The seven challenges of China

High-profile private equity success stories from China are attracting a growing number of US and European investors to the country. Structuring a deal in China, however, is complex. Investors should bear in mind the following seven selected key issues:

1. Multiple layers, multiple jurisdictions
The customary vehicle for private equity investment in China is the offshore holding company (generally incorporated in the Cayman Islands or the British Virgin Islands), which does not operate in China. It is a distinct entity from its wholly owned subsidiary in China – i.e., the ?wholly foreign owned enterprise? (WFOE) that operates the business. The offshore holding company structure appeals to foreign investors such as private equity funds because it provides an easier exit, either through an initial public offering outside China or through a trade sale to a foreign buyer. In addition, Chinese founders may hold their interests in the offshore holding company through their own offshore holding entities.

Therefore, unlike most other markets where investors invest directly in the operating company (and where founders hold shares in the company directly), Chinese businesses frequently have multiple levels of ownership and control. As a result, it is crucial that the legal documents bind various parties and levels of control together into one overall structure.

For example, the shareholders' agreement should specify that any negative covenant on the ?company? applies to both the offshore holding company and the WFOE. In addition, any restriction on transfer imposed on the corporate shareholders of the offshore holding entities applies to the individual shareholders as well.

2. Restricted industries need special structures
Certain industries, such as telecom value-added services, the Internet and media, offer attractive growth potential but are restricted from direct or indirect foreign ownership. Therefore, a WFOE cannot operate such a business. When a foreign group is interested in investing in such a business, instead of establishing an offshore holding company to hold the existing Chinese company and turning the latter into a WFOE, both an offshore holding company and a WFOE are created. The existing Chinese company (still held by Chinese citizens and commonly known as the PRC Operating Company) will continue to hold the license, and will operate and contain various aspects of the business. The offshore holding company and the WFOE in turn exercise both operational and financial control over the PRC Operating Company through a series of agreements, and the accounts of the three companies are consolidated.

Customary agreements between the PRC Operating Company and either the offshore holding company or the WFOE include asset leases, intellectual property licenses and other service agreements. In addition, the offshore holding company or the WFOE will generally have a call option or a pledge – or both – over the equity interests of the PRC Operating Company against their holders.

3. Foreign exchange rules
It is likely that the most discussed challenge to foreign private equity investments in China is the State Administration of Foreign Exchange (SAFE) Notices 11 and 29. In October 2005, SAFE issued Notice 75, which superseded 11 and 29. Under Notice 75, when Chinese companies reorganize themselves into the customary offshore holding company/WFOE structure, Chinese resident founders may not establish or control a company outside China, nor give up assets within China in exchange for assets or equity outside China, without prior registration with SAFE. In addition, if the offshore holding company undergoes a major change in its capital structure, including an increase or decrease of capital, transfer or exchange of equity interests, or merger or spin-off, such event must be reported to SAFEwithin 30 days of occurrence. Further, a Chinese resident must repatriate all distributions of income, dividend and profit received from the offshore holding company within 180 days after receipt of such distributions.

Foreign exchange control can also cast doubt over the enforceability of certain contracts involving cross-border currency flows. For example, without registration with SAFE, a foreign currency bridge loan from the offshore holding company to the WFOE is not enforceable in China. If the PRC Operating Company, which is not foreign owned, wants to borrow from a foreign party (such as the offshore holding company), prior SAFEapproval is required. Yet this can be difficult for small and medium-sized companies to obtain. In practice, repatriating any money, for a purpose such as satisfying covenants made by the offshore holding company to redeem an investor's shares, will also trigger SAFE rules.

