We received the following article in our inbox earlier today from Dechert’s HK office…
They write:
A Growing Trend in China Private Equity: Back to Basics
Notwithstanding recent financial market turmoil, frozen credit markets, and global uncertainty, reports indicate that investors remain interested in private equity opportunities in emerging economies in Asia, including China. Transaction structures appear to be changing to some extent, and those best equipped to adapt to onshore direct investment transactions will have additional opportunities.
The Background
“Round-trip” investment transactions have been a common feature of private equity deals in China in the recent past. Round-trip deals involve an existing offshore holding company structure, set up by a Chinese resident founder who is often a key driver behind the China-based operating company. The investor would simply invest in that offshore holding company and hold an indirect interest in the underlying operating business. Both investors and Chinese founders alike were looking for an IPO exit or a sale of their interests. Round-trip investment transactions involve much that is familiar to sophisticated Western investors, such as common and preferred shares, complex financial ratchets and valuation adjustments, and familiar corporate regulatory regimes. The bulk of the China-related work related to reviewing the underlying operating business and assets in China, and in some cases preparing Chinese transaction documents covering such matters as operational control, non-competition, and executive compensation.
The round-trip investment landscape began to change a few years ago. In early 2005, the State Administration of Foreign Exchange (SAFE) issued the first of several circulars , requiring Chinese residents to register with SAFE before setting up or participating in offshore entities. Without SAFE registration, the underlying foreign investment enterprise (FIE) may not be able to register with the State Administration of Industry and Commerce (SAIC). In addition, without SAFE registration, the FIE would find it difficult, if not impossible, to engage in any transactions involving foreign exchange. Given these problems, registration with SAFE was crucial. However, SAFE often refused to accept applications for registration. Furthermore, in August 2006, the Ministry of Commerce (MOFCOM), together with five other central authorities, announced new rules that effectively required MOFCOM approval for most offshore structures involving Chinese interests, and MOFCOM granted very few approvals under these rules. Although some locations are reportedly now granting approvals, these regulatory hurdles made private equity deal structuring extremely difficult.
That, however, did not signal the end of foreign private equity investment in China. Foreign investors have since explored, and in many instances done deals, involving basic onshore investment structures, with private equity money being invested directly in a Chinese FIE, typically a Sino-foreign joint venture (JV). An FIE direct investment is different from an equity stake in an offshore holding company in a number of key respects. The execution of a direct investment transaction requires a thorough understanding of key differences and an analysis of the attendant risks. That said, the FIE vehicle is not new. JVs trace their history to 1979, when the first JV was born in Tianjin on the strength of one slender law—the equity joint venture law—and equally slender documentation. The FIE regime has evolved and matured over time. Moreover, the experience of longer-term FIE investors, both positive and negative, can inform private equity investors as they venture into the Chinese direct investment environment.
All investment in the form of an FIE requires governmental approval, and subsequent material changes to the FIE also require approval at the time of the change. Approval processes and requirements can differ from sector to sector, and generally speaking, investments of scale are approved at the central government level. Recent changes to the law have made it clear that approval considerations may, if relevant, include national security concerns. That said, the approval regime has long been a feature of onshore investments, and can usually be navigated without undue complications.
Against this background, we highlight below a summary of major considerations for FIE direct investments. Each investment will, of course, involve other structural and business considerations, and require its own analysis. The major considerations summarized below include capital structure, financing considerations, certain equity rights, and documentation concerns. Finally, we will conclude with a brief discussion of exit rights, which may also present distinctive challenges for the private equity investor.
Capital Structures
Capital structures available for typical FIEs are limited. The fundamentals of capital structures in China are somewhat counterintuitive for investors familiar with corporate vehicles in the US or common law jurisdictions, including Delaware, Hong Kong, the Cayman Islands, the British Virgin Islands, and Mauritius. Firstly, FIEs do not have shares as such. The investors hold an equity interest in the FIE, and that interest need not be held in certificated form. It is evidenced by independent verification that the investor’s equity contribution has been made, and the registration of that verification with the SAIC. Technically, the interest comprises an undivided percentage of the FIE’s “registered capital,” which comprises the capital paid in by the investors. The overall funding required by the FIE, reasonably estimated at its formation, is called “total investment.” The difference between total investment minus registered capital, strictly speaking, represents the borrowing capacity of the FIE. Specific rules require minimum ratios of registered capital to total investment, or debt to equity ratios, which are roughly analogous to but more conservative than typical thin capitalization constraints known elsewhere. “Total investment” generally determines the level of government required to approve the FIE and any expansion. Any later increase is subject to the same debt to equity rules, applied only to the amount of the increase. The increase must be unanimously approved by the board of the FIE and reflected in amendments to its constituent documents, all of which are then approved and registered with the SAIC.
