05 May 2020

China: New Opportunities for Foreign Technology

Part 1


China as a Technology Superpower with an appetite for foreign technology

 “For China to flourish and rejuvenate, we must vigorously develop science and technology and strive to become the world’s major scientific center and innovative high ground.”
Xi Jinping


China has Changed - Cutting Edge Technology; Consumer Markets; Capital Markets 

When China embarked upon its opening up in the 1980s, there was little reason to expect that within 40 years it would be at the cutting edge of many crucial technologies and become a champion of globalization. China was able to transform itself from being in isolation from the world to being the world’s factory. From being the world’s factory to becoming a technology powerhouse and innovator. Another big difference is that China has become the largest market in the world for many products and is responsible for most of the world’s growth.

China may need the world but the world also needs China.

International companies rely upon the purchasing power of Chinese consumers eager to consume international goods and services. Foreign investment has moved from being a one way road to China to being a two way super highway. Chinese companies in countries around the world pulled all stops to encourage Chinese inbound investment. Chinese enterprises buoyed by massive domestic savings and high valuations on Chinese stock markets scoured the world for investment opportunities. The Go Global campaign’s investment targets moved from securing overseas natural resources to cutting edge technology.

China has realized that it will need to continue to deploy cutting-edge technology into its economy. Demographics are moving against China and therefore it cannot rely upon factories alone to drive growth.

China as an Innovator … and Disruptor

As China has grown in global prominence there was also growing concern on the part of the PRC authorities that China was too reliant on foreign technology in a variety of sectors. Based on this background the Chinese government launched a number of technology driven initiatives. The most famous being “Made in China 2025” - a 10-year strategy launched in 2015 to modernize China’s industrial capacity and secure China’s global competitiveness in the high-tech industries (such as robotics, aviation and new energy vehicles, etc.) for decades to come. Importantly, China technology efforts have not just been limited to writing strategy papers but taking the lead in crucial technologies such as 5G, AI and big data to name a few.

Despite this local innovation, a sizeable appetite remains for foreign technology. Technology comprises of 21% of China’s imports, totaling $449 billion in 2018 and it is grew by 19% year-on-year. Technology imports is the largest part of China’s total import pie.[1]

The sources of technology are highly concentrated geographically – 65% from the United States, Japan and Germany.[2] Although the sources of technology have remained consistent for the last decades the nature of China’s technology imports have changed from complete sets of equipment and production lines to technology licenses, consulting and services. Key sectors include  transportation, communications, computer/electronic equipment, chemicals, and advanced equipment manufacturing.[3] Semiconductors alone have annual imports totalling over $300 billion.

China as a Competitor

The mood towards Chinese investment has soured in many countries relatively quickly. Rising populism in the West coupled with economic concerns about the future has led to antipathy towards Chinese acquisitions of tech heavy companies. Western governments fear that such deals may not deliver the much discussed win-win outcome but rather help China to build an economy which will would dominate the technologies of the future.

The US and to a lesser degree the EU have become increasingly wary of Chinese acquisitions – especially acquisitions of national champions in innovative technology. Precisely the companies that the Chinese are targeting. A case in point is the acquisition of Kuka by Midea in 2016. This led to widespread concern that Germany may be losing control of its companies of the future. It is also likely that the US-China trade war was really much more about technology than trade; more about silicon chips than soya beans.

China as a Market; China as a Competitor; China as a Partner

China is the largest or second largest market in almost all sectors. As such, China is too big to ignore for international companies. However, many European and US companies find China is a challenging market for a variety of reasons. These include regulatory and cultural differences but also concerns about intellectual property rights and compliance. In recent times, a number of international companies believed that they were capable and comfortable to establish their business in Europe and North America but felt China was too far away and too challenging to take on by themselves. In addition many of these high tech companies are happy to have a Chinese partner but less keen on a Chinese owner.

At the same time many Chinese companies have found overseas acquisitions to be frustrating. Auction processes are unfamiliar and often require quicker decision-making processes than with which they are comfortable. Chinese authorities concerned about depletion of foreign exchange are applying ever more scrutiny to overseas investments. Foreign governments especially the US are increasingly sceptical or even hostile to Chinese investment.

And that is just in relation to the acquisition. Many Chinese companies have come to the realization that acquiring foreign companies is often the easy bit. The challenges often only come when they need to run the operations. Running overseas companies often stretches Chinese businesses accustomed to success in their home market and export markets in ways they do not find comfortable. Loss of key personnel, cultural clashes, synergies that do not eventuate – most acquisitions are failures or at best modest successes.

