The ways in which private equity investors participate in the Chinese economy may be poised to shift from minority and non-control investments to control investing. As in many developing economies, private equity investment in China has been dominated by minority investments that have provided growth capital and pre-IPO funding to founders not willing to fully “cash out” or cede control of their high growth businesses. The slowing Chinese economy and the generational shift in Chinese business owners suggest to many deal professionals in China that there is likely to be a new wave of transactions in which control and possibly even complete sales of Chinese businesses will become prevalent.
As private equity firms contemplate participating in this new phase of Chinese deal activity, they will need to recognize the cultural, legal and economic factors that influence the deal scene in China and create a number of obstacles to doing “Western”-style deals. This article will focus on those obstacles insofar as they relate to three key issues in Western private equity transactions: debt financing, purchase price adjustments and exits.
Historically, Chinese enterprises were prohibited from taking out loans, and Chinese banks were prohibited from extending loans, for the purpose of funding M&A transactions. However, in December 2008, the China Banking Regulatory Commission (the “CBRC”) issued guidelines that lifted this ban, as part of the Chinese government’s efforts to strengthen financing support for M&A transactions and to promote outbound investment by Chinese companies. Under the guidelines, banks are permitted to grant loans to domestic enterprises in connection with M&A transactions, subject to various requirements.
Despite this pro-lending shift in regulation, the effect on the availability of debt financing for onshore M&A transactions has been limited. According to a study by Deloitte, M&A lending by Chinese banks for the first two years after the Guidelines were issued totaled around RMB 85 billion (approximately US$13 billion). By comparison, according to data released by Standard & Poor’s, M&A lending in the U.S. reached US$234 billion for the year 2010 alone.
There are numerous possible explanations for the lack of a robust market in M&A lending by Chinese banks, including that:
- The guidelines are vague in certain areas and there is no clear guidance on how they will be interpreted.
- The guidelines contain strict requirements, such as having a dedicated team for conducting M&A loan-related due diligence investigations and risk assessments.
- Due to political considerations and relatively low risk tolerances, Chinese banks have historically focused primarily on making loans to state-owned enterprises, leaving many private sector businesses without relationships with lenders, and lenders without familiarity with many private sector businesses.
- The guidelines require that the borrowers must obtain “actual control” of the target company as a result of the M&A transaction (which term is not defined). As discussed above, that likely makes most of the private equity investments made in recent years ineligible, which makes the absence of a sizeable market for lending into private equity transactions not surprising.
However, as the number and size of M&A deals in China grows, and the trend towards control investments gathers steam, the demand for acquisition financing is likely to reach the critical mass needed to push lenders to overcome these obstacles. There are already some early signs of this. For example, according to a report in August 2011 by China Venture, a leading investment consulting organization, Industry and Commercial Bank of China signed strategic agreements with various local equity exchanges to allocate more than RMB 60 billion (approximately US$9.5 billion) to finance M&A deals that are facilitated by such local exchanges.1
Purchase Price Adjustment
Purchase price adjustments are a common feature in U.S. private equity M&A. They often play a critical role in transactions by ensuring that the target company has a certain level of working capital or net worth at closing, protecting the buyer against the seller siphoning off value and allocating the benefits and burdens of the business between signing and closing, among other things. In an acquisition of a Chinese company in an “onshore” deal,2 however, there are considerable obstacles to utilizing this mechanic.
An acquisition by a foreign investor of shares or assets of an onshore Chinese company will require, among other things, approval from the Ministry of Commerce (“MOFCOM”) or its local counterparts, and registration with the State Administration of Foreign Exchange (“SAFE”) or its local counterparts. The MOFCOM approval will include, among other things, the purchase price and SAFE will only allow the foreign purchaser to remit into China the amount of foreign exchanges equal to the purchase price approved by MOFCOM. MOFCOM generally only stipulates a fixed price, not a pricing formula or a variable price and MOFCOM only issues one approval per transaction. That is obviously at odds with the use of a purchase price adjustment, which results in the ultimate purchase price not being determined until some time after the closing.
One possible solution is to structure a portion of the purchase price as an offshore payment. However, this requires careful navigation of Chinese tax and foreign exchange control regulations and is only an option if the offshore payment has commercial significance (beyond simply being a means to evade the regulations), which would typically require that a portion of the target business be conducted offshore. Otherwise, the payment could be characterized as a tax evasion scheme (assuming the seller does not pay tax in China on it) and/or a violation of China’s foreign exchange control regulations, which require that the proceeds of the transaction be remitted onshore.
