Private equity: Fine-tuning the process

Author: | Published: 1 Apr 2008
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Private equity (PE) commonly refers to equity investments in non-public companies, particularly small- to medium-growth businesses. It covers deals such as initial start-up, buy-outs, expansion and pre-public offering financing. Private equity funds have long been recognised as serving a useful role in corporate growth by filling in the financing gap between small- to medium-sized enterprises and public capital markets. The last couple of years have seen the emergence of renminbi-denominated domestic private equity funds. The establishment of the Bohai Industrial Investment Fund, the first mainland renminbi-denominated PE was approved by the National Development and Reform Commission (NDRC) in December 2006. The Rmb20 billion ($2.8 billion) fund made its debut investment in November 2007, by acquiring a Rmb1.5 billion ($212 million) equity stake in Tianjin Pipe Group Corporation, a major producer of oil-pipes in China.

NDRC has since approved other domestic PEs with fund sizes ranging from between Rmb6 billion and Rmb20 billion, notably the Shanghai Financial Fund, Guangdong Nuclear Electricity New Energy Fund, Shanxi Energy Fund, Sichuan Mian Yang Hi-Technology Industrial Fund, and Zhong Xin Hi-Technology Industrial Investment Fund.

Approvals for the establishment of domestic PEs were granted on a case-by-case basis, in the absence of clear laws and regulations. Considerable legal and policy uncertainty surrounds the formation and operation of domestic PEs. The PRC government needs to resolve this before the domestic PE industry can truly flourish.

Legal grey zone

China's regulatory framework for the domestic PE industry is a work-in-progress. The Rules on Industrial Investment Funds for Pilot Implementation, intended to be pioneer rules governing the fledgling sector, have undergone prolonged consultation and are still in draft form. The State Council has allowed NDRC to lead the domestic PE experiment, with a task force including the People's Bank of China, the China Banking Regulatory Commission (CBRC), the China Securities Regulatory Commission (CSRC), the China Insurance Regulatory Commission (CIRC), the Ministry of Commerce (Mofcom) and the Legislative Affairs Office of the State Council. The task force will be the primary approval and supervisory body for domestic PEs. NDRC is likely to have the final say, but the precise interplay of administrative powers within the task force still remains unclear.

No specific regulations set out the approval criteria and process for establishing domestic PEs – the qualifications of fund managers and investors (in particular, whether commercial banks are permitted to be investors), any continuing obligations during a domestic PE's operational term, or the tax rules applicable to earnings under different types of ownership structures. One overarching area of concern is the level of government supervision that will be exercised over the industry. Most investors would presumably favour a more market-oriented approach in the selection of qualified investors and managers, and in the areas and scope of investments. This is linked to the fear that over-regulation would distort the development of the domestic PE industry. The worst-case scenario is that domestic PEs would be reduced to mere financing instruments of local governments. Continuing this thread is the argument that existing PRC legislation, including the Company Laws, is already sufficient to govern small and medium domestic PEs, and that there should be a threshold for domestic PEs to cross before they trigger the need for further supervision.

The PRC government has apparently heeded these concerns. The draft Rules for Pilot Implementation define its subject matter – that is, industrial investment funds, as private funds set up in the PRC to invest in unlisted securities with investments from "specific institutional investors". NDRC indicated that specific institutional investors would be limited to state-owned or state-funded enterprises, and financial institutions such as commercial banks, insurance companies, securities companies, and social insurance funds. Furthermore, NDRC is likely to focus only on funds beyond a certain scale, perhaps those in excess of Rmb5 billion in size, judging from the scale of the existing domestic PEs and various press reports. It remains to be seen whether small independent domestic PEs will be left to operate freely in the market.

