As the leading foreign firms race up the value chain of the legal services market in China, they leave an expanding vacuum in their wake that the local firms have been more than willing (and capable) to fill.
While there is more than enough room in the market for both the foreign and local firms to coexist peaceably and profitably, there has been a long-held expectation on the part of many foreign lawyers that certain categories of higher-end work would continue to be dominated by the foreign firms. Inbound M&A was (emphasis on the past tense) one of those categories.
In the early and mid part of the 2000s, the China market saw a discernible uptick in inbound M&A work. Before then, the risks associated with acquiring a Chinese target were always seen to outweigh the potential benefits. Traditional state-owned enterprises (SOEs) typically were seen to be bloated, under-performing manufacturing enterprises with sub-standard products, weak brands and inferior distribution channels, and as a bonus they had unreliable financial statements and unknowable liability exposures. Not the most attractive targets, to say the least. Moreover, the foreign direct investment (FDI) experience in the 1990s had been that is was better to start with a clean sheet with a wholly foreign owned enterprise (WFOE) you controlled than to get into bed with a Chinese partner in a JV, so the idea of adopting a Chinese company as a full-fledged subsidiary was not terribly appealing.
This changed in the early part of the last decade with the convergence of two trends – increased activity on the part of foreign venture capital and private equity funds in the China market and the rise of non-SOE high-tech domestic companies, which had real technology, innovative products, foreign-educated entrepreneurial founders, a short operating history (meaning that you could feel more comfortable that you knew what their liabilities were), a need for additional capital (since commercial bank financing in China was not readily available) and a desire for a path to an offshore IPO, making them much more attractive as targets. Multinational corporation (MNC) operating companies similarly started to see acquisitions as a positive alternative to traditional green-field FDI, offering the chance to jumpstart a new business line through taking over the existing infrastructure of the target company.
In other words, this was the new wrinkle to FDI in China, and this new M&A trend also created a new and attractive market for law firms. In the early stages, the foreign law firms once again dominated the market, with local Chinese firms playing only the more limited and secondary local counsel role. The West Coast US firms took a commanding market share in the venture capital/private equity work at first, but all of the top foreign firms in the market benefited substantially from this new source of higher-value work. During the early to mid 2000s I was one of the foreign lawyers who shared the consensus view that this was the next ’safe harbour’ for foreign law firms in China where the local Chinese law firms would find it difficult to compete. Even senior officials at the PRC Ministry of Justice privately expressed the view early on during this time period that the local firms did not have enough expertise and experience to run top-tier M&A deals and other similar projects requiring higher standards of process management and involving a larger number of more sophisticated inter-related contracts. Coinciding as it did with the pre-crash euphoria in the global economy and the very hot China market, this confident assessment of our superior market positioning in what was sure to be a growth market, led to a feeling of comfortable security, which is also known as hubris.
This conclusion, as should have been obvious even then, was mistaken and my confidence in the level of superiority of the foreign law firms in this market segment was misplaced. Even before the 2008 crash, which led to a sharp drop-off in M&A activity in China, and everywhere else, the Chinese firms had started to make significant inroads in this market sector. First, the private equity/venture capital work started to show signs of being commoditised. More foreign law firms piled in, driving the market price down. With the continuing exodus of local Chinese senior associates from the foreign firms, some of this work followed (or found) these lawyers at their new local firms. Top international investment banks and funds, whose on-the-ground deal teams were led mostly by Chinese returnees from overseas, became increasingly comfortable with using the top local firms for this work, further reinforcing this trend. Even some of the M&A projects undertaken by strategic MNC investors started to find their way to the local firms, starting with the lower value projects and moving up from there.
