(Bloomberg, Nov 30, 2006) Dale Colling is learning just how serious economic security is for China.

The chairman of ALC Advisors earlier this year brokered the sale of a Chinese manufacturer to a U.S. buyout firm. Completion of the deal has been slowed because the company's products contain glass, which may be classified as a strategic material.

``We're told by the lawyers we may have to get special approval because the product uses a lot of glass,'' says Colling, 55, who is based in Shanghai and wouldn't name the companies involved since talks are continuing. ``Larger, more visible deals are going to be more difficult to get done.''

New takeover rules in China are crimping overseas buyout funds such as Carlyle Group and Ewing Management after lawmakers criticized the government for selling state assets too cheaply. Private equity and venture capital firms this year had raised $27.3 billion to invest in Asia as of Oct. 17, up from $23.2 billion in 2005, according to the Asian Venture Capital Journal.

``There appears to be a new sense of domestic nationalism -- under the guise of protecting national economic security -- which may have the effect of restricting foreign investment,'' says James M. Zimmerman, chairman-elect of the American Chamber of Commerce China.

Almost 70 percent of the $19.5 billion of acquisitions announced by overseas investors this year in China have yet to be completed, according to data compiled by Bloomberg. Last year, all but 25 percent of the $34.4 billion in purchases were cleared.

The country's nascent domestic private-equity industry, bolstered by new laws and state-sponsored funds, may get a boost from the restrictions on overseas investors, says Liang Meng, co- head of China investment banking at JPMorgan Chase & Co., which advised on six acquisitions in China this year.

New Rules

The government on Sept. 8 decreed that overseas investors would need Ministry of Commerce clearance to buy controlling stakes in key industries, well-known trademarks or ``old Chinese brands.'' Deals can be vetoed or scaled back if they affect the ``security'' of China's economy.

The new rules have cast a pall over takeovers by international buyout firms because the ministry hasn't specified what industries, brands and trademarks are subject to heightened review, says Guo Pengcheng, vice president of Ewing Management Group, a private-equity firm based in Dallas.

``There is still a lot of nationalistic emotion, and the rule ambiguities will continue to overhang the market,'' Guo says. Ewing, which last year hired former U.S. Secretary of State James Baker as an adviser on Asia, is shelving plans to invest in Chinese state-owned companies.

People's Congress

Closely held investment firms such as Ewing Management and Carlyle use a combination of their own funds and borrowed money to buy companies, with the goal of selling them at a profit.

Asia has sometimes been a difficult market for buyout funds. Most recently, Dallas-based Lone Star Funds canceled a $6.8 billion agreement to sell Korea Exchange Bank because prosecutors are probing the acquisition of the lender in 2003.

In China, delegates to the National People's Congress in March called for stricter controls on the sale of assets to overseas investors after allegations that international banks were buying the nation's lenders at windfall prices.

New York-based Goldman Sachs Group Inc. in April paid $2.6 billion for 4.9 percent of Industrial & Commercial Bank of China Ltd., the nation's biggest bank. The value of the stake has more than tripled since the shares began trading Oct. 27.

Cnooc Blocked

China's tougher stance on international takeovers also may be linked to the aborted acquisition of El Segundo, California- based Unocal Corp. by Cnooc Ltd., China's biggest offshore oil producer. Cnooc backed out after the U.S. Congress threatened to veto the deal because of national security concerns.

U.S. saber rattling gave China an excuse to increase barriers to overseas investors, former Federal Reserve Chairman Paul Volcker said in a Nov. 3 interview with Bloomberg News.

``The action that we took and the political pressure we brought to bear were mistakes,'' says Volcker, 79. ``It's sort of like xenophobia in the U.S., as well as elsewhere.''

Previously, many deals involving less than $100 million needed only local government approval, says Liu Jinrong, a partner of Beijing-based Global Law Office, which advises on acquisitions in China.

``China is still a communist country, and they need to tighten the grip on certain industries to ensure economic and state security,'' he says.

The Commerce Ministry may decide that financial services, telecommunications, heavy machinery, power grids and media are ``key'' industries subject to increased scrutiny, Liu says.

Deals Crimped

Overseas buyout firms are already feeling the heat.

Washington-based Carlyle in October scaled back its purchase of state-owned Xugong Group Construction Machinery Co., agreeing to buy 50 percent of Xugong for $228 million instead of the 85 percent it initially sought. The deal is awaiting approval.

Arcelor Mittal, the world's largest steelmaker, may fail in its $266 million bid for Laiwu Steel Corp. because the offer lacks support from some government departments, Laiwu Vice General Manager Zhang Shengsheng told Bloomberg News on Oct. 2.

``If China turns its back on foreign direct investment, the consequences may be a policy folly that will draw the ire of its trading partners and negatively impact its economy,'' says Zimmerman of the Chamber of Commerce.

The National Reform and Development Commission, China's top planning body, said Nov. 9 that the government plans to focus on attracting ``quality'' investment, rather than ``quantity.'' The nation seeks to import more technology, management and research capabilities, the agency said in a statement, without providing further details.

Airbus Investment

So far, China has maintained its allure for overseas investors. The country attracted $48.6 billion of direct investment in the first 10 months of this year, compared with $60.3 billion for all of 2005, according to the National Bureau of Statistics.

Airbus SAS, the world's largest commercial airplane maker, plans to open its first assembly plant outside Europe in eastern China, the Toulouse, France-based company said in October.

``China has come to a stage when we can afford to say no and be selective in the type of capital we want from overseas,'' says Cheng Guoqiang, an adviser to the Ministry of Commerce on issues related to the World Trade Organization.

The new investment rules come as the government attempts to slow the world's fastest-growing major economy, which expanded 10.4 percent in the 12 months through September, the third straight quarter above 10 percent.

China's record $1 trillion of foreign-exchange reserves means the country can afford to be selective in accepting overseas investment, says Carson Wen, who specializes in China acquisitions at the U.S. law firm Jones Day.

Local Firms

``The government wonders whether it really needs that much foreign capital anymore given its huge pile of reserves,'' says Wen, a Hong Kong-based partner.

Buyout firms controlled by Chinese investors may profit from the crackdown on international rivals, says Zhang Yichen, chief investment officer of Citic Capital China Partners, owned by China's biggest investment firm. Citic Capital in September raised $220 million for its first China buyout fund.

Chinese investment funds will get a boost from legislation that permits limited partnerships for the first time, beginning in June.

The structure will boost fundraising in China because it limits the liability of domestic investors, says Zhang, who last year led the $258 million buyout of China's biggest drugmaker with New York-based Warburg Pincus.

People's Bank of China Deputy Governor Wu Xiaoling called the new law a ``legal cornerstone'' for Chinese private-equity when he met with 170 officials and financiers in Beijing in September.

`Competitive Threat'

``It provides a key engine for the domestic private-equity industry to start growing,'' Wen says. ``To the overseas players, it poses a new competitive threat.''

The cabinet is also backing a 20 billion yuan ($2.5 billion) fund that is being organized by the government of the northern port city of Tianjin to invest in a new special economic zone.

Official concerns about the strategic value of glass aside, ALC's Colling says he expects to eventually complete the stalled transaction. ALC's buyout unit plans to include Chinese partners in future deals to blunt government objections.

``Chinese investors are going to be a much more important factor going forward,'' he says. ``In the future, there's going to be more teaming up with local investors.''

Source:Bloomberg