A second solution involves converting the purchase price adjustment into a closing condition. This is a significant departure from the way purchase price adjustments are implemented in the U.S., but it achieves most of the benefits. To avoid the obstacles described above, rather than one party making a payment to the other, this solution requires the seller to deliver the target company with the previously-agreed level of assets and liabilities— typically, a target working capital amount and no cash or debt. The purchaser has the right to appoint an accountant to review the amount of working capital and the net debt position of the target and does not have to close until it is satisfied that the amounts are as agreed. This approach may not be practical in deals in which the seller does not, for example, have sufficient resources to fund the debt payoff or a working capital shortfall. It also will not be as precise as a traditional purchase price adjustment, since it does not allow for a post-closing confirmation that the estimates used for purposes of closing were accurate.
A third possible solution requires cooperation from MOFCOM and SAFE. Based on our conversations with local MOFCOM officials in Beijing and Shenzhen, the officials appear to understand the commercial need for purchase price adjustments and the obstacles that their regulations create. One possible construct to which they appear receptive would be for MOFCOM to approve the purchase agreement, which contains the purchase price adjustment mechanism and a fixed base price.3
A viable path to a successful exit is obviously critical for private equity investors, and many times the preferred exit is an IPO. For a financial investor that owns a controlling stake in a Chinese onshore company, there are three possible routes to an IPO, each presenting its own challenges.
One route is to list the offshore investment vehicle that made the investment in the Chinese company on an overseas stock exchange, such as the New York Stock Exchange (“NYSE”) or the Hong Kong Exchange and Clearing Limited (“HKEX” ). This route would not require Chinese government approval. However, marketing such an IPO may be difficult if the foreign investor has a Chinese minority partner in the investment, because a Chinese partner will have considerable difficulty under applicable Chinese law flipping its interest in the onshore Chinese entity into the IPO vehicle. Therefore, the onshore Chinese entity, which would be the only asset of the IPO vehicle, would likely have to be partially owned by the Chinese partner. The existence of the downstream investor could create “noise” that might impair the success of the IPO. In addition, a Chinese partner would likely resist such an arrangement, because it would have difficulty obtaining liquidity under such a structure.
A second route would be to conduct an IPO and listing of the onshore Chinese company at an overseas stock exchange, such as NYSE (commonly referred to on the market as an “N Share Listing”) or HKEX (an “H Share Listing”). Unlike the path described above, approval from the China Securities Regulatory Commission (“CSRC”) would be required for an IPO following this route, and CSRC has typically granted approvals only to large Chinese state controlled companies.4 In fact, CSRC so far has not approved any foreign controlled Chinese company to conduct an IPO following this second route. Moreover, shares owned by Chinese minority shareholders are not permitted to be listed and traded on an overseas stock exchange, so this route would not provide liquidity to Chinese minority shareholders.
A third avenue is to pursue a domestic IPO and listing on one of China’s Shanghai or Shenzhen Stock Exchanges (commonly referred to as an “A Share” offering). This route requires CSRC approval and, based on a review of companies that have been approved by CSRC to conduct IPOs since 2010, it appears that no approvals have been granted to companies controlled by private equity investors. A possible explanation for this is rooted in the Chinese regulators’ bias in favor of continuity of control of IPO candidates, which is viewed as supporting the consistency and sustainability of the issuer’s business and operations. In China, the controlling stockholder of an IPO candidate cannot have changed during the three-year period leading up to the IPO (two years for an IPO and listing on the Growth Enterprise Board of the Shenzhen Stock Exchange) and cannot change for another three years after the IPO. CSRC’s reluctance to approve private equity-controlled companies for listing may reflect a view that financial investors are likely to run for the exit once the three-year lock up period has expired. Therefore, convincing the CSRC to rely on continuity in senior management, as opposed to ownership, may be necessary to pave the way for domestic IPOs by private equity-controlled companies.
China is an increasingly important jurisdiction in the global M&A market, but it also presents many unique challenges. As more Chinese businesses become available for sale, the ability to identify and work creatively to meet these challenges will be key to developing and implementing a successful investment strategy. Many of the tools in the U.S. M&A professional’s toolkit will be useful in that effort, but not all of them will translate seamlessly.
1. Chinese banking regulations do not prohibit “offshore” loans (i.e., by non-Chinese banks), but other regulations restrict the ability of Chinese companies to pledge their assets as collateral in support of such offshore loans. This presents a significant obstacle to the development of the type of debt financing that is common in the U.S. and other western markets, the central element of which is usually a fully-secured credit facility.
2. An acquisition of a company incorporated in mainland China. This contrasts with an “offshore” deal, in which the target company is held by a non-Chinese holding company that has all its operations in mainland China.
3. A possible limitation is that MOFCOM might only be willing to approve upward adjustments through this process, since downward adjustments would require that the excess purchase price be transferred out of China.
4. In fact, there is an unwritten rule informally enforced by CSRC that the minimum capital to be raised by the issuer through an H share IPO and listing shall be no less than US$1 billion. A senior CSRC official, however, stated at the beginning of 2012 that CSRC is planning to lower the thresholds for private-owned Chinese companies to pursue an overseas IPO and listing.