Currently, the foreign law firms’ position in the M&A market segment is still much stronger than in the generic FDI sector generally, but again the trend lines are clear, and it is only a question of timing as to when the local firms will take a leading position in this market segment in the same way as they have done in the FDI sector generally. However, for obvious reasons (see prior blog), I am no longer in the business of predicting the date of the end of the world, so I will be happy to let these trends play out as they do. I will say that the foreign firms are like to continue to enjoy a significant leading role in super-premium inbound M&A deals where brand value, and big deal experience, trumps all. But at the same time, if we look at the deal tables and at the deal values, we can readily observe that China is very much a mid-cap deal market with a relatively small number of super-premium deals in terms of value. Over time, that leaves a lot of room for the local firms to continue to expand market share and move up the value chain from there.
Moreover, even for the China bits of some of the major global M&A deals, even though the main deal may run to the top of the league tables in the US and Europe and involve high-profile parties, the China aspects may not be rocket science. Over the years, I have interviewed dozens of Chinese associates from the China offices of top New York firms (as they looked to leave voluntarily, were pushed out or were exiting in connection with a ’resizing’ of the office, which seems to happen with alarming regularity in outposts of many NY firms), who all boasted a long string of high-profile deals, but when you drilled down a little more it became clear that the China bits they worked on were, in fact, comprised of relatively simple FDI work. I have also done scores of these deals and, to be fair, the China aspects of many global deals will not be so simple and in many cases the China part of a global share acquisition will need to be run as an asset acquisition in order to separate good assets from bad assets, but that still leaves a lot of deals where the China bits are comprised mostly of relatively straight-forward FDI equity transfers and re-registrations. It often is not a question of high art in terms of technical legal work that can only be done by presumptively (and, in some cases, presumptuously) sainted lawyers in hallowed international firms but rather a deep understanding of the interface between the local regulatory environment and the deal structuring imperatives globally, deal management capability, problem solving skills (especially in regards to management of the common mismatch of China administrative process timelines with the timeline of the main deal closing) and the ability to meet the overall service delivery requirements of the US or European counterparts leading the global deal. These are skill sets that should not be taken for granted and in fact are of high value, but these skills also now can easily be found at both top domestic and foreign firms in China. If the China offices of a foreign law firm can charge New York or London rates for that work, then by all means they should do so, but I expect that market dynamics will end up forcing a regularisation of this market sub-sector over time as well.
On the other hand, the leading local firms have an important advantage over the foreign firms as a result of their superior access to government departments for M&A deals. For merger control filings, the door to the ministry of commerce is closed to the foreign firms, so they have to work with a local firm in any event. Similarly, Chinese firms have much superior – sometimes essentially exclusive – access to various other key ministries and regulatory bodies whose approvals must be sought in such M&A deals. On global M&A deals with a China element, there will need to be coordination between the China regulatory approval piece and the corresponding filings and approvals offshore, while for inbound acquisitions of Chinese targets, the China approvals will take centre stage. The superior positioning of the Chinese firms in this important aspect should prove to be an oversized Trojan horse, allowing the leading Chinese firms to continue to erode the market share of the foreign firms in respect of M&A deals in China.
Perhaps the biggest threat to the positioning of the foreign law firms in the M&A market in China will be the ongoing dramatic shift in terms of diversification of sources of capital. In the early days, MNCs ruled the market because they had capital and industry expertise. They were followed by foreign investment funds. But the coin has now flipped, or at least it is standing on edge ready to fall, and it is now the Chinese corporates that are flush with cash, and the domestic RMB funds are chasing more of the companies which previously would have been targets for foreign acquirers. So while there may be no early sunset for foreign private equity funds active in China, and strategic acquisitions by MNCs are likely to accelerate as another important prong of FDI into China (in both cases, so long as China does not erect additional regulatory or political barriers), at a minimum these foreign sources of capital will now be competing with domestic sources of funds for many of the same acquisition targets. And domestic M&A deals will be the domain of the domestic law firms, further eroding the overall M&A market share of the foreign firms.
