Foreign affairs

Among the benefits of private equity is control – an ability to steer an investment to success not available to most public shareholders. But in emerging markets, control has not historically been made available to foreign investors, and this has presented challenges to private equity firms in these regions.

Fortunately, and not surprisingly, the most popular emerging markets today offer greatly relaxed rules governing foreign investors. But the rules vary from country to country and even within the respective countries from jurisdiction to jurisdiction.

This article gives overviews of the foreign-ownership rules of six hot emerging markets in which international private equity firms are active – Russia, China, India, South Korea, Brazil, Poland. The article also discusses many of the legal and regulatory challenges that these investors face as foreign entities in these markets.

Russia
By way of Cyprus, a game of monopoly

Until 1987, the USSR allowed no private ownership, period. Then Mikhail Gorbachev opened up the country with the creation of joint ventures that initially allowed foreign entities to own up to 49 percent of Soviet enterprises. Two years later, that limitation was lifted in favor of allowing majority foreign ownership of Soviet companies. In 1991 the Russian government adopted legislation allowing for 100 percent foreign ownership of Russian companies, a standard that stands in place today.

According to Mark Borghesani, general counsel at Russian private equity firm Baring Vostok Capital Partners, some foreign ownership restrictions still apply to certain Russian industries. Explicit restrictions on foreign direct investment are in effect for certain sectors. A 1998 law on the aerospace industry limits foreign ownership to 25 percent of an enterprise, although some existing joint ventures were ?grandfathered.? In 2001 foreign ownership limits in the natural gas monopoly Gazprom were raised from 11 to 20 percent. In 2003, Russia enacted several amendments to the insurance law that effectively liberalized the market, allowing majority-owned Russian subsidiaries of insurers from the European Union to sell life insurance in Russia.

Although the law only permits those companies with offices in the European Union to wholly own Russian insurance companies that offer life insurance, the regulator has interpreted the legislation as allowing any foreign insurer to set up life insurance operations in Russia provided that the company has an office in the EU via which the investment is made. A 1998 law limits foreign investment in the electric power giant Unified Energy Systems to 25 percent or less, although it has not been enforced to date. The defense industry has a total ban on any foreign ownership, for example. Russia's enormous energy sector still features strict controls on foreign entities participating in privatizations. That said, ownership rules are loosening. Just recently, for example, Russian gas giant Gazpromallowed foreign ownership its of locally listed stock.

Although Russia allows broad foreign investment in its businesses, there still exist challenges for private equity investors in the region. A major potential roadblock comes in the form of the Russian Federal Antimonopoly Service, a federal entity with regional divisions. The Service is charged with approving mergers after determining whether proposed deals will create anti-competitive entities. The Service is widely regarded as sometimes pursuing politically motivated policies. For example, in 2004, German giant Siemens attempted to acquire a 71 percent share in Russia's Power Machines company. The bid was blocked by the antimonopoly ministry, reportedly under pressure from the other government entities. A stake was later acquired by an oligarch-linked energy systems concern.

According to Borghesani, Russia's legal system is weak on enforcement of shareholder rights. It has therefore become standard practice for private equity investors in Russia to acquire local companies through offshore entities based in Cyprus, or other jurisdictions with favorable tax treaties with Russia. These jurisdictions allow shareholders to apply English or US partnership law. For example, English and US law allow for the enforcement of tag-along and drag-along rights. ?If you have a direct investment in Russia, and you have less than 100 percent ownership, it is unlikely that a Russian court could provide these types of protections,? notes Borghesani.

further complication comes into play in Russia's banking sector, says Borghesani. Russia's central bank requires that foreign acquirers of banks show three years of accounts prior to completing a merger. For private equity investors interested in this sector, this means that foreign entities must be in place for three years prior to the pursuit of a banking deal. Borghesani notes that Baring Vostok already has offshore shelf companies in place in anticipation of these potential opportunities.

China
Open and shut case

Following the widespread economic reforms that were instituted in 1979, including the encouragement of joint ventures between domestic firms and foreign partners, the Chinese market has certainly been liberalized since the pre-1979 era of communal farming and nationalization of key industries.

But for the countless foreign investors keen to play a role in China's growth story today, progress has not been as rapid as many would wish. Perhaps the biggest problem is the difficulty of knowing which way the regulatory wind in China is blowing, with very different outcomes for different sectors while, within sectors, the rules appear subject to frequent change.

Last year saw the usual mix of good and bad news. Perhaps the highest profile disappointment was the announcement that foreign firms were officially forbidden from acquiring majority stakes in major domestic steel companies (the restrictions, however, did not apply to small and medium sized steel firms). Meanwhile, a new set of regulations banned foreign companies from operating in the media and publishing industries.

