As the Chinese government makes it harder to do "round-trip" investments, private equity firms are considering onshore deals
While there are still opportunities for private equity transactions in China, the structure of deals is changing, says international law firm Dechert in a recent report. As offshore transactions require more and more approvals, onshore deals are providing a more flexible option.
It is the so-called "round-trip" investments that have been getting harder to do. This is when an investor puts money into an offshore holding company to gain an indirect stake in a company operating in China. The advantage of these deals is that they have many sophisticated features that Western investors are familiar with: common and preferred shares, financial ratchets and valuation adjustments.
The problem is that, since 2005, the Chinese government has made it harder to set up the offshore entity that is the key part of these deal. Gaining the relevant approvals "made private equity deal structuring extremely difficult", says the report.
Instead, private equity investors have invested money into one of the oldest channels of foreign investment in China—foreign investment enterprises (FIE)—typically in the form of a joint venture. Dechert highlights three major considerations relating to this kind of investment.
With regards to capital structures ?FIEs do not have shares. Instead, an investor's interest is represented by an undivided percentage of the FIE's registered capital, the capital paid in by investors. This interest is not freely transferable since a transfer of equity requires not only the approval of the government and the entire board, but for the FIE's documents to be changed too. Therefore, one recalcitrant board member can scupper any transfer by either refusing to allow the transfer or by not allowing for the relevant documentation to be changed.
"These concerns can be mitigated to a great extent by appropriate drafting at the outset," Dechert says in the report. "The hapless investor who simply signs up to what may be characterised as the local 'standard form' may later be hamstrung on these and other important points."
On the subject of equity rights, Dechert points to an uncommon form of FIE that could become increasingly interesting to private equity investors called a foreign invested company limited by shares (FICLS). An FICLS can, in theory, have differing classes of equity, and it is the only FIE that can be listed on the stock exchange, allowing an exit via an initial public offering. Compare this with, say, the inflexibility of equity joint ventures, where equity rights and board representation must be set in accordance with equity percentages.
For a private equity firm that wants to exit its investment, the onshore transaction offers fewer options than its offshore equivalent, which can often be concluded without government approval by the sale of the holding company. It might be necessary to sell the foreign-held equity to domestic Chinese investors—an increasingly likely option if the number of renminbi equity funds continues to rise. A listing in Shanghai or Shenzhen might be possible, but this faces significant regulatory hurdles, says the report. This is the route that FIEs are already taking.
"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," concludes the report.