Structuring investments in China

Legal Issues
Rethinking M&A in China
With China's new mergers and acquisitions rules in place, foreign and domestic investors need to find more creative ways to structure their investments
by Marcia Ellis and Auria Styles

Foreign private equity investors for the past several years have often invested in PRC companies by bringing the Chinese founders of such companies offshore and investing together with the founders in an offshore special purpose vehicle (SPV). The investors successfully exited their investments by listing the SPV on a foreign stock exchange or selling the shares—through a trade sale—to another fund or strategic investor. This investment strategy, commonly known as "round-tripping," was essentially prohibited when the Provisions on Acquisition of Domestic Enterprises by Foreign Investors (mergers and acquisitions [M&A] rules) took effect on September 8, 2006.

As a result, private equity investors must rethink their investment structures and move their joint ventures (JVs) with the Chinese founders of the investee companies from relatively unregulated tax havens, such as the Cayman Islands and British Virgin Islands, to the more restrictive environment of mainland China. These changes, however, have not deterred foreign investors and their Chinese partners from structuring investments in Chinese JVs that replicate, to the extent possible, the features of their offshore JVs.

Anatomy of the M&A rules
The final M&A rules are similar to the 2003 Interim Provisions on the Acquisition of Domestic Enterprises by Foreign Investors, which provided the first firm legal basis for the acquisition of the equity of a non-foreign-invested PRC company by a foreign investor and permitted a number of transaction structures that previously had been of dubious legality. For foreign investors, the most troubling aspect of the interim measures was the antitrust provisions that required the PRC Ministry of Commerce (MOFCOM) and the State Administration for Industry and Commerce to review acquisitions that met certain thresholds. In retrospect, however, these provisions appear largely to have been a trial balloon for China's long-awaited Antimonopoly Law—slated to pass this year—and have yet to be used by MOFCOM to block foreign acquisitions.

The final M&A rules retain most of the provisions of the interim measures but also include sections that attempt to control the various forms of round-tripping by requiring MOFCOM approval for such transactions, regardless of the size of the investment. The criteria that MOFCOM currently uses to determine which, if any, round-trip transactions it will approve remain unclear, and, to date, there have been few reported cases of such approvals. Thus, many private equity funds are seeking alternative means of structuring investments to avoid the requirement of MOFCOM approval.

Onshore investments
Structural challenges
To avoid MOFCOM approval for round-tripping transactions, companies can invest directly in JVs in China. The fundamental nature of foreign-invested enterprises (FIEs), however, renders onshore investments more difficult. For example, in the United States and offshore tax havens, it is possible to create two classes of stock—preferred and common—but in China, only one class of equity is available for FIEs. As a result, it is difficult to structure investments in a way that would allow funds to enjoy some of the basic preferential rights associated with private equity investments, such as preferential payment of dividends and liquidation proceeds. In addition, without two classes of shares it is impossible to effect a value adjustment—for instance, when the investee company fails to meet certain financial targets—by automatically adjusting the rate at which preferred shares are converted into common shares. Investors without these protections are relatively unprotected in a downside scenario, making these onshore investments in China inherently more risky.

Although it is possible to structure dividend preferences in an onshore investment in a cooperative JV (CJV), obtaining approval for such investment vehicles is becoming increasingly difficult in some areas of China. Some local PRC officials are now carefully scrutinizing CJV structures to ensure that investors do not abuse the flexibility of the structure for purposes of creating dividend preferences that are not otherwise permitted. Currently, PRC law allows for liquidation preferences in both equity and cooperative JVs, and in several localities in China, foreign investors have obtained approvals for favorable liquidation preferences in their onshore JVs.

Another difficulty with setting up mainland JVs is that conversion price adjustments (sometimes called valuation adjustment mechanisms [VAMs]) require skillful structuring in an onshore investment. VAMs essentially permit investors to exchange their preferred shares for a larger number of common shares if the investee company does not meet certain financial targets. For example, an investor generally calculates its purchase price based on a multiple of the investee company's earnings for the following year. If the investee's earnings do not meet that amount, a VAM will be triggered, and the percentage of the total number of the investor's preferred shares that can be converted into the common shares of the investee will increase. Because there is only one class of equity in FIEs, and thus no conversion of preferred shares into common shares, it is impossible to directly implement a VAM in an FIE.

To structure VAM-like mechanisms in FIEs, foreign investors must use either debt that is capitalized at a different rate, depending on whether the relevant financial targets are met, or use a holdback provision—which transfers a certain percentage of equity to the founder if and when the financial targets are met. Provisions incorporating these features into the transaction documents must be drafted carefully to avoid various pitfalls—such as potential conflicts with statutory rights of first refusal—and comply with PRC law. In some cases, these provisions must also comply with extra-legal requirements imposed by approval authorities when reviewing JV contracts. For example, investors must address officials' concerns that foreign parties are obtaining too many benefits and that an overall "fairness" requirement has been breached.