There is a growing sense amongst many Chinese investors that it may be easier to import technology into China via technology license or joint venture rather than attempt acquisitions that have never been easy but are now occurring against an increasingly hostile overseas jurisdiction. At the same time many Western tech companies are intrigued by the massive opportunities of the Chinese market but are deterred by what they see as being a very challenging and different market. These Western tech companies often feel confident in dealing with the Western markets (i.e. Europe and USA) but seek a local partner for China.

Solving the Dilemma: Finding a New Way Forward

For international tech companies, China is too big to ignore but also often too challenging to conquer alone. They often feel they need a Chinese partner for China but not for their home or familiar markets. For Chinese companies, international technology and international markets are too important to ignore but they often find overseas acquisitions too challenging.

  • How to resolve the dilemma? Return of the JV

In China’s early days of opening up the joint venture was the default option for most international companies entering the market.

China has changed a great deal in the last 40 years. One of the changes has been that increasing numbers of foreign investors decided to set up their own subsidiaries rather than enter into joint ventures. This was due to a number of factors including local authorities that embraced foreign investment as being good for jobs and taxes; as well as central authorities increasingly confident that Chinese companies could compete on the world stage – and not just for mass produced goods but also in respect of technology and brands. The fear held by some officials that foreign investment would monopolise the key sectors of the PRC economy largely abated. This increased confidence also resulted in a loosening of restrictions on foreign investment. Also for international companies China is no longer just a location for low cost manufacturing but now a major market and key part of the supply chain. Also China business has become increasingly professional. Most visitors to China are struck by the improvements in “hardware”. However, the development of “software” such as internationally trained Chinese managers and professionals has made it ever easier for foreign companies to find suitable Chinese partners.

Originally, joint ventures were seen as a means by which China could gain access to advanced technology, obtain investment, add jobs and foreign exchange. For foreign companies, China was a low cost, good quality workforce and possibly for some far sighted companies, access to a large potential market. In 2020 these reasons are different for international companies - China is no longer a potential market but a massive one; China is not just a destination for cash but has a very large and highly lucrative capital market; finally, China is becoming a global innovation hub – fall behind in China, you may well fall behind everywhere.

The dilemma is how can Chinese and foreign companies alike collaborate in tech and have access to markets while avoiding regulatory and implementation challenges?

Somewhat surprisingly, the joint venture may be a possible solution and for this reason the writer believes the Sino-foreign joint venture is posed to make a comeback.

  • Structuring Options

The most likely questions for such joint venture projects will be:

      • How to attract Chinese investors?
      • How to structure the joint venture?
      • How to protect the technology?
      • How to deal with issues that will arise?
      • How to exit?

Attracting Chinese Investors 

There is great appetite in China for the right technologies. Hot sectors include autonomous cars, AI, big data, and robotics to name a few. Thirty years ago, almost all Chinese joint venture partners were industrial partners. Today, these strategic players are joined by Chinese high-tech companies, private equity, funds and VCs. Additionally, Chinese local authorities are highly motivated to attract the right kind of technologies to their regions. Many of these tech heavy projects have a lead investor that has a close relationship with the local government. For the right projects local authorities are willing to shower companies with subsidies and preferential policies.

This appetite for technology driven growth is affecting investments. In July 2019, the Shanghai Stock Exchange launched the STAR Market, a new exchange market specifically for technology companies. The STAR Market is designed with tech start-ups and other companies not yet profitable enough for more established markets. As of March 2020, 91 companies were listed on the STAR Market with 70 expecting net profit growth after preliminary earnings results.

How to Structure? 

Structuring the joint venture will require consideration of whether there are any restrictions on foreign investment in the sector and what is the favoured exit.

Direct to China mainland option – The most traditional option is for the international and Chinese partner(s) to establish an operational joint venture in the Chinese mainland. If the intended China business strays into areas that are restricted to foreign investment (for example value added telecoms), then the China entity may need to be either a joint venture or the structure may include a Variable Interest Entity (VIE). A VIE is a structure whereby the business that is off limits to foreign investment is placed in a captive entity that is bound contractually to the joint venture or WFOE.

The direct approach will be preferred for most companies. The advantages are that it will be easier for Chinese investors to invest; and the exit may be more lucrative.

We have seen some companies establish a Hong Kong holding company for the technology license and have this company establish a wholly foreign owned enterprise (WFOE) that operates in the China mainland. The Chinese investors would then participate at the Hong Kong or China mainland level.

The main reason for interposing a Hong Kong structure is to either have an Asian wide holding structure or if there is an intention to have investors from beyond China involved or that an exit is planned on the Hong Kong exchange or due to tax considerations or familiarity with the Hong Kong legal system. The major drawback of a Hong Kong structure is that Chinese investors (i.e. PRC domestic institutions) need to file with the National Development and Reform Commission or its local division and cross border investments will be strictly monitored.