Still, the highest profile inbound M&A deals in China likely will always involve both a leading international law firm and a leading local law firm working side-by-side, and in this category of deal no one needs to be overly greedy about the division of the work since there is more than enough for everyone. Even for many mid-cap deals, there can be opportunities for international and domestic firms to work the project on a cooperative basis (as we often do very happily with foreign firms with a smaller or no presence in China – and we do so in a circumspective manner which fully respects the existing relationship between the referring foreign firm and the shared client), and it will always make sense for this combined team of foreign lawyers and local lawyers to sort out the work allocation in the way which produces the most sensible result for the MNC client. But in many cases, a significant segment of the market is already comfortable working solely with the top local law firms, and this is a trend which has a lot of string left to play out. So, in sum, for inbound work for foreign clients in China, the market will continue to sort itself out, and the foreign firms and the local firms will each find their natural market positioning and the correct equilibrium in terms of how they work together as appropriate.
Those who have been paying attention (you have been paying attention, haven’t you?), may note that even though I indicated in the last blog that I was planning to cover both the inbound and domestic aspects of the foreign client segment of the China legal services market in this coupled pair of blog entries, leaving the Chinese client market segment to my next postings, I have not yet dealt with the market for domestic legal services for China subsidiaries of MNCs. The reason is quite simple – this market segment has effectively been ceded to the local firms for 10-plus years, so there is not much else to say. Once the MNC subsidiary is set up, it has to run on its own budget, and its legal service requirements are almost all domestic in nature. As their China business grows, these MNCs also tend to build up an in-house law department staffed with foreign-educated bilingual local Chinese lawyers.
All of these factors have combined to drive the work for these MNC subsidiaries in China to the domestic law firms. This is not something to be bemoaned by the foreign firms as this is typically lower value, more routine work, and in some cases the fees are not sufficient to attract the attention of partners in the leading Beijing and Shanghai law firms. Still, there are some important regulatory advisory matters as well as domestic deal structuring projects that are chunky enough for the top Chinese firms, and there will also be some highly sensitive issues, such as FCPA or fraud issues, that will rise to the HQ level in the MNC for which there will be a role for the China offices of the international law firms, often in conjunction with a strong local firm. But overall, this is not an important area of focus for business development on the part of the foreign firms.
There is one more related category of legal work for MNC clients in China that bears mention, namely regulatory advisory work. While foreign law firms cannot practice Chinese law, they in fact regularly provide advice on Chinese laws and regulations for their MNC clients. Leaving aside for the moment the question of whether this is appropriate (we will address this in a later blog in this series), it is a fact of life in the market, and one with which I personally have no quibbles, and the MoJ appears to take a similar laissez faire view as a practical matter. In-house counsel at MNCs are big boys and girls and they can go to whomever they want for this advice. As noted in a prior blog, in earlier days, local lawyers could tell you the black letter law but did necessarily frame the advice in a practical way that provided the level of comfort and direction required by the MNC client. Now the leading local lawyers have developed more finesse in both analysis and presentation, but beyond that they have in many cases added impressive depth of knowledge of all nuances and details of the increasingly complex regulatory schemes. When combined with the trump card of what in some cases is near exclusive access to and intimate “guanxi” with the government regulators, this becomes a very powerful set of arrows in the local law firm quiver, which is difficult for the foreign firms to compete with. This provides a significant competitive advantage not only (as noted above) in connection with M&A transactions and advisory work for MNC subsidiaries in China, but also for more and more MNCs which are entering more highly regulated industry sectors, for which regulatory advice is crucial.
So where are the current inbound market opportunities for the foreign firms in China? There are many obvious areas where the foreign firms have important competitive advantages with which the local firms will have difficulty matching in the near, medium and perhaps even long term. As noted above, there will always be ample space for the leading international firms at the very high end of the inbound M&A and FDI market, but that likely will be increasingly competitive at least vis-à-vis other foreign firm, and will likely involve a peer-to-peer cooperation with a top local firm in any event. Matters involving the extra-territorial application of foreign laws in China, such as FCPA or the UK Bribery Act, or involving significant inter-related on-shore/off-shore elements, such as for cross-border IP, bankruptcy, tax, disputes and the like, will also be areas of growth for the foreign firms, although again many of the on-shore elements will need to be supported by local firms in most if not all cases.
