpass—Western technological prowess in advanced industries.”  These sectors include electric vehicles, artificial intelligence, robotics. wireless communications, biomedicine and aerospace. In addition, MiC strengthens regulatory authority in anti-bribery, anti-monopoly, environmental and food safety protections.

When the government decides to implement its initiatives, it is decisive.  Investors need a clear understanding of how their investment fits into that plan … or doesn’t, and over the entire investment timeframe.

These plans are written in detail as are hundreds of other laws, regulations, guidelines, policies and drafts; and the overlap of national, provincial and local authorities is mind-boggling.  Much of the regulatory regime is new and evolving.  Which ones apply to you?  And have they changed recently?  How do they interact with other goals of the government?  Investors should first understand the policies that might impact their investment.     

2. Understand Enforcement of Relevant Policies

Because investments have a finite time horizon, the understanding of implementation, including timing, is crucial.  Chinese policies are often accused of being vague and hard to understand.  We help our clients navigate the purpose of various laws and regulations, the relevant bureaus and people who help to enforce them, and their motivations.  Also, in China, regulatory policies and procedures are a lot more local than you think.

The requirement to fall in line with government stated goals is not unique to foreign companies and investors.  Chinese companies must do the same.  For example, “Xi Jinping, long distrustful of the private sector, is moving assertively to bring it to heel,” according to a December 2020 Wall Street Journal article.  “The government is installing more Communist Party officials inside private firms, starving some of credit and demanding executives tailor their businesses to achieve state goals.  In some cases, it is taking charge entirely of companies it regards as undisciplined, absorbing them into state-owned enterprises.”

3. From the Horse’s Mouth and Predicting the Future

Most of our work is centered around conducting interviews with relevant people in all sorts of situations.  When we conduct research around China’s regulatory policies, we speak with a variety of knowledgeable people including many within the relevant bureaus of major and relevant regulators.  We help our clients understand how existing policies relate to each other and how implementation might take place.  

Our clients often ask us to predict the future.  If we could do that we’d be in a different business.  However, our years of experience do help us to give well-informed sentiment analysis based on current facts and previous experience.  We do help our clients spot problems predictively, before a real government bureaucrat shuts them down.

Due diligence — vetting the vetters.

To improve your due diligence standards and minimize the risk of your China investment, deal or employee hire:

  • Investigate your concerns:  There are always people who spot red flags that are discounted by senior executives eager for a deal to go through.  Rely on an experienced investigator to act on those suspicions and you could save your company, or your investment, from disaster.
  • Work with experienced local investigators: Find out if your investigators have “boots on the ground.”  Are these trained investigators?  Are they fluent in Chinese language and culture?  How well do they understand China’s regulatory bureaucracy and the differing national and local jurisdictions?  How deep is their relevant network? 
  • Assure investigations are ethical and legal: There are unethical investigators operating in China. Recognizing this problem, China’s State Administration for Market Regulation issued a “Notice of Special Inspection and Enforcement into Foreign Investigations” on July 27, 2020.  Be sure your investigators are compliant and adhere to the highest standards of practice.
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