Overlooking Hamarikyu Gardens, Tokyo © Toshiki Senoue
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China’s surging technology sector has nurtured behemoths such as online marketplace Alibaba, with its $195bn market capitalisation, and search engine Baidu, which reached 663m users in March. They owe much of their success to a vast and increasingly affluent population, growing internet use and the need to supply IT services to the public and private sectors.

It is not easy for foreign rivals to gain a share of this market, in part because Beijing has several concerns over the sector beyond the narrow self-interest of economic protectionism. These anxieties cover cyber security risks, increased freedom of speech for internet users and the threat of international espionage.

Revelations by Edward Snowden, the contractor turned whistleblower, over the US internet spying programme Prism have fuelled government concerns about foreign entities operating within China even as homegrown champions such as Huawei and ZTE emerge globally.

Those anxieties are evident in a tighter regulatory environment. It was widely reported last year that the authorities were even planning to station police officers inside large internet companies. A draft cyber security law unveiled last summer would have required companies to store user data in China, although Beijing dropped this provision after US protests. A requirement that made it into the final law was that companies must assist China in decrypting any information relating to terrorism incidents.

“The Chinese government and western governments or western firms have a fundamentally different perspective on how to use the internet,” says William Glass, an analyst at cyber security firm FireEye. “In the west it’s a common platform where you can post whatever you want. In China it’s viewed as almost a little bit of a liability.”

Beijing’s unease runs against its desire to develop a sophisticated domestic technology industry and lessen its reliance on foreign expertise as part of a strategy first outlined in 2006 and known as “indigenous innovation”. The process is best understood as “not so much a hard and fast legal rule but a procurement approach”, says one dealmaker.

There has been a varied response among foreign companies — and their lawyers — as they seek a compromise while retaining access to the lucrative market. Microsoft, for instance, began sharing its source code with governments around the world, including China, in 2002.

Others have taken more ambitious approaches. Two years ago, Hewlett-Packard — now split into two entities, Hewlett Packard Enterprise and HP Inc — began exploring options for restructuring part of its operations in the country. Its aim was to secure a Chinese partner to navigate the market.

Under the terms of a deal announced in May 2015, HP sold a majority stake in a new company comprising H3C Technologies, its network business, and its China-based server division to Unisplendour Corporation for $2.3bn.

Unisplendour is a subsidiary of Tsinghua Holdings, the asset management arm of Tsinghua University in Beijing.

Being one of China’s leading institutions — it is the alma mater of President Xi Jinping — “made Tsinghua a very attractive partner” for HP, one person with knowledge of the deal says. HP will still own other businesses in China outright, including various software divisions, but the new entity, headquartered in Hangzhou and Beijing, is the main plank of its operations. It strikes a careful balance between HP’s identity as one of the world’s biggest tech companies and also makes it clear it is prepared to adapt to thrive in China. The deal closed in May.

In its submission, Allen & Overy, which advised HP, said its innovation came in the deal’s “structuring to create an indigenous profile”, which meant HP could retain “strong operational control” even as its ownership was 51 per cent Chinese. The firm talked of its “groundbreaking” regulatory work, given “complicated PRC [People’s Republic of China] listing rules” and market turmoil.

Law firm Bird & Bird required similarly creative structuring when it acted on behalf of SinoCloud, a Singapore-listed IT service provider. SinoCloud wanted to buy a controlling stake in Guiyang Zhongdian, a Chinese internet data centre company, but Chinese takeover rules made this harder. A recalcitrant minority shareholder added a layer of complication.

To comply with China’s rules, Bird & Bird had to use a variable interest entity, which allows a company to take a controlling interest without holding most of the shares, similar to HP’s “strong operational control”. But because of the minority shareholder, a new company had to be established above the target with which SinoCloud could deal. This entity was a limited liability company, rare in China, the law firm says. The deal was completed in October 2015.

One of the most striking trends among homegrown tech companies operating in China is the number of ventures that are delisting in the US. Seventy-three US-listed Chinese companies have been taken private since 2009, according to data from Dealogic, nine of them in 2016 alone. Lawyers expect many to relist on the mainland.

Their path may be determined by the novel approach adopted by Qihoo 360, an antivirus company, which abandoned its US listing after receiving a $9.3bn management-led buyout offer last year. Having several partners in the buyout consortium who were not Chinese meant “it would be difficult to restructure the company to permit a Chinese domestic A-share listing in the future,” said Kirkland & Ellis, the law firm that advised the consortium. The deal was innovatively structured to facilitate a Chinese listing with all funds raised onshore and in renminbi.

The investor consortium included Sequoia Capital China and Ping An Insurance but totalled 30 parties in all. To add to the difficulty of the deal, discussions were taking place against the backdrop of China’s fluctuating stock market last summer when the benchmark Shanghai Composite fell 30 per cent between the beginning of June and the end of August. “On a particular day you could almost feel the enthusiasm going up and down among the various investors, but most took the long view,” says one person close to the deal, adding that it “highlights the need to really carefully plan”, given the increased regulatory scrutiny and opacity.

Though the Qihoo 360 deal was signed only recently, lawyers say more delistings and joint venture restructurings will almost certainly follow. Despite the challenges, Asia’s biggest economy remains the prize for many foreign enterprises in the technology sector. Companies that began life outside China are signalling that beefing up their profile in the country, even given the expense and the wait, is worth it.

China has more than 700m people connected to the internet, says FireEye’s Mr Glass. “That’s something that can’t be ignored.” But he warns: “The Chinese government is cognisant of this and is able to use their market power to extract concessions. China’s only going to permit what it wants to permit.”

Copyright The Financial Times Limited 2017. All rights reserved.
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