Finally, structuring and implementing call and put options—the rights to purchase or sell equity at a certain time at a certain price—in an FIE is also challenging. Although it is possible to receive approval for call and put provisions in a JV contract that comply with PRC law, implementing them proves more difficult. After the initial JV contract approval, the actual transfer of equity requires additional board and government approvals. If the JV partner is a state-owned enterprise, it may not determine, at the time of the original transaction, the exercise price because the value of the interest to be transferred must be appraised by a duly qualified asset valuation firm at the time of the transfer, and the exercise price cannot be less than the appraised value. Thus, such structuring requires creativity and deep knowledge of PRC regulations and how they are implemented.

Exit challenges
Perhaps the greatest challenge faced by a foreign private equity investor that invests in an onshore JV is finding a viable exit strategy. Without round-tripping, an overseas listing would be hard to accomplish. Although the M&A rules permit founders and investors to swap the equity of an onshore entity for the shares of an SPV incorporated for the purpose of a listing shortly before it lists, such an undertaking cannot occur unless other requirements in the M&A rules are met. For example, a minimum initial public offering price must be set months before it actually takes place. Because these requirements are so onerous, and the uncertainty of obtaining approval so great, most private equity funds are, for the moment, pursuing other methods.

A-share listing
One of those options is to list A shares on a Chinese domestic stock exchange. To do so, an FIE must first obtain MOFCOM approval at the national level to convert into a foreign-invested company limited by shares (FICLS), which must then apply to the China Securities Regulatory Commission (CSRC) for listing. If approval is obtained and the shares of the FICLS listed, each shareholder of the FICLS will be subject to lock-ups stipulated by law and the rules of the relevant stock exchange that prohibit the sale of shares of stock for a specified period—from one to three years depending on when each shareholder made its investment and the percentage interest it holds in the FICLS. After the lock-up period expires, an investor can either sell its shares on the A-share market or effect a private sale.
Because investors face long waiting periods for approvals and lock-ups, it is unclear whether the domestic stock markets will be developed enough to provide the desired liquidity at the time of exit. Despite these hurdles, a number of funds are optimistic about the possibility of exits through A-share listings.

Swap for shares of a listed entity
Another exit alternative permitted under the M&A rules is to make the original investment through a share swap, in which the equity of the domestic investee company is swapped for shares of an offshore listed company. Again, MOFCOM must approve such swaps, but once approved, the fund's ability to exit the investment is essentially guaranteed because it already holds listed shares.

Another possibility would be to swap the shares of an offshore special purpose acquisition corporation (SPAC) for the equity of a PRC domestic company. US securities regulations allow a SPAC to be incorporated and listed immediately, before it acquires any assets. In effect, the SPAC is simply a holding company with a plan to acquire assets but has no existing assets at the time of listing. After listing, the founders of the PRC domestic company could receive the SPAC's shares in exchange for their equity in the domestic company. In turn, the proceeds from the SPAC's listing could be used to expand the business of the domestic company. Implementing such a share swap under the M&A rules and relevant US regulations could present certain difficulties, not the least of which is that listed shares being swapped must have been steadily traded for the 12-month period prior to the swap—a requirement that many SPACs would be unable to meet.

The Internet structure

Some funds are adopting a structure that has been widely used in China's Internet sector to circumvent the need for MOFCOM approval of a round-trip transaction. Often called a Sohu, Sina, or NetEase structure after the PRC Internet giants that pioneered its use, the structure has been used in industries where foreign investment is restricted, such as telecom and media and publishing. Under this structure, the foreign private fund and the PRC founder establish an offshore SPV that in turn forms a wholly foreign-owned enterprise (WFOE) in China. The PRC founder continues to hold all of the equity of the actual onshore operating company, which then enters into a series of contractual arrangements with the WFOE that allows it to take over the operating company and to receive all the after-tax profits of the operating company as fees.

The advantages of this structure are that it does not require MOFCOM approval at the national level because it is not considered a round-trip investment and that the fund can obtain a VAM and enjoy all of the features normally associated with private equity investments through an SPV. In addition, the fund can achieve an exit through an SPV listing.

The disadvantage of this structure is that despite being replicated many times by Chinese media and Internet companies, it is confusing to some foreign investors that are unfamiliar with it. Moreover, MOFCOM could claim that such a transaction constitutes round-tripping since the M&A rules include a broad catch-all provision under which such contractual arrangements could fall. (This provision, set forth in Article 11 of the rules, prohibits parties from using domestic investment by an FIE "or any other means" to circumvent MOFCOM approval.) Finally, even if MOFCOM accepts this structure and does not regard it as "any other means" of circumventing approval, it is unclear whether CSRC will block the SPV listing because of the use of this structure. CSRC officials have stated that they would at least examine closely any such contractual arrangements that were entered into after September 8, 2006 to determine whether the contracts were intended to circumvent MOFCOM approval.

Next steps?
The M&A rules have, for the time being, achieved their unstated purpose: to curtail round-trip investment. In addition, they have slowed private equity investment in China because funds must now pause to consider options for structuring investments and become comfortable with the levels of risk involved in such structures. For now, however, with a bit of creativity and patience, investors are finding novel ways around the more onerous requirements of the M&A rules.