True international-standard industry/subject matter expertise in areas such as oil and gas, pharmaceuticals/life sciences, private client work, etc. is not well represented in the market as yet, so there is room for certain high-value niche practices. A lot of practitioners in both local and foreign firms will be able to point to deals on their CV in many of these areas, but generally they will not have the same depth of expertise as someone who has spent a career doing similar deals in multiple jurisdictions and who, as a result, are steeped in international industry best practices and know the related puts and takes for a myriad of business/legal issues that arise in the context of such projects elsewhere. The challenge in these specialist categories is that the market may still be open because the level of demand has not yet risen to the point which can support such a narrow focus – it will likely be a question of timing.
In any event, the established international firms in China have a significant head start and can pick and choose new areas to develop on top of what they already have and can afford to manage a transition out of old market segments and into new ones. New market entrants will need to find an underserved niche where they can demonstrate some comparative advantage. Simply planting a flag and presenting another “me too” offering of general corporate/commercial legal services will not generate much in terms of profile, business or revenues (although it may look good on the letterhead). I was a bit amused to read an article a couple years back from a recently arrived “laowai” (foreign) partner in the Shanghai office of a late-comer US firm. He wrote passionately about how the China offices of most US and other foreign firms which did not have a business plan based on a truly distinctive service offering might as well pack up and go home now because there was no room in the market for “me too” players. He then went on to describe his firm’s practice expertise, which was a carbon copy of 90% of the other US firms in the market. Last time I checked, their Shanghai office was still open, so I suppose they haven’t looked in the mirror yet or taken their own advice.
One play that we see many new foreign law firm market entrants making is to set up a smaller liaison presence in Beijing or Shanghai as a platform for marketing and developing relationships with leading local firms and clients in particular niche areas. They thus can maintain their existing client relationships while working the inbound matters for these foreign clients on a side-by-side basis with a local law firm, and doing the reverse for outbound matters for Chinese clients of the local firms. This makes a lot more sense in my view than setting up a mid-sized office to try to compete head to head with the established players, both foreign and domestic. When clients come in and start counting noses, it is hard to make a good impression with a small team playing on its own when the big international firms have 150-250 lawyers on the ground in Beijing-Shanghai-Hong Kong and the top Chinese firms have 500-1,000 lawyers. Partnering makes for good business sense in that scenario, which is why we are looking to employ a similar strategy for our new ZL office in London. We similarly want to use our new London office as a platform to facilitate cooperation with a broad range of UK and European firms in London to better serve clients on China-related matters going in both directions – and not, as some uninformed commentators outside the firm apparently have supposed, to facilitate a merger with a UK firm!
Overall, the trend for foreign law firms in China seems to be more in line with the market positioning of international firms in Japan – there may be sustainable levels of inbound work for MNC clients at the top end or in cooperation with local firms, but the primary opportunity for international firms in Japan is acting for the Japanese conglomerates on outbound matters, both contentious and non-contentious. The apparent strategy of many of the foreign firms in China similarly is to maintain sufficient inbound work for MNCs in order to sustain a team on the ground in China while positioning themselves for the anticipated tsunami of outbound work for Chinese clients investing abroad.
As of a few years ago, outbound work from China was, in my view, the last of the “safe harbours” for the foreign law firms in China, where the foreign law firms would have a clear, continuing and unassailable competitive advantage over the Chinese law firms. However, once again, when I drilled down a bit more, I decided that it was not as clear cut as I had suspected or hoped, and it was this conclusion that pushed me over the line and created the market imperative that compelled me to make the move to a leading Chinese law firm after more than 25 years of practice in international firms and MNCs.
As with so many other business opportunities in China, this may prove to be another elusive brass ring which always appears so tantalizingly close but in many respects remains just out of reach. We will talk next time about who is in the best position to grab and hold on to it. The answer may surprise you, just as it did me.
Robert Lewis is international managing partner at Zhong Lun Law Firm, based Beijing