Such moves have been criticized as a step back from China's commitments as part of the World Trade Organization, which it joined in 2001. However, in other industries it was a very different story last year. For example, moves were underway to allow foreign investors in car manufacturing firms to acquire majority stakes rather than being restricted to 50 percent. Also, the country was expected to lift restrictions on the trading activities of foreign-funded travel agencies and allow 100 percent foreign ownership of such firms.

In addition, there were signs that restrictions would be eased in the commercial banking sector, where the threshold is currently 25 percent (for total foreign ownership) and 20 percent (for an individual foreign investor). Despite these limits, Citigroup is currently bidding for a stake in Guangdong Development Bank believed to be between 40 and 45 percent – the outcome of which will be eagerly awaited.

Albert McLelland, senior managing director at Ampac Strategic Capital, a specialist in the sale of Chinese stateowned enterprises, says it is understandable that foreign investors want reforms to quicken, but that ?given the government's sensitivity to employment and social stability issues, it is hardly surprising that they would want to protect nascent industries.?

McLelland says the key to obtaining favorable outcomes as a foreign investor in China is ?strategic influence? with the leaders whose decisions shape the policies, laws and regulations. In an emerging market, good lobbying can pay dividends.

India
Regulatory cornucopia

India has not traditionally been the most confidential place in which to invest. Until a few years ago, acquisitions of existing shares in almost any type of company had to be approved by a signature from a government minister. What this meant in practice is summarized by Donald Peck, managing partner for South Asia at emerging markets investor Actis. He says: ?It often gave the game away completely. News of the deal would often leak out and all hell would break loose.?

This protracted and frustrating approval process has since been swept away – as have many of the constraints on foreign ownership of Indian companies. In sectors where private equity firms have traditionally been active participants such as IT, pharmaceuticals and manufacturing, 100 percent ownership is possible. This is also now the case in a wider range of real estate projects than was once the case.

However, the government still does place limits on foreign investment in certain industries. For example, the insurance sector was deregulated six years ago but still only allows 26 percent foreign ownership (though this is expected to rise shortly to 49 percent). Other sectors where limits apply include: telecoms (49 percent); oil and gas pipelines (51 percent); airports (74 percent); and diamonds and precious stones (74 percent).

In some sectors, what appear to be punitive constraints are not quite what they seem. In defense equipment, for example, foreigners are only allowed 26 percent stakes, although this is not particularly miserly given the sensitivity of the military: many other countries have tighter restrictions. In banking, maximum ownership by an individual investor is a mere ten percent – but is designed simply to prevent too much concentration of ownership and applies equally to domestic and foreign investors alike.

It is also worth noting that foreign companies can circumvent any restrictions by setting up a registered company in India that will then operate under the same laws, rules and regulations as any Indian-owned company would.

Some might argue that the only roadblock in the way of further reform of ownership laws in the near future is the time it takes politicians to act in a country where a coalition government encompasses some wide-ranging political views. ?The declared rhetoric is in favor [of further liberalization],? says Peck. ?But there are always protracted points of negotiation in coalitions.?

South Korea
Come to invest, stay to pay tax

South Korea has many elements that make it an extremely attractive destination for private equity investment – rule of law, a thriving democracy, growing cultural clout throughout Asia, a highly educated and Internet-savvy populace, and huge conglomerates in need of repositioning.

Not surprisingly, a number of multinational private equity firms have opened offices in Seoul, including The Carlyle Group, Warburg Pincus and JP Morgan Partners Asia. The government has welcomed foreign direct investment by allowing 100 percent foreign ownership over most types of businesses, and by gradually reducing the types of industries that have foreign ownership restrictions.

One of the industries in South Korea that continues to restrict foreign ownership is telecommunications. Specifically, ?backbone? businesses such as cable networks may not be majority owned by foreign entities, although minority stakes are allowed.

In the banking sector, only foreign banks or bank holding companies are allowed to acquire majority ownership of a South Korean bank. However, notes JK Park, a partner at Seoul law firm Kim & Chang, the government regulators have made exceptions to this rule in the case of failed banks. This happened in 1999 when San Francisco-based Newbridge Capital acquired a 50 percent stake in foundering Korea First Bank, in partnership with the South Korean government. Regulators also made an exception for Lone Star's acquisition of a 51 percent stake in Korea Exchange Bank, although a controversy later ensued as to whether this institution was indeed ?failed? or just struggling.

While in most cases total ownership of South Korean businesses is allowed, the government has recently taken an aggressive stance against the offshore vehicles used by foreign investors to do their deals. Many of the most successful deals, including Newbridge's Korea First Bank profits, were structured through Labuan, a tax-treaty territory off the coast of Malaysia. Other tax-treaty havens used by private equity firms to invest in South Korea have included the Cayman Islands and Belgium.

