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Valuation Insights is a quarterly e-newsletter that provides you with the latest news from Duff & Phelps and the trends and changes in valuation and accounting that could affect your business transactions in Asia.
We will also look at various important updates, including global trends affecting Chinese outbound investment in Europe and new investment guidelines from the Chinese government.
Updates and Market Trends:
Latest Duff & Phelps Report and Articles:
Start-ups in Greater China: Growth Presents New Challenges
The start-up spirit is alive and well in China creating a new age of entrepreneurship encouraged by the government.
In a March 2017 report, Chinese Premier Li Keqiang reported “a 24.5-percent year-on-year increase in the number of new businesses registered—an average of 15,000 new businesses daily,” he beamed. “We had an average of 45,000 new market entities launched per day. New growth drivers are opening new prospects for China’s development.”
“Fintech is quite hot and popular in recent years; in the past 10 years we see the surging of a lot of different industries,” noted Kevin Leung, managing director for Valuation Advisory Services, Duff & Phelps Beijing. Leung said that a particular subsection of these start-ups enjoys greater government support. “It depends on whether companies operate in sectors that are in the government interest for strategic development,” Leung explained. “Artificial intelligence, robotics, electric car manufacturing– for those industries, the government will provide incentives.”
With this surge comes a pressure-cooker environment for Chinese start-ups. The hyper-competitive atmosphere has the majority of start-ups scrambling rel="noopener noreferrer" to raise capital. A study released by Shanghai-based SPD Silicon Valley Bank indicated that 84 percent of Chinese start-ups expect a challenging fundraising environment ahead.
More than half of Chinese start-ups expect funding to come next from either venture capital or private equity. China's venture capital industry is the world's second-largest. With Chinese start-ups accessing new inflows of capital, accurate valuations have become more important than ever. “It's not only private equity firms investing in those start-up companies, Hong Kong and U.S. listed companies are also acquiring minority stakes.” Leung said, noting that next year's implementation of IFRS 9 will also trigger a greater need for valuation of China's new start-ups.
Singapore Accounts for 70% of H1 2017 Southeast Asia M&A
In H1 2017, Singapore, Malaysia and Indonesia recorded a total deal activity valued at US$63.3 billion spread across 818 deals. Globally, about 19,900 deals valued at over US$1.5 trillion were registered in the same period.
Singapore contributed over 70% of the M&A value in the region for H1 2017, while Malaysia experienced record M&A deal volumes and grew 28% for deal values relative to H1 2016. Indonesia's M&A deal value for H1 2017 doubled over the prior corresponding period. Singapore remains the driving force behind M&A deal-making in the region, with deal volume up 13% and a deal value of US $42.6 billion.
The largest contributor to M&A deal values in Singapore was the Real Estate sector, which accounted for approximately 29% of deal values. Real Estate also contributed the most to deal volume, accounting for over 23.6% of the deal volume in Singapore with a total of 90 deals.
“The region has shown a robust growth in M&A and investment activity in H1 2017, in spite of the negative outlook in certain sectors,” said Srividya Gopalakrishnan, managing director, Duff & Phelps Singapore. “Corporates and funds have been opportunistic in tapping into the global markets, leveraging low valuations and high growth in certain sectors.
“Singapore has contributed to a significant part of the deal values, driven by outbound transactions, while Malaysia and Indonesia have contributed to the growth in deal making, driven by inbound investments,” Gopalakrishnan said.
More information on capital markets activity in southeast Asia can be found here: Duff & Phelps Transaction Trail H1 2017
The mandatory adoption date for a new standard is fast approaching for companies filing under International Financial Reporting Standards (IFRS). IFRS 9 Financial Instruments, a replacement to the existing IAS 39 Financial Instruments: Recognition and Measurement, will become effective on January 1, 2018, for calendar-year companies.
IFRS 9 was originally a joint project between the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB). The joint effort was accelerated in response to the global financial crisis of 2007-2008. The boards eventually diverged in the direction of the project, which means that, when comparing financial statements of companies filing under IFRS versus US GAAP , there will be material differences in the presentation and measurement of financial instruments.
IFRS 9 substantially improves the classification, measurement and impairment of financial instruments as well as general hedge accounting.
IFRS 9 simplifies classification and measurement by introducing three categories for all types of financial assets: Amortized Cost, Fair Value through Other Comprehensive Income (FVOCI) and Fair Value through Profit or Loss (FVPL). The use of one of these three categories is a function of an entity’s business model and the characteristics of the contractual cash flows associated with each financial asset. Two critical tests need to be passed to achieve an Amortized Cost designation for any given financial asset:
The objective of the entity’s business model should be only to hold the asset in order to collect contractual cash flows (“the Business Model test”).
The contractual cash flows of an asset are solely payments of principal and interest (SPPI) on the principal amount outstanding (“the SPPI test”).
To be able to classify a financial asset in the FVOCI category, the Business Model test above is expanded so that the objective of holding the asset is not just to collect contractual cash flows, but also to sell the financial asset. These criteria must be met simultaneously for an instrument to qualify for measurement at Amortized Cost or FVOCI. If any of these criteria is not met, then the asset must be measured at FVPL (i.e., mark to market) at every reporting period.
