A shift towards protectionism in western countries could complicate exit processes and limit the returns available to private equity firms and their investors.

Germany is among the latest countries to clamp down on foreign direct investment. The German Foreign Trade and Payments Ordinance, known as AVW, was expanded in July 2017 to focus on “critical infrastructures” that may constitute a threat to security if acquired by foreign interests. Sectors include health, telecoms and finance.

The government made its first intervention in August to prohibit the acquisition of Leifeld Metal Spinning by a French company owned by China’s Yantai Taihai Corporation. Though the act was not enforced, Germany’s attention was enough to make Yantai withdraw from the deal.

Transactions for equity stakes under 25 percent do not technically qualify for AVW protection. But when a Chinese investor attempted to buy a 20 percent stake in German electricity grid operator 50 Hertz earlier this year, the government urged the company’s Belgian co-shareholder to exercise its pre-emption right to acquire new shares. The co-shareholder refused to acquire a second 20 percent tranche later in the year, prompting the government to order state-owned KfW bank to purchase the interest instead.

The situation could become more complex. The German government is reportedly pushing to cut the threshold to 15 percent, and there is talk of a state-owned fund that could acquire stakes in domestic tech companies in lieu of non-European investors.

Think again

Trade buyers have dominated the German exit market in recent years. Strategics accounted for €8.1 billion of the €12.5 billion of private equity exits in the first half of this year, according to the Centre for Management Buyout Research. Last year, exits to trade buyers generated €8.6 billion, compared with €6.9 billion of secondary buyouts and €0.4 billion of stock flotations.

Chinese foreign direct investment in Germany fell to €1.8 billion from €11 billion in 2017, according to Mercator Institute for China Studies. The institute noted that while Germany remained a popular destination, several big takeovers were not completed in 2017 “due to regulatory delays or other reasons” and deals of under 10 percent were not recorded as they fell below the 10 percent threshold.

Recent deals involving Chinese buyers include CVC Capital Partners’ sale of  German metering and energy management business Ista to a joint venture between Hong Kong’s CK Infrastructure and Cheung Kong Property for a reported €4.5 billion last year.

In 2016 Canada’s Onex Corporation sold plastics machinery business KraussMaffei Group to a consortium of Chinese investors including China National Chemical Corp for €925 million. Blackstone sold a German offshore wind farm to China Three Gorges for around €1.6 billion the same year.

“It’s very early days but my feeling is the Chinese interest in certain assets might become smaller because they anticipate that they will not be able to buy it,” Dimitri Slobodenjuk, a Dusseldorf-based counsel at Clifford Chance, told Private Equity International.

“It was a very clear message from the German government to the Chinese government that they see certain asset classes as off limits currently for certain investors. People will need to consider in their investment papers whether part of, or the whole case, is built around selling to the Chinese, because that might be impacted through losing some of their exit market.”

Strategic buyers are an appealing exit route for assets of a certain size as they typically spend more than a financial sponsor. The €8.1 billion of trade exits in the first half of this year was spread across just seven deals, while the €4.5 billion of secondary buyouts was across 18, data from CMBOR show. AVW could reduce the number of non-European players bidding for a German asset, thereby lowering the multiple at which it sells.

Double impact

The initial time period for obtaining an AVW clearance certificate from the German Federal Ministry of Economic Affairs and Energy has been extended to two months, and there are scenarios in which a clearance process could stretch well beyond six months. Private equity deals can be subject to strict time constraints, adding to the potential for reduced interest or collapsed deals.

“There are longer approval periods, so for owners of businesses or potential sellers of businesses it’s very important to anticipate that and factor it in to the planning around a disposal,” said Thomas Fetzer, head of DACH at investment bank Baird. “In certain situations it is advisable to test potential interest for Chinese buyers well-ahead of the process.”

The implications stretch beyond Germany and China. UK buyers of German assets will no longer be considered a European entity in the event of a hard Brexit in which Britain leaves the EU single market and the customs union. North American investors could also face delays.

“Even if you have a consortium that plans to invest in a critical infrastructure that includes a continental PE fund with a majority shareholding, and a minority co-investor from the US, you would have a filing requirement under the foreign investment rules,” said Frederik Mühl, a partner at Clifford Chance.

“This can have an impact on how you build your bidding consortium for investing in German assets.”

US and Canadian businesses invested €15.1 billion and €3.5 billion in German M&A last year respectively, accounting for almost 30 percent of all inbound deal values, according to Deloitte’s Cross Border M&A Yearbook: 2017. Hong Kong and the UK also invested €10.8 billion between them.

The mood in Germany has shifted. Sentiment regarding exit opportunities in German private equity fell to 49.3 balance points in Q2, down from 60.3 and 59.4 in Q2 2017 and Q1 2018 respectively, per KfW’s latest German Private Equity Barometer, which surveyed roughly 250 members of the German Private Equity and Venture Capital Association and other German PE houses. The business climate is calculated as positive responses minus negative responses, expressed as a percentage.

Shared concern

Germany is not alone in adopting a more cautious approach to foreign direct investment.

The European Commission announced last year that it would enhance scrutiny of acquisitions from outside the European Union in industries including infrastructure, adding to measures already being taken by member states and bringing some degree of concern to the asset owners. Tools to check that foreign investment in EU countries does not threaten their security or public order were approved by the Trade Committee in May 2018.

The US signed the Foreign Investment Risk Review Modernisation Act into law in August, broadening the government’s remit over transactions through its Committee on Foreign Investment in the United States (CFIUS). Its purview now includes sales or leases of real estate in close proximity to government facilities, sales of critical technology or critical infrastructure companies and minority investments that involve access to sensitive confidential information.

The Trump Administration’s US-China trade-war, as well as heightened regulation in China, has already contributed to stifled investment activity. Chinese outbound M&A into North America stood at $4.7 billion between January and late July, compared with $9.4 billion in H1 2017, according to Asia-focused investment banking advisor BDA Partners.

“China has been an important player in US M&A in recent years, but multiple overlapping factors both in China and in the US have had an impact,” John Reiss, a New York-based partner at law firm White & Case, noted in a February report.

“There are limitations on Chinese outbound activity because of regulation and over-leverage in Chinese financial institutions and large corporates. On the US side, regulation by Trump and CFIUS further limit activity.”

– This article has been updated to to show that John Reiss is a partner at White & Case, rather than BDA Partners.