In an earlier issue of this publication, we reported that foreign private equity firms were turning to alternative structures when investing in Chinese companies, due to certain Chinese legal restrictions. One alternative often used was to invest directly onshore through a Sino-foreign joint venture under the foreign-invested enterprise (FIE) laws. As previously noted, there are a number of issues with this structure and many foreign private equity investors have failed to get comfortable with the idea of what could best be described as “fitting a square peg in a round hole”.
Of course, prior to the introduction of the Regulations on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors (the “M&A Rules”) in September, 2006, the common practice was to use an offshore “red chip” structure. Typically, this entailed the foreign investor investing in an offshore holding company formed by the Chinese founders, which then acquired the onshore business that such Chinese founders own, thereby converting it into a wholly foreignowned enterprise (“WFOE”). However, since the introduction of the M&A Rules, such “red-chip” offshore structure, also commonly known under the Chinese regulations as a “round-trip” investment, has essentially become unviable.
Sina Structure
So where has this left foreign private equity investors still keen to invest into China? Yet another alternative has been to consider a structure well known to practitioners in China known simply as the “Sina Structure” (named after one of the earlier Chinese portal companies that used this structure to go public).
The “Sina Structure”, was first adopted for the purpose of dealing with the Chinese regulatory restrictions on foreign investment in certain industry sectors. The offshore holding company holds a controlling interest over the domestic operating company through a series of contractual arrangements rather than through direct majority equity ownership. Under this structure, instead of acquiring and holding the existing Chinese business operated by the founders, the offshore company will set up a WFOE in China and the WFOE will then enter into certain captive agreements with the domestic operating company and its shareholders that, in effect, transfer the economic interest of the domestic company to the WFOE and ensure the holding company’s control over the domestic company. Typically the agreements comprise the following:
»» a loan agreement under which the WFOE grants a demand loan to the Chinese founders/shareholders of the domestic company for the capitalization of the domestic company;
»» a technical service and/or license agreement under which the WFOE provides technical support and consulting service to the domestic company in exchange for a substantial portion of the economic benefits of the domestic company being transferred to the WFOE;
»» a proxy agreement under which the WFOE is appointed proxy to exercise substantially all the rights which the shareholders of the domestic company have as the shareholders of such entity;
»» a call option agreement under which the WFOE is granted an option to purchase all or part of the equity interest in the domestic company when and to the extent permitted by PRC law; and
»» an equity pledge agreement under which the shareholders of the domestic company pledge their equity interest in the domestic company to secure their obligations under the relevant contractual control agreements.
The lack of any outright equity ownership has essentially enabled foreign investors to acquire and hold controlling interests in restricted industries in China. However, this same structure can be used to gain control of Chinese companies without it being deemed a “round tripping” investment, obviating any need to seek the approval of the Chinese Ministry of Commerce at the central level – an approval that has been extremely difficult, if not impossible, to obtain.
GEM and its Opportunity The long awaited Growth Enterprise Market (GEM) in China, which is likely to be launched in the second half of 2009 as China’s first alternative or secondary market, is anticipated to represent a viable new financing platform for emerging companies in China. For the rapidly emerging RMB denominated funds, the GEM will likely be an attractive exit option.
However, for foreign private equity funds that are comfortable with investing through an FIE onshore structure, there are a number of hurdles that may make GEM a less attractive option. These include the need to convert from an FIE to a foreign invested company limited by shares (“FICLS”), which requires three consecutive years of profitability, compliance with a more onerous set of prelisting requirements, a potentially extended post listing lock-up period and possibly higher income tax exposure. Notwithstanding these hurdles, GEM still potentially provides an exit option to those foreign private equity funds who choose to invest through an onshore vehicle in China.
However will the same opportunity exist for those investors who prefer to, or must, use an offshore structure?
Hybrid Sina Structure The core of the contractual arrangements that make up the Sina Structure is to make the domestic operating company a quasi-wholly-owned subsidiary of the WFOE so that the offshore holding company is entitled to consolidate the financial results of both the WFOE and the domestic company in its own consolidated financial statements, which in turn is the fundamental basis for the IPO and listing of the offshore holding company.
Unlike the “red-chip” offshore structure, the foreign investors in a standard Sina Structure do not actually hold any equity interest in the domestic company and, as a result, an IPO and listing of the domestic company on China’s GEM doesn’t provide the foreign investors with an exit. However, by slightly modifying the captive agreements, such hybrid Sina Structure arguably could provide both an onshore and offshore exit.
As indicated above, the contractual arrangements under a Sina Structure consist of agreements that transfer economic benefit from the domestic company to the WFOE and agreements that provide the WFOE with effective control over the domestic company. These agreements could be modified so that the foreign investor is also granted a right to purchase an interest directly in the WFOE with the other ongoing agreements terminating upon an exercise of such call option. Additionally, the offshore financing documentation could be drafted so as to ensure that the preferred rights of the foreign investors are forfeited upon exercise of their call option to purchase the equity interest in the domestic company.
Clearly, the market access restriction would still need to be satisfied by the time a domestic IPO listing is being contemplated. In this regard, for purposes of satisfying the profitability track record requirement, the domestic company would likely need to refrain from actually transferring its revenue to the WFOE. For foreign investors focused on an exit rather than income generation, this may not be an issue.
Conclusion The indications are that the Chinese Government is keen to ensure that China’s new GEM will provide a successful alternative listing venue for emerging PRC companies. However, many foreign private equity fund managers in China continue to have a strong preference towards structuring their investment offshore, due in part to the ongoing challenges created by the current PRC regulatory framework.
Some careful drafting modifications to the agreements that make up the “Sina Structure” may enable foreign private equity investors to enjoy the best of all worlds – that is, the ability to structure an investment offshore without having to get central MOFCOM approval and to achieve an exit both within and outside China. Of course, such structures have yet to be thoroughly scrutinized by the Chinese authorities and, based on prior history, the regulatory framework within which foreign investment into China takes place is subject to frequent change.
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