How escalating US-China tensions are reshaping private equity

American GPs with Chinese capital may have to re-think not just their deal and exit strategies but also future fundraising.

Add US private equity and venture capital firms to the list of organisations with growing anxiety over the ongoing trade and security dispute between the US and China.

Top executives from Oaktree Capital Management and Blackstone have spoken publicly about trade war concerns. Most recently, Henry McVey, head of global macro and asset allocation at KKR, said in the firm’s latest China report that “the escalation of trade barriers between the US and China is an undeniable attack on the traditional global supply chain”.

Since Donald Trump became US president, international trade tensions have slowed cross-border M&A. Outbound dealmaking by Chinese investors into North America has fallen; at $4.7 billion, the total value dropped almost 50 percent year-on-year from $9.4 billion in the first half of 2017, according to Asia-focused investment banking advisor BDA Partners. China’s tech-focused investors are looking elsewhere for acquisitions, in particular South-East Asia and Europe.

Trade concerns could, however, become more top-of-mind for US-based private equity firms with Chinese investors after Congress passed the Foreign Investment Risk Review Modernization Act this month.

FIRRMA was designed to strengthen the Committee on Foreign Investment in the US, an interagency committee that reviews investment in the country from overseas. CFIUS can advise the president to block deals on national security grounds, as Canyon Bridge Capital Partners – a firm based in Silicon Valley but investing Chinese capital – discovered when its $1.3 billion acquisition of Lattice Semiconductor was blocked in September last year.

Under FIRRMA, the committee’s jurisdiction is no longer limited to acquisitions involving sensitive technologies, critical infrastructure and real estate near US military installations, but also covers changes in the rights a foreign investor has in a US business.

This will have profound implications for US-based private equity firms with foreign investors, particularly from China. For CFIUS purposes, a US fund may be a “foreign person” if one or more foreign persons controls or could exercise control over it, regardless of the vehicle’s place of incorporation.

John Fadely, a Hong Kong-based partner at Gibson, Dunn & Crutcher, explains: “A managed account or ‘club fund’ that gives a Chinese state-owned investor or a small group of such investors more control than passive limited partners typically have, and any investment fund that supplies this kind of investor with ‘material non-public technical information’ about portfolio companies operating in areas of sensitivity under CFIUS, could come under scrutiny.”

CFIUS’s expanded remit means US GPs will now have to carefully examine not just their investment and co-investment strategies, but also future fundraising, as well as the level and nature of foreign LP ownership.

FIRRMA could also impact private equity firms contemplating exits for their portfolio companies, especially if the buyer is Chinese. Edmond Ng, co-founder and managing partner of fund of funds manager Axiom Asia, notes that GPs have already come to the realisation that they will face difficulty flipping their US tech companies to Chinese strategic players or state-owned enterprises, and therefore must recalibrate their exit strategy.

As with any battle, we must assume China is primed to strike back. As the trade war continues, a fair and predictable environment for international private equity players is not on the cards.

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