Moreover, an equity interest in an FIE is not freely transferable. There are statutory preemptive rights in favor of each equity holder. A transfer of equity in an FIE not only requires governmental approval at the time of the transfer, but also unanimous board approval and amendments to the FIE’s constituent documents. A recalcitrant equity holder can therefore block a transfer either by refusing to approve the transfer or refusing to execute the necessary amendments to the FIE’s constituent documents. These concerns can be mitigated to a great extent with appropriate drafting at the outset. The hapless investor who simply signs up to what may be characterized as the local “standard form” may later be hamstrung on these and other important points. Being silent on these issues is not prudent, as the laws and regulations will not fill in the gaps, even in the face of arguments based on lack of good faith on the part of an uncooperative equity holder.
Financing Options
Bank loans remain the most common source of FIE financing, although as the financial markets slowly mature, FIEs do have a few more options. That said, bank loans remain important, but can be difficult for a start-up FIE to obtain, unless the offshore investor is willing to guarantee repayment by the FIE. This typically involves a guarantee from the investor’s offshore bank for the benefit of the Chinese lending bank. The offshore bank will also have full recourse to the offshore investor if its guarantee should be called. For the investor with more than one FIE, even intercompany loans are problematic—unless it is authorized to engage in “financial business” by the China Banking Regulatory Commission, a Chinese company cannot lend money, even to affiliates. As a result, intercompany loans, even within the same corporate family, may usually only be done through a third-party licensed bank that acts as the nominal lender between the affiliates. The bank charges a fee for its role in such an “entrusted loan,” thereby adding to the cost of borrowing. Given these considerations, shareholder loans from offshore investors remain common, but as noted above, the amount of shareholder debt is limited to the difference between the FIE’s total investment and its registered capital. In summary, FIE financing tools are limited and should be taken into account in planning for either a new FIE or a direct investment that results in the creation of an FIE.
Equity Rights
Different laws and regulations govern each type of FIE, including the three most common types—the wholly-foreign owned enterprise (WFOE), the equity joint venture (EJV), and the cooperative joint venture (CJV). There is little leeway to modify the rights conferred by law and regulation in an EJV. There is an express requirement that distributions must be in accordance with equity percentages and that board representation must be set “by reference to” equity percentages. The CJV is slightly more flexible, primarily because it permits distributions in agreed ratios that may not correspond to equity percentages. In addition, subject to approval, early return for the foreign investor is possible, so long as the assets of the CJV revert to the Chinese investor at the end of the stated term of the CJV without the payment of additional consideration. The WFOE, which can be owned by multiple foreign investors (but is less relevant in the context of a direct investment in an existing Chinese business), is generally less circumscribed. A number of common equity-related features, such as different classes of equity, convertible debt, and options are not typical and are likely to face approval roadblocks at the outset and upon later exercise. Many of these features, even if successfully documented and approved, have not been sufficiently tested, either by the regulators or by formal dispute resolution proceedings.
Notwithstanding these limitations on EJVs, CJVs, and WFOEs, another corporate vehicle is available and of significance, particularly for private equity investors. This vehicle is the foreign invested company limited by shares (FICLS). Although the FICLS has been available for a number of years, less than 1% of foreign investment is initially structured as a FICLS. This may change, however, if private equity interest in direct onshore investments increases. The FICLS is more akin to corporate vehicles found in other jurisdictions. It has shares, and the highest authority is the shareholders’ meeting (which elects the board). Differing classes of equity should in theory be possible with a FICLS, and significantly, a FICLS is the only vehicle that can be listed on a Chinese stock exchange. IPO exits on a Chinese stock exchange are still uncommon for a variety of reasons, and those that have occurred or been planned have all involved conversion from a more traditional FIE to a FICLS.