How to protect the technology? 

Both foreign and Chinese investors need to be very clear at the outset about what technologies will be contributed to the JV and what will not; whether the technology will be contributed to the JV via license or assignment, etc. Outlining the scope of technology and type of contribution is crucial to determine possible infringement and thereby seek for protection in the future.

One of the mostly discussed topics among the investors is how to contribute the technology. Licensing without transferring the ownership of the technology will likely be preferable to the international technology owner. However, a license (even an irrevocable and one exclusive for China) may complicate a preferred China exit by listing as the target company will require independence from the shareholder (i.e. not under a high degree of reliance on foreign shareholder/technology provider). Therefore if possible it would be better if some of the core technology could be owned by JV. In addition, foreign companies and the Chinese investors or strategic investor will have a strong interest in ensuring that the JV obtains hi-tech status, which would greatly facilitate the JV’s development and secure multiple preferential policies (especially much lower income tax rate for the JV). Such hi-tech status will require certain core technologies to be owned at the JV level.

Technology transfers will be sensitive while it is common for foreign companies to encumber IP assets. Obtaining control over the JV, especially the technology-related position, will also help supervise the JV’s use of the contributed technology. In addition, we believe IP protection in China is much better than its reputation. For example, forced technology transfers are expressly forbidden pursuant to the landmark PRC Foreign Investment Law published in 2019. In addition, Chinese courts are generally capable of and willing to reasonably protect intellectual property rights, regardless of the right holder being either a Chinese or foreign company.

On the other hand, protecting technology from third parties is equally, if not more, important. For example, many foreign investors find copycats will emerge once a successful product is launched. In addition to the judicial remedy as mentioned above, investors need to think about branding at the early stage, that is how to differentiate a premium high-end foreign engineered brand from a more affordable Chinese domestic brand.

One issue to bear in mind is that the stock exchange will likely set requirements on companies’ wishing to list as high tech. The main requirements will include requiring applicant companies to hold the core technology; hold PRC invention patents (rather than the weaker design or utility patents); meet R&D spending thresholds; have objective recognition of the core technology; also that the patented technology is connected to the main business of the applicant.

How to Exit?

Unlike most traditional joint ventures, these new technology centric joint ventures are often focussed early on in respect of the favoured exit. The reason being is that the Chinese joint venture may well develop distinctly from the foreign company in its traditional markets. The most common possible exits are listing, strategic sale or, upon satisfaction of certain requirements such as a proper capital decrease proceedings, equity redemption.

When it comes to listing, the PRC operations will need to satisfy various requirements, particularly in terms of size, profitability, independence of operation and connected party transaction. Careful planning is needed to prepare the business to the listing requirements. This is especially true for the traditional A-share IPO in China.

Meanwhile, backdoor listings are also attractive in the China capital market. Backdoor listings provide an instant way for not-so-qualified companies to go public and raise funds. Given that China’s delisting rules are extremely relaxed until the recent few years, most struggling listing companies turn out to be ideal shells for going public. Despite transparency problems of shell companies and increasingly tight regulations, backdoor listings are still a lucrative and welcomed option in China.


Summary

China’s emergence as a technology superpower has not diminished its appetite for foreign technology. China is a massive but also highly competitive market. Apart from being a major market for almost all products and services it also represents most of the world’s growth. Too big to ignore, too difficult to conquer. How can international companies grapple with a problem of this size?

China’s emergence as a technology superpower has not been embraced by the West. On the one hand the West is keen to sell to a new and lucrative market. On the other hand there are fears that China may buy up the technologies of the future and the West will be left with an empty husk of an economy. Technology may not know borders but geo-politics certainly does. A de-coupling of USA and Chinese economies due to political will materially affect trade and investment flows.

Global innovators need markets. It is likely that Western companies will both see China as a market where joint ventures make commercial sense and also to enter into grand bargains whereby they give up part of their technology in order to gain market access. The obvious solution is to have strategic joint ventures within China. This time not due to legal requirements but for commercial expediency.

It is also not likely to be the whole story. China has learned a lot in a relatively short period of time. It is likely that Western governments will also learn from China. We expect that Chinese tech giants may also find that they can only gain market access if they joint venture in lucrative Western markets.

 

[1] https://londondaily.com/credit-suisse-charts-china-s-drive-for-tech-independence

[2] China and the world: Inside the dynamics of a changing relationship, McKinsey Global Institute, July 2019.

[3] http://www.china-esc.org.cn/c/2018-02-11/1959551.shtml

A Guide to Doing Business in China

We explore the key issues being considered by clients looking to unlock investment opportunities in the People’s Republic of China.

Doing Business in China
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