Re-assessing China

Stephen Mulrenan, IBA Asia CorrespondentThursday 16 March 2023

Through the early part of the 21st century, China’s economy has seen relentless growth. Now, a slow-down, the pandemic and various geopolitical issues are forcing international law firms to rethink their strategies.

In February 2022, reports emerged that Norton Rose Fulbright, one of the largest UK law firms in Hong Kong, intended to ‘pivot’ its office in the city more towards China. This was a consequence of the ‘localisation’ of some of its most significant practice groups. In other words, it would recruit more Chinese lawyers to work with more Chinese clients using Chinese as the primary language of communication.

The move shouldn’t have come as a huge surprise given that the firm’s Chinese corporate finance practice – led by Hong Kong Managing Partner Psyche Tai – had long been the ‘engine room’ of the office. In a statement, the firm said: ‘To ensure we meet the evolving needs of both our international and local clients who operate in the region, we have been developing our capabilities in the Greater China market for many years and building a diverse team to service our clients in the future’.

The increasingly vital role that China is playing in Hong Kong, both politically and economically, is forcing many international law firms to re-evaluate their strategy in the city. Energy-focused Baker Botts pulled out of Hong Kong (and Asia) at the end of 2021, while UK firm Addleshaw Goddard, for example, has closed its Hong Kong office but maintains a presence in other Asian countries. Other firms, such as Goodwin Procter, used the opportunity to open in Singapore by relocating staff from Hong Kong.

By the time the 20th National Congress of the Chinese Communist Party was held in mid-October, one Hong Kong-based lawyer was quoted as saying: ‘Only those lawyers with a significant China practice are still here in Hong Kong. Everyone else has left.’

Living in interesting times

By the beginning of 2022, many international firms had bet big on China after a blockbuster year in terms of revenues in 2021 – albeit off a low base in 2020 following the arrival of Covid-19. With increased revenues, the more ambitious firms moved swiftly to increase their headcount in China and across the region to seize market share and service client needs. The pandemic proved to be something of a catalyst for substantial volumes of restructuring and insolvency matters, while environmental, social and governance considerations governed many capital raisings and business transitions.

But the picture deteriorated quickly in 2022 as a slowing Chinese economy – which had fallen to approximately three per cent growth from 8.11 per cent a year earlier – was significantly affected by months of widespread Covid-19 lockdowns and a historic downturn in the property market. While overall law firm revenues in 2022 were reportedly on a par with 2021, profits per partner were down as a result of more bodies being on the ground.

Clients were faring no better. Midway through 2022, global investment banks (IBs) reviewed their mainland operations – more specifically their securities activities and wealth management services – in light of regulatory tightening, escalating frictions between China and the US, and the impact of the Chinese government’s stringent approach to Covid-19. A number of IBs sought to recalibrate their plans to conquer China’s $56tn financial market. Some, such as JPMorgan and UBS, shuffled senior executives within China, while others reportedly made the decision to cut ten per cent of their China IB staff in 2023.

China feature secondary image

Elsewhere, private equity companies Carlyle Group and Warburg Pincus trimmed their China investments and dealmaking teams respectively, while hedge fund Tiger Global Management has also reduced its investments in the country. At least some of the big four audit companies have also quietly closed their legal operations in China. The downsizing is a far cry from three years ago, when China’s financial opening enabled the likes of Goldman Sachs and JPMorgan to move to majority ownership of joint ventures they had operated in China with little success over the previous decade.

The IBs have traditionally been, and continue to be, significant clients of the UK ‘magic circle’ firms. Hong Kong-based Robert Ashworth, Global Co-Head of M&A at Freshfields Bruckhaus Deringer and former Asia Managing Partner at the firm, doesn’t believe the banks are downplaying China. ‘Covid-driven difficulties were a significant part of why maintaining large numbers of expatriate staff in China became an issue’, he says. ‘But there are parts of those financial institutions that are grabbing more control of their domestic operations even though the pure investment banking model, which we think of as capital markets and M&A, has been very quiet.’