Barriers for foreign players

The issue of regulatory supervision is of even greater concern to foreign PE players eyeing investment opportunities in the PRC. Foreign investors acquiring a stake in domestic enterprises are already subject to multiple regulatory hurdles under the Rules on Merger and Acquisition of Domestic Enterprises by Foreign Investors, and to a myriad of other controls on matters ranging from the inflow and outflow of foreign exchange to the acquisition of state-owned assets. The PRC government is noted for its vigilance against foreign monopolies or the domination (whether perceived or real) of domestic industries. For instance, the M&A Rules empower Mofcom to take into account issues of national security and the need to protect "key industries" and "famous domestic brands" in its approval process. Furthermore, policy shifts over the past two years have made obtaining Mofcom approval for shifting domestic assets into offshore holding vehicles in which PRC domestic residents have an interest (a structure traditionally favoured by international private equity investors because of its flexibility and the ease of exit) virtually impossible

The past few years have seen a series of foreign PE deals rejected. In 2006, Mofcom refused to endorse the Carlyle Group's attempt to acquire 85% of the stake in Xugong Group Construction Machinery, China's largest manufacturer of building machinery. Last year also saw the CSRC rejecting both Goldman Sachs' bids to acquire a 10% stake in Guangdong Midea Electric Appliances, a major home appliance manufacturer, and Fuyao Group Glass Industrial, a Shanghai-listed glassmaker, apparently because the agreed prices for these share placements had become too low as a result of skyrocketing stock markets over the course of the lengthy approval process.

By contrast, domestic funds such as the Bohai Fund do not face such regulatory opposition or delays when they mobilise billions on short notice to acquire what may be considered strategic assets. Hence they enjoy a significant advantage over foreign private equity investors.

Foreign players will have to tread carefully through China's investment landscape. Participation in smaller deals that barely register on the regulatory radar screen is likely to encounter fewer obstacles. Still, forming strategic alliances with influential domestic players may be a sensible approach for foreign investors seeking significant investments in strategic or high-profile PRC enterprises.

Fund managers

One area that the Rules for Pilot Implementation emphasises is the qualification criteria for fund managers. These encompass registered capital, management expertise, financial conditions and (legal and financial) records.

The Zhong Xin Fund demonstrates that regulators are prepared to exercise close supervision over the choice of fund managers, at least when a big fund is concerned. The Suzhou Industrial Park had initially intended the Suzhou Ventures Group to act as fund manager for the Rmb10 billion ($1.4 billion) fund. However, NDRC did not welcome the proposal, and suggested that a nationally-recognised group be involved. This led to the formation of a joint venture with Hope Investments (the structure of the Zhong Xin Fund is discussed in greater detail below).

Besides meeting the criteria set out in the Rules for Pilot Implementation, securities companies, insurance companies and commercial banks will also probably have to obtain the specific approval of the CSRC, CIRC and CBRC respectively before they can act as fund managers.

Domestic PE structures

Another area of concern is the structuring of domestic PEs, which will have a direct impact on how such funds are run, the allocation of powers and responsibilities between investors and fund managers, and tax implications. The draft Rules for Pilot Implementation provide three possible legal forms: corporate, limited liability partnership, or trust/contractual fund. The limited liability company has hitherto been the mainstream structure, though the situation is likely to change with the revised PRC Partnership Enterprise Law, which came into effect on June 1 2007. The chief reform brought about by the Revised Partnership Law is the formal introduction of limited liability partnerships, a common structure adopted by private equity funds in western countries.

Limited liability partnerships

A limited liability partnership is formed by general partners (GP) and limited partners (LP). Every GP is jointly and severally liable without limits for the debts of the partnership; LPs are liable to the extent of their capital contribution. The Revised Partnership Law prohibits wholly state-owned or state-funded enterprises, listed companies, charitable institutions and social organisations from acting as GPs. A limited liability partnership should be made up of between two and 50 partners, at least one of which should be a GP.

The chief advantage of a limited liability partnership over a limited liability company as a PE vehicle is tax transparency: each of the partners is liable to pay individual income tax for the partnership's gains, but the partnership itself is not subject to corporate income tax. Companies, on the other hand, have to pay a 25% corporate tax, in addition to the individual income tax payable by shareholders.