“Historically, not all financial assets were recorded at fair value in the books of a financial institution – as a new requirement, most financial assets must be marked to fair value, with a couple of exceptions,” said Ricky Lee, managing director of Valuation Advisory Services, Duff & Phelps Hong Kong.
“The practical implication of the new criteria is that only certain assets can qualify for measurement at Amortized Cost or FVOCI. A good example is a debt instrument, where the contractual cash flows are predictable, such as payments of principal and interest,” Lee said. “If you’re a financial institution and you hold the debt investment until maturity, then you don’t need to mark to fair value and instead can use the Amortized Cost classification of the debt instrument.”
The new standard also has significant implications on equity investments owned by minority shareholders or private equity funds. “In the past, if you owned less than 20 percent interest in an equity instrument, a cost method was used to record your investment,” Lee explained. “After the new standard becomes effective, even though the interest is less than 20 percent, you will need to mark the equity instrument to fair value.”
“This changes the outlook for companies, which now must decide whether they require an external and independent valuation services provider, something that previously would not have been justified or necessary,” Lee said. “Companies that own several investments in lower than 20 percent equity interests will now need to mark them to fair value at every reporting period. Many of these valuation exercises will be based on very limited information due to lack of access to management of the target company. In such cases, the valuation methodologies that can be used will be restricted.”
In these circumstances, Lee considers a simplified analysis based on the limited information available. “We have a range of services, from a full, independent valuation analysis to a positive assurance based on the client estimation of the fair value,” he explained. “The latter approach is more appropriate for clients with smaller equity holdings.”
IAS 39’s treatment of financial liabilities is carried forward to IFRS 9 and essentially unchanged. This means that most financial liabilities will continue to be measured at Amortized Cost unless the company uses the fair value option. There are a few exceptions, however, one of which is very pertinent to financial institutions. Specifically, IFRS 9 addresses the so-called “own credit” issue. The fair value of an entity’s own debt is affected by changes in the entity’s own credit standing (own credit). Under IAS 39, when an entity’s credit quality declines, the fair value of its liabilities decreases, which results in the somewhat counterintuitive result of a gain being recognized in the income statement when the outlook for the entity has actually deteriorated (and vice versa for an improvement in credit worthiness). With IFRS 9, such changes in own credit related to an entity’s own debt measured at fair value will impact OCI rather than the income statement, thereby reducing earnings volatility.
Finally, perhaps the most significant change of IFRS 9 is the introduction of a forward-looking expected credit loss (ECL) model for all financial instruments subject to impairment accounting. The ECL model only affects the subsequent measurement and impairment of financial assets that are classified under either Amortized Cost or FVOCI, not instruments that are measured at FVPL. Expected losses will be quantified at inception and will be updated periodically, whereas under IAS 39 losses were recognized only when they occurred (a “backward-looking approach”). This will increase volatility in earnings, particularly in periods of credit deterioration in financial markets.
Transfer Pricing in Hong Kong: IRD Responds to BEPS
The Hong Kong Inland Revenue Department (IRD) recently published proposed measures to counter base erosion and profit shifting (BEPS). Spearheaded by the Organisation for Economic Cooperation and Development, the proposed BEPS measures are intended to counteract tax structuring and planning practices that, amongst other things, lead to a misalignment of economic activity and tax revenue.
“Aggressive tax structures have been set up across a diverse range of industries, such as technology. These structures, often used when the value of intangibles is significant, enable groups to minimize tax by recognizing profits in low tax jurisdictions such as Ireland and Singapore,” explained Steve Carey, managing director of the transfer pricing practice at Duff & Phelps Hong Kong.
“Therefore other tax jurisdictions in the transaction are questioning: Does that allocation of profit really reflect the economic substance of this business, and are we receiving a fair tax contribution from this business? In most cases the answer is ‘no’", said Carey. The new BEPS initiatives counter this by introducing a series of 15 action plans. “What BEPS focuses on in relation to intangibles is economic ownership. For example, if you believe your trademark is owned in a certain jurisdiction, can you show that your marketing team is located there, as well as prove that all the marketing expenses incurred to build up that trademark over the years have been expensed and funded from that same location?” asked Carey.
“Closer to home, if you have a marketing team on the ground in China, but you are arguing that the brand is owned by the Hong Kong parent company and the Hong Kong company enjoys the profit from that brand, such a mismatch is likely to face scrutiny from the Chinese tax authorities in the future, if it hasn’t already.”
This does not mean the end of tax structuring in relation to intangibles; however, for accounting and tax purposes, it does require careful planning and in many cases the need to accurately value a brand or other intangible that is being moved between tax jurisdictions.