He adds that while it might stand to reason that law firms – who have historically always followed their clients – might downsize in a particular market if that’s what their clients are doing, investment banking is only a small part of what a lot of the international law firms are doing in China. A case in point is US firm Seyfarth Shaw which, in addition to handling corporate finance work out of Hong Kong and Shanghai, is well-known for its labour and employment expertise. The firm’s Regional Managing Partner Raymond Wong admits that his corporate finance practice has been ‘super quiet’, but adds that he’s beginning to ‘do other things such as restructuring that’s linked to [his] area, because many listed companies are struggling and trying to survive the challenging market conditions, so they’re busy with internal or business restructuring and trying to cut costs’.

‘The reason we’re expanding compared to many other international law firms is because we have a strong niche labour and employment practice, and we are somewhat recession-proof,’ adds Wong. ‘That’s because in good times companies are hiring people so we’re busy, while in bad times they’re firing people so we’re busy. That’s how we survived Covid-19 very well and why we have been steadily growing.’

Fundraising activities on the Hong Kong Stock Exchange (HKEx) dropped by a staggering 70 per cent in 2022. On the mainland, some $6tn was wiped off stock valuations following October’s 20th National Congress, where Chinese President Xi Jinping emphasised national security and ‘common prosperity’ over the market economy and wealth creation.

Caroline Berube, Co-Chair of the China Working Group of the IBA Asia Pacific Regional Forum and Managing Partner at HJM Asia Law & Co, which has offices in China and Singapore, says there’s a concern among international law firms in China about a potential ‘sanctions war’ between the US and China and the knock-on effect this could have on IBs operating on the mainland. ‘The ongoing China–Taiwan tensions could be resulting in spikes in costs for political risk coverage from insurance companies, potentially being passed on to the banks who have already had to withdraw their investments from Russia’, she says. ‘The resulting consequences are likely to mean international law firms possibly diversifying and reconsidering their client base to deal with any gaps left by lost clients and revenue.’

Domestic bliss

In addition to coping with a restrained ‘pure investment banking model’, another headwind faced by international firms in China last year was the continued growth of the country’s own leading law firms off the back of a thriving domestic M&A market, one that’s fuelled in part by the increasingly sophisticated bankruptcy and restructuring of major conglomerates. Chinese law firms are by some distance the largest in Asia, and in recent years have developed their domestic offering by opening regional offices and recruiting top talent, including directly from international rivals. In the last few years, Blank Rome and DLA Piper have both lost their heads of practice in China to local law firms, for instance.

It’s a very different sort of dynamic in China and, not surprisingly, those tie-ups take a long time to come to fruition

Robert Ashworth
Global Co-Head of M&A, Freshfields Bruckhaus Deringer

China’s latest ‘In China, for China’ policy, which focuses on expanding the domestic market and reducing dependence on foreign markets, has seen various international companies draw on deeper research and development (R&D) facilities in China to make products for a growing domestic market. AstraZeneca, which has revenues of $6bn a year in China and in 2022 opened a regional headquarters and an inhaler manufacturing facility in the city of Qingdao, said in November that it would advance R&D in the country and expand its manufacturing bases there.

As a result, the ‘China for China’ strategy is likely to lead to further expansions or tie-ups by international firms with local practices in the Chinese free trade zones (FTZs). Many of these joint ventures have, as their main strategy, the goal of capturing more inbound international work that would otherwise go to a Chinese law firm. The first such venture to be established in the Shanghai FTZ was Baker McKenzie’s tie-up with FenXun Partners in April 2015. Since then, other firms such as Linklaters and Allen & Overy have formed joint ventures in the city, with Zhao Sheng in 2018 and Lang Yue in 2020 respectively.

International firms are generally looking to partner with a view to servicing their international clients rather than having to hand that work over, or have that work go direct, to a Chinese competitor. A key benefit is that they don’t need so many of their own lawyers on the ground, which is useful given that many wish to trim down their operations in China. The flipside is that they become reliant on their Chinese partner firms, which makes finding the right one critical. ‘Entering into any partnership must be carefully assessed, more so when entering into a business relationship with an overseas […] partner’, says Berube.