4. Registered capital and total investment
Generally, after foreign investors make investments into an offshore holding company, the latter would inject working funds into the WFOE on an as-needed basis, either as equity or shareholder loans. The equity of most foreign-owned or invested Chinese companies is in the form of registered capital, which must not only be approved by the government, but usually contributed within three months of such approval. In addition, except for very large enterprises, a WFOE generally may not incur debt (including shareholder loans) in excess of its registered capital, and the total investment (i.e., the sum of registered capital and the maximum amount of debt the WFOE may incur) must be approved by the government. These approval and timely contribution requirements mean that the debt-to-equity ratio of the WFOE is strictly controlled, and follow-on investments and bridge loans are not at the absolute discretion of even the 100 percent owner.

Moreover, registered capital is expressed as an amount of money rather than a number of shares (as in share capital). As a result, it is difficult to have different valuations of a company between different rounds of financing, or to document or implement anti-dilution provisions.

5. Consider exit at point of entry
To exit from an investment via an initial public offering (IPO) requires careful planning at the outset. For example, to list on the Hong Kong Stock Exchange (SEHK), a company generally must be incorporated in Hong Kong, the Cayman Islands, Bermuda or China. Further, to enter the SEHK Main Board, the company must have had the same owners for the full financial year immediately preceding the listing, and management must have been substantially the same for the past three years. These requirements mean private equity investors who want to take a substantial stake in a company followed by a quick IPO in Hong Kong should consider investing by way of convertible debt rather than shares.

If, alternatively, an IPO in the US is contemplated, an investor should ask for registration rights to ensure that its shares may be publicly traded. Also, to avoid potential ?cheap stock? issues, the investor should be closely involved in the preparation of the company's share option plan, and the grant and pricing of options.

Unlike, for example, in the US, jurisdictions such as the Cayman Islands, the British Virgin Islands and Hong Kong do not have merger laws. As a result, two companies may not merge simply by a consent or vote of the shareholders. ?Drag-along? clauses are necessary to make sure that if the requisite percentage of shareholders decides to sell their shares, the minority shareholders will not hold up a sale of the company.

6. Multiple layers of decision making for state-owned enterprises
If a transaction or restructuring involves a state-owned enterprise (SOE), the investors must remember that every asset transfer (whether in the form of purchase, sale or gift) decision that the enterprise makes is subject to the review and approval of the State Owned Assets Supervision and Administration Commission (SASAC). While smaller transactions may be reviewed and approved by local SASAC branches rather than provincial or national offices, an auction of the subject asset may then be required. As a result, an investor may find that a deal or valuation it has agreed with the management of a state-owned enterprise is later deemed invalid. Also, if the transaction is divided into several stages (for example, multiple closings), even if the parties agree that one valuation would apply throughout, separate SASAC approvals (and therefore valuations) may be needed for each stage as it occurs. If the company is growing fast, the valuation by SASACmay change substantially between stages.

In addition, when dealing with a SOE, investors must remember that there are multiple layers of decision makers. Sometimes, it is not immediately apparent that state-owned interests might be involved. One example would be intellectual property, where a university professor or graduate had provided assistance during its development while receiving a stipend from the university. Finally, the SASAC valuation (and potentially auction) process can make it difficult to predict the time schedule for the investment.

7. Fiscal matters
Last but not least, all parties should establish whether any financial information (whether historical information set forth in representations and warranties, or future performance warranties or financial reporting) is based on generally accepted accounting principles (GAAP) in China, Hong Kong, the US or another country, or on International Accounting Standards – and whether it is on a consolidated or an individual basis. As an example: the initial valuation of a business is a multiple of revenues in the preceding year, with adjustments based on revenues in the following two years; but the company produces only PRC GAAP financials for the preceding year and US GAAP financials after the investment. In that case, does the adjustment formula work? Further, Chinese companies frequently make no distinction between an invoice and a receipt, and as a result do not issue the invoice/receipt until payment arrives. This makes it more challenging for investors to gain a full picture of the quality and aging of receivables and recognition of revenue and expenses.

Maurice Hoo is a partner in the private equity group of international law firm Paul, Hastings, Janofsky & Walker, based in Hong Kong.