China's Belt and Road Initiative (BRI) is a monumental global development program initiated to connect China with the world to promote trade, economic integration, and growth. Since its inception by President Xi in 2013, the BRI, set out along ancient land and maritime networks, is now a US$1 trillion project spanning over 137 countries and 30 international organizations.
For many investors, particularly Chinese investors, the attraction of South East Asia (SEA) along the BRI is clear. SEA is a large and relatively untapped emerging market experiencing significant economic growth, has relatively lower costs, has a growing middle class, and has huge growth potential. Whilst the general investment outlook for SEA remains cautious due to the US-China trade war and regional geopolitical tensions, the attraction to “go south” has increased in recent times with Chinese companies seeking to hedge their risks, restructure their supply chains, and avoid tariffs arising from the US-China trade war and with the recent uncertainty in Hong Kong. Along with its key focus on infrastructure development and construction, SEA's key sectors for investment now cover manufacturing, wholesale and retail, technology/media/telecommunications, real estate and power.
In this article, we will discuss the key issues to note in structuring and managing a successful investment in SEA along the BRI.
Understand and hedge against macro-conditions
Due to their developing status, many SEA countries generally face a common set of problems. These include relatively poor infrastructure and transportation connectivity, lack of clear and detailed laws, lack of consistency and transparency in the application and enforcement of laws, greater level of government control and intervention, longer and more complicated government approval processes, and currency controls. These problems are more apparent in SEA's frontier countries such as Myanmar and Laos, as compared to more developed countries like Singapore.
Many SEA countries occupy low rankings in the Global Competitiveness Index 2019. Indonesia is ranked 50, Philippines is ranked 64, Vietnam is ranked 67, Cambodia is ranked 106, Laos is ranked 113, with the exception of Singapore which is ranked 1. Many SEA countries also score poorly in the Corruption Perceptions Index 2018. Indonesia is ranked 89, Philippines is ranked 99, Vietnam is ranked 117, Laos is ranked 132, Cambodia is ranked 161, again with the exception of Singapore which is ranked 3.
Investors should: (1) Establish and maintain a good network of contacts and relationships with government authorities and agencies; (2) Set realistic timetables and build in appropriate buffer times to cater for delays in administrative processes, consultations with regulators, internal and external co-ordination, and cross-translation of documents; and (3) Be flexible in negotiating issues and resolving disagreements through legal (both traditional and alternative) and commercial means, whilst ensuring that core legal interests are protected.
Assess foreign investment laws
Many SEA countries have foreign investment regimes prohibiting or restricting foreign investment in certain sensitive sectors, the concept of which is similar to China's Negative List.
For example, Thailand has a more restrictive foreign investment law. Thailand: (a) prohibits foreign investment in press, farming, forestry, fishery, land trading and other special sectors; (b) restricts foreign investment (i.e. by requiring prior Thai cabinet approval) in businesses related to national security or safety, and businesses that could have an adverse effect on arts and culture, natural resources or the environment; and (c) restricts foreign investment (i.e. by requiring a foreign business license to be obtained) in businesses which Thai nationals are not yet ready to compete with foreigners (e.g. construction with certain exceptions, small-scale wholesale and retail, hotel operation, and a catch-all category known as “other services”). The Thai government imposes severe penalties for violation; a nominee shareholding arrangement circumventing foreign investment laws is an illegal act that attracts both civil and criminal penalties (including a fine and jail term).
In comparison, Vietnam and Cambodia have less restrictive and more equitable foreign investment laws. Vietnam restricts investment in certain “conditional sectors” such as those relating to national defense and security, social order and security, social ethics, and public health, but these restrictions apply to both foreign and local investors alike. Having said that, the Vietnam government could place certain restrictions on foreign investment in certain sectors (such as on the form of investment and via foreign ownership limitations). Cambodia does not close any sector to foreign investment in principle, and restricts investment in the production/processing of narcotic substances, production of poisonous chemicals that affect the public health and environment, production/processing of electrical power by using waste imported from a foreign country, and prohibited forestry exploitation. However, such restrictions are again applicable to both foreign and local investors. In this regard, Singapore has the most permissive approach towards foreign investment as it does not have a discrete foreign investment law. Investments in certain sectors such as finance, banking, telecommunications and power, however, may require prior regulatory notification or approval.
Investors should: (1) Check their proposed business activity against the foreign investment laws of the host country beforehand to ascertain whether it is feasible, whether there are any government approvals required, and what the procedures, documents and timeframes involved in obtaining such approvals are; (2) Reach out to the government authorities and seek early clarification if the proposed business activity is in a grey area, and be prepared to present a case to convince the authorities or to restructure the investment; and (3) Prepare applications for government approvals together with the required supporting documentation with care and in advance, as document translations or document notarization/legalization for use between countries would take time and affect document submission or approval timeframes.