‘Commercial differences are one thing, but cultural differences can also play a huge role when selecting the right local partner.’

Recorded Chinese outbound direct investment in the first half of 2022 was $68.8bn, down 3.6 per cent year-on-year, as Chinese enterprises found themselves in a progressively complex environment when investing overseas. A concern for international firms therefore is that any joint venture might help a Chinese partner firm leverage relationships with multinational corporations to grow in China, while being unable to send the foreign element of Chinese client work to their international partner.

Wenxin Zhou, a partner at Lang Yue, acknowledged the value proposition to Chinese firms at the time of his firm’s collaboration with Allen & Overy. ‘The top-tier training and exposure to high profile cross-border opportunities offered by Allen & Overy to our team under this Joint Operation is unparalleled’, he said.

Although all international firms are looking for something slightly different in potential partner firms, one cultural challenge they all face in China is the relative youth of their prospective ally. Many Chinese firms are typically between ten and 20 years old and some are even younger – Lang Yue was founded in 2014, for example – and were created by partners spinning off from some of the more established Chinese firms.

Ashworth says this is quite different to a big merger between two well-established international firms. ‘It’s a very different sort of dynamic in China and, not surprisingly, those tie-ups take a long time to come to fruition and take a huge amount of preparation and diligence’, he explains. ‘But we may see more international firms going down that route because it’s now a path that is reasonably well trodden. And, from what we’re hearing, the one-stop-shop is an attractive model in China provided you have the right quality on the ground.’

A bullish future

It seems unlikely that successfully sealing a joint venture with a Chinese law firm partner will lead to more domestic instructions as Chinese companies tend to use the so-called ‘red circle’ Chinese law firms. ‘Chinese law firms do the lion’s share of domestic work, whether that is share issuances or public company M&As on the Shenzhen or Shanghai stock markets, as that requires significant resources that the joint ventures tend not to have’, says Ashworth.

As a result of the slow workflow from Chinese clients, some Chinese partners of international law firms are known to have suffered high staff turnover. Regardless of whether that changes in the future, the joint venture option won’t suit the business development strategies of every international firm in China.

The Hong Kong office of Charles Russell Speechlys (CRS), which is focused on private wealth and dispute resolution, has recently celebrated its fifth anniversary and the firm will soon open in Singapore too. Simon Green, an international partner who leads the firm’s focus in Asia from its Hong Kong office, says that in China, the firm partners ‘with leading Chinese firms for “on the ground” advice when our clients need local support’.

We have found that clients who are keen to transact with Chinese counterparties prefer to do so with the familiarity of the common law system in Hong Kong

Simon Green
International partner, Charles Russell Speechlys

In June 2022, CRS announced Silvia On as the new head of its China Desk in Hong Kong. Green says it’s the territory’s recognised legal system that’s a key attribute to the firm’s China strategy. ‘We have found that clients who are keen to transact with Chinese counterparties prefer to do so with the familiarity of the common law system in Hong Kong,’ he explains. ‘Although Chinese local firms are developing rapidly, we believe there will continue to be a need for collaboration with Hong Kong-based law firms to deliver successful outcomes for clients.’

While CRS provides advisory, transactional and contentious services to private clients, other international firms are hoping for the return of capital markets work. In 2020, mainland investors poured $270bn into the Hong Kong market, up from $1.7bn just seven years earlier. But while the Shanghai and Shenzhen stock markets were the top two markets in the world in 2022 in terms of capital raised, Hong Kong barely made the top ten. That was partly due to increasingly stringent listing requirements – around market capitalisation and revenue – imposed by the HKEx and Hong Kong’s Securities and Futures Commission.

With the likely delisting of Chinese stocks from American bourses, Hong Kong is seeking to relax its listing requirements with a view to attracting a number of Chinese companies that may delist from US exchanges. ‘Among other things, Hong Kong is offering a new channel for specialist technology companies to be listed on the mainboard and further tax breaks for family offices’, says Berube.