The public, as well as many in the government, have been incensed at the spectacle of foreign funds profiting from the sale of local assets without paying local taxes.

According to Park, tax authorities in South Korea are expected to soon announce new rules on the use of offshore vehicles in the country. It is expected that beneficial ownership rules will be applied to designated tax-treaty jurisdictions, meaning that taxes will be due unless the investment entity can prove that it is not a shell company. Although the list of affected jurisdictions is not yet known, it is expected that Labuan will make the cut.

Brazil
Restrictions on foreign ownership are now the exception, not the rule

The sole Western Hemisphere member of the BRIC equation has been steadily opening up its economy to foreign capital, with 1991 standing out as a milestone year. Not only was it the year that marked the beginning of foreign investor participation in the Brazilian stock market, but in 1991, Brazil also hosted what some refer to as the largest privatization effort in the world, with over $100 billion of assets transferred from public to private ownership.

A few years later, many of Brazil's infrastructure- and energy-related industries – including petroleum, mining, power generation, telecommunications, and internal transport – previously closed to foreign investors were opened up in 1995, although foreign participation was limited to minority stakes.

Although certain restrictions apply to foreign ownership of some types of Brazilian businesses, foreign investors – among them a number of internationally based private equity firms – have established a significant presence in Brazil's economy. These investors typically enter Brazil through joint ventures with local companies and investors, as well as through direct investments.

One notable liberalization development took place in 2002, when Brazilian media – a historically closely guarded area – was opened up to foreign investors by a legislative decree allowing up to 30 percent of foreign ownership in Brazilian media companies.

Non-Brazilian residents are still not allowed to enter into the domain of determining media programming content.

The first investor to take advantage of the opening of this sector was global private equity firm Capital International, which acquired a minority stake in Brazil's largest publishing company, Editora Abril, in mid-2004. This high-profile investment made waves across Brazil, and according to a source close to the transaction, the new investors had to step carefully in approaching this politically charged sector.

Despite the loosening of rules on foreign investment in media companies, non-Brazilian residents are still not allowed to enter into the domain of determining media programming content. Sector-based restrictions also remain for the investment of foreign capital in other areas of strategic and security importance to Brazil, such as nuclear energy, health services, rural property, fishing, mail and telegraph, aviation, and aerospace.

The treatment of foreign capital does vary, to an extent, by geographic region, with tax benefits for both domestic and foreign investors applicable when investing in the less developed parts of Brazil. To date, most investments have targeted the southern, industrialized part of Brazil, and the government is seeking to direct capital toward the northeastern and Amazonian regions of the country.

Poland
The EU prescription to an open economy

As investors continue to take a shine to Central and Eastern Europe, Poland is increasingly a magnet for various sources of external capital, not least of which is private equity.

The economic reforms first introduced in Poland in the late 1980s and early 1990s have since increasingly liberalized the country's treatment of foreign capital. For instance, there had been limitations on the size of a stake that foreign investors could hold in Polish telecommunications, energy and banking businesses, but over the years, these allowances have progressively increased.

?There are still some regulations which limit the freedom of foreign investors in certain sectors, but they are minimal,? says Aleksander Galos, managing partner of the Warsaw office of Hogan & Hartson law firm. ?For instance, foreign entities or companies from other EU countries and from outside of the common European market cannot directly buy land in Poland for agricultural or forestry purposes. However, it is possible to organize a transaction so that these limitations have little to no practical impact.?

As a new member of the EU, Poland is required to harmonize its regulations with EU regulations regarding foreign investment, which includes granting the same treatment for residents of the EU and European Free Trade Agreement states as that of Polish nationals.

Restrictions on how foreign investors residing outside of Europe can invest in Poland still exist. ?Other foreign persons, provided that international agreements do not state otherwise, may conduct their commercial activity in Poland only in the form of a limited partnership, a limited joint-stock partnership, a limited liability company, and a joint stock company. In practice, this means that they are not allowed to form, for example, general partnerships, a legal form which is very popular among Polish small entrepreneurs,? says Agata Jankowska, a lawyer at Zbigniew Marek Czarny Law Firm in Warsaw. ?However, most limitations concerning ownership regime are not related to investors' countries of origin but rather to Polish governmental policy regarding the protection of competition or public interests.?

The remaining challenges for overseas investors seeking entry to the Polish market have become less regulatory-based than has been the case in the past. ?Now, we are a completely different country, and we face different issues than before,? says Galos, referring to the lack of full privatization, regulatory efficiency and capital in Poland as the current key concerns faced by foreign investors.

This article was written by Judy Kuan, David Snow and Andy Thomson.