Different sectors , different approach
Certain sectors, such as construction, natural resources and banking, are protected and more heavily regulated than others. Investing in such sectors requires complying with more onerous requirements. These can include establishing a local presence, partnering up with a local entity, being subject to foreign ownership caps, obtaining an array of permits and licenses, submitting regular reports to government authorities, and complying with foreign labor restrictions.
A case in point would be the Indonesian construction sector, a sector that is poised for significant and imminent growth following Indonesia's decision to relocate its capital from Jakarta to East Kalimantan. Foreign investors who want to provide construction services in Indonesia are required to set up, together and in cooperation with an Indonesian construction company, a joint venture company (BUJK PMA) or a representative office (BUJKA RO). For general construction activities, foreign investors from countries outside of the Association of Southeast Asian Nations (ASEAN) can hold up to 67% of the shares in a BUJK PMA, whilst foreign investors from ASEAN countries can hold up to 70% of the shares in a BUJK PMA. The construction sector licensing regime requires investors to first obtain a Business Identity Number from the Online Single Submission system, following which a temporary construction permit will be issued, and then an effective construction permit will be issued once certain conditions are fulfilled by the investor (most notably, after a business entity certificate from the National Construction Development Institution is obtained).
Some sectors (such as large-scale infrastructure, power and construction) often are led by or involve government or state-owned entities. Such entities could be driven by political or public interest considerations, and not (or not just) profit or commercial motivations. Their decision-making and approval systems are usually multi-layered and more cumbersome. Their procedures and documentation are usually more time-consuming and complex, involving concession agreements, pre-qualification requirements, and open tender and procurement requirements. Where the host country in question is a developing country with poor governance, the process can also be vague and opaque.
Investors should: (1) Approach and structure each deal differently, depending on the industry in question and on whether the deal is driven by the public or private sector; (2) Be familiar with the applicable regulatory and licensing framework for their industry and project; and (3) Communicate regularly with the government authorities and plan ahead to ensure that regulatory requirements are met on time.
Different transactions, different strategy
The legal and commercial considerations involved in structuring M&A and investment transactions share many similarities across many industries, and would apply to transactions in other parts of the world just as they would in SEA.
For example, in a greenfield investment, where the focus is on developing a project for a new entity: (a) transaction capital would be injected into the new entity; (b) construction requirements and timeframes, and the corresponding investment, financing and risk-sharing arrangements are critical; (c) an extended exit structure such as via conditions subsequent should be in place to protect against project delays or abortions; and (d) the focus of due diligence, representations and warranties, and indemnities will be on the proposed project going forward, and forward-looking commitments and undertakings to ensure project completion should be in place. In a M&A transaction, where the focus is on acquiring an existing entity: (a) transaction capital would be paid to the seller; (b) the nature of the acquisition and consideration structure is important (i.e. whether complete or partial/staggered with earn-out mechanisms); (c) a more limited exit structure via conditions precedent would usually be used; and (d) the focus of due diligence, representations and warranties, and indemnities will be on the existing entity being acquired.
In a bid deal, which are particularly common for government tenders and PPP (public-private partnership) projects where bargaining power rests with the project owner, bidders typically face higher pricing pressure, have to adhere to tighter timetables, can only conduct limited due diligence, and have less room to negotiate contract terms. In a 1-on-1 negotiated deal, where bargaining power is typically more evenly balanced, parties have more leverage to maneuver and eke out a deal.
If investing in an asset-heavy company with steady and predictable revenue streams, traditional valuation methods and consideration structures (e.g. cash or cash plus equity, subject to adjustment with completion accounts) can be applied. If investing in an asset-light company where revenue is particularly susceptible to volatility or seasonality (e.g. service or technology companies), contingent or adjusted consideration structures involving milestone payments, earn-out payments, holdbacks or clawbacks could be useful.
Chinese investors typically want to obtain control of the target company when making outbound investments, thereby allowing for the target company to be financially consolidated as a subsidiary under the parent Chinese company. Having said that, retaining the seller as a minority shareholder to continue to run the target company on the motivation of future earn-out payments can help ensure the continued stability and success of the business. In such cases, the majority shareholder must take care not to allow “control” (from an accounting perspective) to be implicitly ceded to the minority shareholder, as that would prevent financial consolidation. This can be done by ensuring that the majority shareholder retains the right to decide on key matters such as business and strategic plans, financial budgets, and appointment of senior management. At the same time, the minority shareholder must buy-in to such an arrangement, and be convinced that it would still be confident of achieving the earn-out payments even though it would not have the right to decide on key company matters. A careful balance thus needs to be struck.