Life has become quite difficult for many Chinese companies listed in the US. On 1 January 2021, the US Holding Foreign Companies Accountable Act became effective, empowering US auditors to seek access to the audit records of Chinese issuers. However, this contravened Chinese regulations on export material – and confidential material in particular – placing Chinese companies between a rock and a hard place.

Pent-up demand in sectors such as AI and green energy will reignite a rebound in deal activity, both onshore and offshore, accelerated by access to capital

Audrey Chen
Regional Fora Liaison Officer, IBA Corporate and M&A Law Committee

‘The US side made clear that, unless these audits were allowed to be carried out, all non-complying Chinese companies would be mandatorily delisted from the stock exchange within three years,’ says Ashworth. ‘But a compromise was found where US auditors go to Hong Kong to examine the books of some of these Chinese listed companies, and that seems to have gone fine. It’s probably still a bit too early to say whether the risk of mandatory delisting is receding, but we will see more Chinese companies coming back from the US.’

Although M&A deal value and volume in 2022 was significantly down from the record heights of 2021, as geopolitical instability, inflationary pressure and interest rises dampened activity, Ashworth is optimistic for the year ahead. ‘Firstly, there’s a pent-up pipeline of potential deal activity. Things that were parked and waiting for more clarity of direction are beginning to open up. So, we hope to see activity levels return, if not to the very robust levels of 2021, certainly to a more normalised environment.’

The second reason, he says, is the Chinese border reopening with Hong Kong and the rest of the world, enabling dealmakers to move in and out without restriction. ‘This will provide a catalyst to do deals that were looking to get done, and that’s a very significant change. Allied to that is the optimism that comes from frictionless business travel. People are looking forward rather than looking at their feet.’

The third China-related reason to be optimistic is, he says, more nuanced and to do with the way China is looking to portray itself in 2023. ‘There is a degree of nervousness within the Chinese establishment about how they are seen by the rest of the world, from how they are perceived in tech and data to how they’re aligned in the geopolitical arena. Yet, fundamentally, China is signalling that it is open for business and very keen to continue to attract foreign investment.’ Ashworth says that China wants the rest of the world to recognise its importance as a manufacturing hub. ‘China is saying it has now sorted out its domestic issues, would like to re-engage, and will try to set conditions, at least economically, financially and from a regulatory perspective, to encourage foreign investment.’

As the turbulent events of recent years – from Trump’s trade wars to Covid-19 to Russia’s invasion of Ukraine – have called into question the vision of a globalised economy, the concepts of ‘nearshoring’ and ‘friend-shoring’ – that is, the practice of relocating supply chains either nearer to home or to countries with shared values – have entered the vernacular of supply chain professionals. ‘But it’s very difficult to mothball a factory in Shenzhen, for example, and shift all of that manufacturing to Vietnam or Thailand’, says Ashworth. ‘A lot of people were talking about a different way of doing business in a post-pandemic, slightly more polarised world. But that’s not going to happen anytime soon. We will see China still being a very desirable destination and trading partner, and a country that offers plenty of upside for people who are prepared to roll with the risks.’

Although three years of Covid-19 restrictions have wreaked havoc on the Chinese economy, sparking public anger and placing extraordinary pressure on local government finances, the easing of Covid controls has, among other things, helped Hong Kong’s main index rally since its October low. And while recent airspace intrusions in the US are a reminder that relations are still fraught between China and the West, China’s determination to reduce its international isolation and boost its growth rate can only spell good news for international law firms.

Audrey Chen, Regional Fora Liaison Officer of the IBA Corporate and M&A Law Committee and a partner at JunHe in Beijing, believes that for the private sector, small- and medium-sized businesses and millions of Chinese people, the reopening of the borders will be the most consequential event of 2023. ‘Despite various uncertainties and geopolitical tension, both domestic and international clients of ours strive to reconnect, revive paused projects, and rebuild confidence to rekindle potential business opportunities’, she says. ‘Pent-up demand in sectors such as AI, agriculture, consumer products, digitalisation, life sciences, infrastructure and green energy will reignite a rebound in deal activity, both onshore and offshore, accelerated by access to capital.’

Stephen Mulrenan is a freelance writer and can be contacted at smulrenan@lextelpartners.com