Xu Zhijun, chief marketing officer at Huawei Technologies, was blunt in his assessment of claims that Huawei’s part in a bid for American firm 3Com was a threat to US national security.
“That would be bullshit,” he told the Financial Times in late February, pointing out that Huawei would own just 16.5% of 3Com. The Chinese firm’s partner, US private equity group Bain Capital, would be the majority shareholder and assume management control of the computer networking company.
The investors were also willing to spin off Tipping Point, the firm’s anti-hacking software unit, which has supply contracts with the US government.
It’s fair to assume the language in the Huawei boardroom was as colorful as Xu’s when, barely two weeks later, the US$2.2 billion bid was withdrawn after it emerged that US government approval was unlikely to be forthcoming.
The doubts came from the Committee on Foreign Investment in the United States (CFIUS), the inter-agency body that reviews the national security implications of foreign investment in US companies. Its reservations about the deal have effectively thrust the issue of US protectionism back into the spotlight.
A protectionist tide?
With presidential elections on the horizon, it is feared that foreign-invested acquisitions in the US are being unfairly politicized. Ghosts of thwarted deals past – such as China National Offshore Oil Corp’s (CNOOC) unsolicited bid for US oil firm Unocal in 2006 – are reappearing in the media.
However, there is a rival body of opinion which suggests the problem is not foreign acquisitions in general or Chinese investments in particular. It is Huawei.
“We have seen other transactions go forward,” said Illinois Representative Mark Kirk, a Republican who heads the Congressional US-China Study Group. “But in this case I don’t think there was any anti-China feeling, it was more an anti-Huawei feeling.”
The key issue is Huawei’s alleged links to the People’s Liberation Army (PLA) and whether part-ownership of 3Com would give the firm access to technologies that could be put to Chinese military use. The US places strict controls on the export of dual-use technologies to China.
In March, the US Department of Defense made its annual report to Congress on China’s military. It identified Huawei as one of several tech firms that “maintain close ties to the PLA and collaborate on research and development.”
A number of US politicians have expressed discomfort at this supposed relationship, often citing a study carried out by the Rand Corporation, an American think-tank, in 2005.
The report speaks of a “digital triangle” in China’s defense industry, with information technology companies, state research institutes and the military as its vertices. It goes on to suggest that, through the increased use of off-the-shelf products such as computer network switches and routers, the military benefits directly from the IT firms’ efforts.
Although Huawei is now largely commercial, it was founded by a former director of a PLA engineering academy. Rand concluded that the military remains an important customer of Huawei’s as well as its “political patron.”
“Given what the Chinese are saying about dual-use bases in telecoms, IT and software, [Huawei] is a legitimate security concern,” said Adam Segal, who researches Asian military and technology issues for the Council on Foreign Relations in Washington DC.
“But is stopping Huawei from investing overseas the best way of dealing with it? I am not sure.”
Segal contends that any foreign investment in high-tech equipment manufacturing in the US is inevitably going to raise alarm bells. There is a precedent. In 2006, when the US$13.4 billion merger of equals between Alcatel of France and US firm Lucent went before CFIUS, a ready-made solution to concerns related to Lucent’s government contracts presented itself: A separate company with a US board would be set up to manage those sensitive operations.
On January 25, 3Com made a filing with the US Securities and Exchange Commission regarding the Bain-Huawei buyout. The filing included details of how the deal would be priced if it did not include Tipping Point. It also stated that Goldman Sachs was in talks with firms interested in buying the unit. Further financial information came in a later filing dated February 19, the day before the deal was withdrawn.
The question remains as to whether the parties involved had done enough groundwork, within a reasonable timeframe, to convince CFIUS that the transaction was sound.
“From what I have heard there was some reluctance to create a structure upfront to divest Tipping Point as they were worried about a fire sale,” said Ivan Schlager, a partner at law firm Skadden, who has been involved in numerous CFIUS cases, including Alcatel-Lucent.
“When we represented a Middle East entity in a US acquisition, one of the first things we did was set up a divestation trust run by three well known trustees. You must have a proactive strategy for dealing with these kinds of situations. If the CFIUS review is only an afterthought to a deal then you are setting yourself up for difficulty.”
The idea of putting out fires before they start often crops up in discussions about Chinese investment in the US. It is not just about pre-empting issues that might be of concern to CFIUS and require a deal to be restructured; winning political goodwill is also crucial.
“The formula for success is to do everything you can at the front-end to eliminate the potential political outcry that may come from a small but vocal few in the political system,” said Tom Ridge, who served on CFIUS when he was US Secretary for Homeland Security. He now runs Ridge Global, a consultancy.
“Before you proceed aggressively down the economic path you must pursue a parallel path that includes a thorough PR strategy to deal with the media and anticipate the political criticism.
“I know of people who CNOOC approached, looking for last-minute help, but it was just too late in the game.”
Big Blue goes red
One deal in which the Chinese party and its advisors got it right was Lenovo’s acquisition of IBM’s personal computer business for US$1.75 billion in 2005. While desktop and laptop PCs do not raise the same national security hackles as networking systems and software solutions, those involved were still apprehensive about a possible backlash.
“We were very worried about it – just imagine what might have happened if the political commentators had started saying ‘Big Blue becomes Big Red’,” recalled one lawyer who worked on the deal. He asked not to be named as he since moved on to a new position and didn’t want to be seen as speaking for his former employers.
“We were talking to people well before the deal was announced. We spoke to politicians, people from think tanks, the media and anyone we thought reporters might contact for comments.
“It was an aggressive strategy to shape the way people thought about the transaction. Our message was always: This is not sensitive stuff.”
To back this up, the lawyers put together portfolios of data that showed how much PC manufacturing was already taking place in China. They wanted to explain that a change of ownership posed no threat to US jobs or security.
In this respect, a little education can go a long way – especially if people’s minds are easily clouded by the misinformation that often tailgates a controversial acquisition. According to Kirk, during all the commotion about CNOOC’s bid for Unocal, most members of Congress were unaware that Unocal’s principal assets were in Indonesia rather than the US.
It is suggested that greater care has been taken in preparing the ground for more recent China-related transactions.
Mike Dyer, director of government relations at law firm Blank Rome, said he was pleasantly surprised by the absence of national security talk when China Investment Corp, the country’s sovereign wealth fund, spent US$5 billion on a minority stake in US bank Morgan Stanley in December. Dyer notes that New York’s Democrat Senator Charles Schumer – who is “usually right out there opposing the transactions” – now receives visits from company representatives looking to discuss deals.
However, both Dyer and Ridge stress that, while good PR can diffuse political tensions, success ultimately comes down to playing by the local rules.
“There are procedures and protocols that US companies have to work through in order to invest in China. Now that Chinese companies are looking to make acquisitions in the US they must follow the procedures and protocols of this country,” Dyer said. “It’s not as easy as one-two-three.”
Bain and Huawei have indicated they will resubmit a modified version of their 3Com application under which the Chinese company’s access to core networking equipment would be even more restricted. If it results in another failure, it would only fuel sentiment among many Chinese that the US is trying to block outbound investment.
“I don’t think there is any doubt about this – Chinese companies have been burned on multiple occasions,” said Roger Cliff, a senior political scientist at Rand and one of the authors of the 2005 report.
“This has the effect of discouraging Chinese companies to make acquisitions in the US that may be to the mutual benefit of both economies.”