Different types of transactions have different sets of risks and issues. Investors should: (1) Focus on the key concerns based on the type of transaction and pick their battles accordingly; and (b) understand their counterparty or partner, learn about the cultural nuances of doing business in the host country, and tailor their negotiating approach accordingly. During negotiations, the phrase “market standard” is often used (and sometimes weaponized) by both sides; such a concept should not necessarily be accepted at face value as it may vary between countries, and indeed can be an evolving concept in many developing countries in SEA.
Go local, Be local
SEA is a culturally, ethnically, politically and linguistically diverse region with 11 countries, 14 official languages and hundreds of dialects, and numerous ethnic groups. Individual countries in SEA have very different legal heritages and legal systems at varying stages of development. Successfully navigating these differences, whilst integrating them with Chinese business culture and practices in the case of Chinese investors, is key to a successful investment.
Investors should: (1) Source for a reputable and reliable local partner or contact, especially if they are investing in the country for the first time and looking for a suitable entry point into the industry; (2) If an expatriate team from headquarters is to be posted over to head up the local team, such expatriate team should be kept lean and team members must have the relevant language capabilities and sensitivities towards cultural differences; (3) Employ and retain key local management and staff who understand how things work on the ground, and engage with them and trust them to operate the business; (4) Resist the urge to micro-manage the local management or to parachute in a large expatriate team; and (5) Promote integration and regular interaction between the expatriate and local teams.
Understand and hedge against geo-socio-political landscape
The geo-socio-political landscape of SEA can be volatile and unpredictable. Global tensions over BRI simmer from pushback by the US and other key competitors seeking to contain China's growing influence. Regional and national tensions in SEA exist over allegations of China's intentions and debt financing terms in BRI projects. All these create additional risks to investors that are hard to allocate or mitigate due to their “force majeure” nature.
For large-scale infrastructure and construction projects, presently a hot sector for Chinese investment in SEA, this is a particular risk due to the complex nature and lengthy timeframes of such projects. For example, in Malaysia, three BRI projects were halted in 2018 following the change of government from Barisan Nasional to Pakatan Harapan, one of which was re-started in April 2019 following an agreement by parties to cut costs. Two large real estate deals in Malaysia I had advised Chinese developers on also stalled due to fallout from political and environmental issues.
The huge political, cultural, economic and linguistic diversity in SEA means that close regional economic integration will be challenging. The chances of a European Union-like integration – a single unified market with free movement of goods, labor and services – is highly unlikely, and ASEAN is expected to continue as a broad international organization with an economic emphasis. As such, whilst regional trade policies and incentives may have some impact, investments in SEA will still need to be assessed and approached on a per country basis.
Investors should: (1) Guard against such volatility and unpredictability by re-assessing traditional “force majeure” clauses and seeking waiver of sovereign immunity clauses in contracts; and (2) Mitigate the impact of possible changes in situation by re-examining standard risk allocation arrangements with lenders and other investors, negotiating appropriate security packages, and incorporating compensatory relief provisions.
Test the water
Given the above issues, investors looking at tapping into SEA's markets can consider setting up a regional base in Singapore first, and use it as a platform to further expand into SEA. Singapore has certain advantages such as a stable political system, a developed and open economy, relatively low taxes, good infrastructure, a skilled workforce, and a mature legal system. Effecting shareholding changes and fund transfers in Singapore is generally more convenient and efficient.
The BRI in SEA is at a crossroads. New and exciting opportunities abound for investors. Vietnam continues to grow as an alternate manufacturing base for Chinese companies. Myanmar shows promise as the region's new investment frontier. A digital technology boom is taking place in the region, most recently seen in Singapore's opening up of its banking industry to digital banks. Indonesia is posed to welcome a construction boom from the upcoming relocation of its capital city.
Challenges will continue to exist, from PRC outbound investment restrictions and foreign exchange controls, to the unique geopolitical landscape and fault lines in SEA, to political and territorial tensions between China and SEA, to the rise of nationalism and protectionism in a pushback against globalization. Chinese investors should focus on the commercial and economic benefits of their transactions, adopt an inclusive “win-win” and mutual benefit approach in negotiations, and moderate the political overtones and rhetoric of their investments. Investors need to build relationships and networks, plan ahead, leverage on resources, tread with care, and remain agile and nimble in order to successfully navigate and overcome the challenges of investing in SEA.
Originally Published 17 January 2020
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.