In summary, there are basics in China that need attention early in the process. There are risks and benefits to be weighed, even with the choice of corporate vehicle. In weighing those risks and benefits, the development of the corporate landscape for foreign investment and current trends should also be taken into account. The experience of the last three decades of foreign investment offers lessons, both positive and negative, and provides practical insight on these and many other issues that are unique to the Chinese regulatory environment.
Documentation Basics
Drafting transaction documents for a direct investment in China involves a number of special considerations. Questions regarding governing law will arise. Many types of contracts, including joint venture contracts, and other documents, such as the constitutional documents of any Chinese corporate entity, must be governed by PRC law. Even if there is no statutory requirement, China’s conflict of laws doctrines will often point to the application of PRC law. Nonetheless, there is some freedom to choose a different governing law in several areas, including technology transfer contracts and certain types of licensing arrangements. Accordingly, if a transaction presents these types of issues, they should be addressed early, even at the term sheet stage.
Certain contracts must, by law, be written in Chinese, although a foreign language text may also be executed. Typically, investment documentation is concluded in both Chinese and English, and the texts are commonly agreed to be equally authentic. As a practical matter, senior Chinese management and the various reviewing authorities will rely solely on the Chinese texts. Experience teaches that drafting responsibility should not be divided between the parties based on language, and that control of both language texts greatly facilitates the process. Generally, foreign parties have greater access to individuals with the degree of bilingual professionalism necessary to produce both Chinese and English documentation.
Throughout the negotiations, decisions will be made by persons who are not parties to the transaction, but whose understanding and approval are critical. Your drafts will be shared with others, including the government, before the transaction is done. Accordingly, it is prudent to present balanced drafts in both English and Chinese simultaneously, and not to commence with aggressively one-sided documents.
Many agreements, such as a joint venture contract, only become legally binding when they are approved by the relevant government authority. While simple to state, this additional feature will need to be woven into the documentation with care to see that the transaction as a whole, and the path to a successful closing, are expressed clearly. Perhaps more in China than in matured legal and business environments where more common ground among parties is assumed, the negotiation of transaction documents is less an exercise of trading points than a process of fully communicating substantive business and structural points.
Exits
Exit avenues for direct investments exist, but they also involve special considerations. Offshore exits can often be concluded without approval in China. Typically, this would simply comprise a sale of the offshore holding company. A public offering of the offshore holding company may also be an attractive option. In most cases, the offering can be done without PRC regulatory approval (so long as the necessary registrations and approvals were made or obtained when the offshore holding structure was put in place.)
It may also be possible to list a Chinese entity on an overseas exchange (for example in Hong Kong, New York, London, or Singapore), but PRC regulatory approvals, including the approval of the China Securities Regulatory Commission, are needed.
Onshore exits are also possible. Sales of foreign-held equity in an FIE to purely domestic Chinese investors are increasingly common, and may increase as a result of significant RMB private equity funds entering the market. While this may result in converting the FIE to domestic company status, that conversion does not, by itself, create barriers to concluding a deal. Listing an FIE on the Shanghai or Shenzhen exchange is also possible, and although regulatory hurdles can be significant, a handful of FIEs are already publicly traded in China. As noted above, conversion of the FIE into a FICLS is required for a listing, and if a WFOE is involved, converting to a FICLS domestic shareholders be brought in as part of the reorganization.
Other possibilities exist as well, such as an approved reduction in equity (and repatriation of that capital), or a full-scale liquidation process. In short, there are exit routes, some more attractive and efficient than others, and some that can be expected to mature as practice develops.
Conclusion
The China private equity landscape is changing. Looking ahead, investors equipped to adapt to transaction and exit structures unique to onshore direct investments will have at their disposal a broader range of alternatives and will be better-positioned than their competitors in a market recovery. Given recent regulatory obstacles placed in the way of round-trip investments, private equity investors should take a serious look at direct investment opportunities. Many private equity investors familiar with China have already done so and have successfully concluded direct investment deals. In order to do so effectively, however, an investor requires an understanding of the basic building blocks in China. The tools for, and the craft of, doing an onshore investment are different than the ones needed for an offshore transaction, but with experience informed by the accomplishments and errors of others, deals with numerous exit routes can be successfully structured and closed.
For more information contact:
Elizabeth Redfern / Business Development & Marketing
Hwang & Co in association with Dechert LLP
3403 Citibank Tower Citibank Plaza
3 Garden Road Central, Hong Kong
+852 3518 4719 direct