The new rules represent a shift of thinking in Hong Kong. “Historically, Hong Kong has been very slow to come to the table, because it is seen as a relatively low-tax, business-friendly place. ,” Carey said. However, the focus is now changing. “China has been focused on transfer pricing for a few years, and so have many other countries,” Carey continued. “In order to be seen as a good global citizen, Hong Kong is starting to fall into line, although somewhat reluctantly. However, with corporate tax rates falling globally, Hong Kong’s perceived advantage in that respect has been greatly diminished.”
Proposals to reinforce the new measures involve, among other things, adoption of a formal transfer pricing regime and mandatory documentation requirements, to take effect on January 1 2018. Now is the time to review tax and transfer pricing models and assess whether they are going to withstand scrutiny from the IRD or other tax authorities in rel="noopener noreferrer" the future.
For more information, read the IRD's Consultation Report on Measures to Counter Base Erosion and Profit Shifting.
Global Trends Affecting Chinese Outbound Investment in Europe
New regulatory developments may directly influence China outbound investments in the near-term.
New German regulation rel="noopener noreferrer" on foreign investment control
The German government recently published an amendment to regulations on foreign investment control, covering the Foreign Trade Act (Außenwirtschaftsgesetz in the German language, or AWG) and the Foreign Trade and Payments Ordinance (Außenwirtschaftsverordnung in the German language, or AWV).
The rule change applies to transactions where an acquirer is located outside of the European Union, and at least 25 percent of the voting rights in a German company are to be acquired. The rules also apply to transactions falling within specific sectors.
Under rel="noopener noreferrer" the revised rules, cross-border transactions and outbound investments originating from China are expected to be held under tighter scrutiny, with prolonged administrative procedures sure to follow. Chinese investors looking to acquire German corporations should plan for additional time in their closing schedules, if acquisitions fall within any of the regulated industry sectors.
Brexit's impact on China UK deals
The UK's Brexit from the EU promises a number of short-term and long-term compliance and regulatory considerations for Chinese investments. This fast-moving and constantly evolving situation makes it hard for market participants and investors to plan with any certainty. Brexit may affect the UK transfer pricing environment in two ways: (1) freedom from the relevant EU Directives, and (2) movement of companies or financial and other assets into or out of the UK.
An expected deterioration of growth expectations will have a negative effect on many investments. Post-Brexit, concerns in the UK, Germany (see above) and France may hamper Chinese Foreign Direct Investment prospects indefinitely. Ongoing bilateral investment treaties have been disrupted by Brexit, with no clear resolution in sight.
New China Guidelines on Overseas Investments Published, Tightening Capital Outflow
New rules on overseas investment by Chinese companies, published on August 17, 2017, codify overseas dealmaking to be encouraged, limited or outright prohibited by the State.
A joint product of the National Development and Reform Commission (NDRC), the Ministry of Commerce (MOC), the People’s Bank of China and the Ministry of Foreign Affairs of the People’s Republic of China, the newly published Opinions on Further Guiding and Regulating the Directions of Overseas Investments (the “Guiding Opinions”) clarify China’s regulatory attitude towards Chinese M&A to date. Part of an effort to curb hundreds of billions of dollars exiting China, the new rules effectively slow down Chinese outbound investment in several key sectors.
Other actions taken by the Chinese government – among them increased scrutiny over overseas investments, unofficial restrictions imposed in governmental departments and banks, and the denial of financing to private companies engaging in highly-leveraged overseas investments – have cumulatively decreased Chinese outbound M&A by 42.9% year-on-year to RMB 331.1 billion in the first half of 2017.
The new rules restrict investments in property, gambling, hotels, entertainment, sports clubs and core defense technologies. Infrastructure projects – particularly those based in countries participating in China's Belt and Road Initiative – remain open, but uncertainty hovers over projects in countries lacking stable political systems. With few outside investors willing to take up the slack, Chinese banks may end up assuming most, if not all, of the risk.
Global Enforcement Review 2017
Duff & Phelps’ Global Enforcement Review (GER) 2017, looks beyond just the words, policies and intentions of the world’s financial services regulators. Drawing from data published by key regulators in the U.S., U.K. and Hong Kong, as well as commentary and insight from around the globe, this report examines those policies in practice: how they invest, when they act and what they do.
IPL: The Decade Edition: A Concise Report on Brand Values in the Indian Premier League
The findings of the fourth edition of Duff & Phelps’ annual study of the Indian Premier League (IPL) franchisee brand values indicate that the overall value of IPL as a business has increased to US $5.3 billion from US $4.2 billion last year, representing a three-year compound annual growth rate of 13.9%. The report highlights the evolution of the IPL since its inception in 2008 and its steadily expanding foothold on the global sporting scene.
Transaction Trail H1 2017
Singapore recorded a total of 485 deals (M&A, PE/VC and IPOs) worth US $46.1 billion for H1 2017, which compares with 383 deals (M&A, PE/VC and IPOs) worth US $43.4 billion for H1 2016. M&A comprised the bulk of the deal volume in Singapore registering 383 deals valued at US $42.6 billion in H1 2017, compared to 339 deals valued at US $40.5 billion in H1 2016.
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$130 million credit facility
Takata Europe GmbH has completed the sale of certain assets and liabilities to Key Safety Systems, Inc.