The prevailing market practice for foreign private equity and venture capital investors looking to invest in a Chinese company has, until recently, been to use an offshore structure. This typically entails using an offshore special purpose vehicle (such as in the BVI or Cayman Islands) established by the founders which will then acquire and hold the existing Chinese business operated by the founders. However, such method of investing, commonly known under the Chinese regulations as a “roundtrip” investment, has essentially become unviable since the promulgation of the Regulations on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors (the “New M&A Rules”) in August 2006.
The New M&A Rules have strengthened the regulation of “round-trip” investments by requiring approval of the Chinese Ministry of Commerce at the central level for any acquisition by an offshore company formed or controlled by any person affiliated with the Chinese target company. Such approval has been extremely difficult, if not impossible, to obtain.
With the continuing insatiable appetite for foreign capital in China and few pre-2006 restructured companies now available for investment, private equity firms have turned to alternative structures, including investing directly onshore through a Sino-foreign joint venture under the foreign-invested enterprise (FIE) laws.
The problem is that the FIE laws were introduced with the view to accommodating long term strategic direct investments, mainly in greenfield projects, and not the shorter-term, more sophisticated financial investments made by private equity firms.
Notwithstanding these fundamental difficulties, private equity firms and their advisors have found a way to build into these onshore JV structures the kind of rights and protections one would expect to see in a minority private equity investment, although not without a degree of uncertainty and risk.
Onshore Preference Rights
Private equity investors are typically issued preferred shares which entitle the preferred shareholders to enjoy certain preferential rights over the common shareholders. Under Chinese law, the premise for a Sinoforeign joint venture is shareholder equality and mutual benefit, and as such preferred shares per se cannot be issued. However, the new Company Law of China, as well as other recent regulatory reforms, provide more structuring flexibility for private equity funds to replicate, to the extent possible, the features of their offshore investments in their onshore investments in China.
Under China’s new Company Law, which also applies to FIEs such as Sino-foreign joint ventures, it is possible to provide contractually for both a preferential payment of dividends and a liquidation preference.
Another feature of private equity investments in China are valuation adjustments or performance ratchet mechanisms. Such valuation adjustment mechanisms will normally be provided through a an adjustment to the conversion price and effected through an exchange of preferred shares for a larger number of common shares if the investee company fails to meet certain financial targets.
Again, whilst there can be no conversion of preferred shares into common shares when investing through a joint venture, such mechanism can still be implemented by introducing a so-called “betting” clause in the shareholders agreement.
Typically, such clause provides that the founder(s) of the company shall transfer a certain percentage of equity interest in the company to the investors without consideration if the company does not meet certain financial performance targets. As a further protection, the investors can require the founders to pledge a certain percentage of their equity interest in the company to the investors in advance.
The new Company Law also permits greater flexibility for shareholders in determining their voting rights in a company. Importantly, no Chinese laws or regulation prohibit a Sino-foreign joint venture from incorporating certain protective provisions into its shareholders agreement and articles of association to provide the foreign investors with veto rights in respect of certain major corporate actions or transactions.
Redemption rights are another feature that are permissible under the new Company Law in certain circumstances. In addition to the statutory right, redemption rights can be granted if agreed to by all shareholders. However, such redemption of equity ownership will result in a reduction of the registered capital of the investee company, which may give rise to certain statutory obligations under the Company Law, including a notice to creditors and public announcement of the redemption, repayment of outstanding debts or provision of security by the company in favor of creditors.
Government Approval Uncertainty
Unlike offshore investments, any foreign investment in China under the current foreign investment regime, including both “greenfield” projects and the acquisition of existing Chinese businesses, is subject to a multi-step, multi-agency government approval process. The nature and level of approvals required generally depends on the industry involved, amount invested and, in the case of an acquisition, the ownership of the target (e.g. state-owned, private, or publicly listed).
Although China has undertaken a series of broad legal reforms since its entry into the WTO several years ago, the legal framework of China still lacks transparency, stability and consistency which, combined with a large degree of discretion exercised by the government authorities, subjects foreign private equity investments to a substantial degree of uncertainty which may only crystallize at a late stage in the investment process.
Unfortunately, there have been instances where the relevant government authority has simply refused to approve a transaction on the basis that the terms and conditions are in violation of the principle of shareholder equality and mutual benefit. Even more problematic is the situation where, after closing the transaction, the private equity investor is prevented from exercising a preference right due to an inability to obtain government approval. For example, government approval may not be forthcoming for a reduction of registered capital of the Sino-foreign joint venture upon exercise of a redemption right.
Lack of Exit Options
The other primary concern for private equity investors going onshore are the available avenues for an IPO exit. Unlike an offshore investment, where the investors typically achieve an exit through listing of the offshore holding company on an overseas stock market such as the Hong Kong Stock Exchange, New York Stock Exchange or NASDAQ without incurring burdens to obtain Chinese government authorities’ approvals, the investors of an onshore company will have to consider exiting through listing on a Chinese domestic stock exchange (i.e., the Shanghai Stock Exchange main board or the Shenzhen Stock Exchange small and medium size enterprises board). Furthermore, the traditional “red-chip” listing is no longer viable because the New M&A Rules have practically closed the door on the necessary pre-IPO restructuring process.
Whilst the Shanghai and Shenzhen Stock Exchanges have become more attractive as they have continued to improve in the past few years, in contrast to a listing on a recognized overseas stock market, a domestic listing candidate must have a long track record of profitability—a criterion that most start-up companies find difficult to meet. Moreover, from the investors’ point of view, they must face a potentially long post-IPO lock-up period, ranging from one year to three years depending on the timing of the investment made and the shareholding percentage held by such investors.
Where to Next?
It’s not clear whether the rules in China will be further amended to bring back the ability for private equity investors to structure their investments offshore. However, what is clear, is that private equity investors desiring to do deals in China continue to find creative ways to do so.