Another distinction is the clear demarcation of responsibilities for management and investment in a limited liability partnership. The Revised Partnership Law expressly provides that the affairs of a limited liability partnership shall only be conducted by the GPs; the LPs are prohibited from doing so, or from representing the partnership in external dealings. The LPs may however make proposals in relation to the business management of the partnership and participate in a decision to admit or remove GPs. A limited liability partnership domestic PE is typically set up by the fund manager in his capacity as a GP, with the investors joining in as LPs. The risks of poor management accordingly fall on the fund manager which has unlimited liability. This contrasts with a limited liability company, where greater ownership of equity interest means greater management powers exercised through shareholder voting rights or directors nominated to the board. In theory, the role of a shareholder is incompatible with that of a fund manager, since the shareholder is entitled (and hence expected) to use its voting powers to further its self-interest; the fund manager, on the other hand, ought to act in the best interests of the fund as a whole.

The Zhong Xin Fund is the first limited liability partnership fund in the PRC. The GP-cum-fund manager, which owns 1% equity interest in the fund, is a joint venture between Yin Xing Investment Management Co (a member of the Suzhou Ventures Group) and Hope Investments (headed by Fang Fenglei, a well-known PRC banker).

The Bohai Fund was set up in the form of a contractual fund, a common structure for public securities investment funds in China. Such a fund is typically set up through a contractual arrangement (for example, trust deed) between the fund manager, trustee and investors. A contractual fund is similar in essence to a trust fund, where a trustee manages the fund for the benefit of the beneficiaries. The investors of a contractual fund and the beneficiaries of a trust fund are entitled under applicable laws to hold investors' and beneficiaries' meetings. They can decide on matters such as the term or termination of the fund, the fund's method of operation, the appointment, removal and remuneration of the manager and trustee, and other matters contractually allocated. In practice, when the investors' or beneficiaries' individual participations are small, management of the fund is often entrusted to the fund manager, with the investors and beneficiaries having little power.

This is not the case for the Bohai Fund. Its investors are a powerful coalition of participants in the financial market, including the National Council for Social Security Fund, the China Development Bank, the China Postal Savings and Remittance Bureau, China Life Insurance, BOC Group, and Bohai Fund Management Company, the last of which, as the name suggests, is also the fund manager. Bohai Fund Management is itself set up by investors of the Bohai Fund, with BOC Group as its largest shareholder, and the other fund investors as smaller shareholders.

The Bohai Fund lacks the characteristics of a typical contractual fund. First, it does not have a trustee, only a fund manager, as in the case of a limited liability partnership. Second, the overlapping shareholding relationship between fund and fund manager means that assets of the fund are not distinct and separate from assets of the fund manager, thus introducing an element of company structure into the Bohai Fund. Despite its formal set-up as a contractual fund, the Bohai Fund on closer analysis, is a hybrid between a company, a limited liability partnership and a contractual fund.

Such a hybrid structure in theory weakens the fund manager's accountability to investors. This is hardly an issue in the context of the Bohai Fund, given its prominent participants. The Bohai Fund perhaps illustrates the need for flexibility to allow domestic PE participants the freedom to tailor structures that best amalgamate their obligations, powers and interests.

Foreign participation

The Revised Partnership Law only applies to domestic partnerships. Article 108 provides that the State Council shall formulate the administrative measures for the establishment of foreign invested partnerships in China. The State Council has delegated this task to Mofcom, which is drafting the Rule on Foreign Investment Partnership. The following aspects of the draft are worth highlighting.

The formation of foreign invested partnerships are, like foreign-invested companies, subject to approval by Mofcom and registration with the AIC. Significant changes to the partnership (such as the amount and scope of investment, business term, identity of the partners, the amount or mode of their investments, and termination of the partnership) are also subject to Mofcom approval and in some cases registration with the AIC. Mofcom is likewise endowed with wide discretionary powers. It may reject approval applications on grounds such as national security, public interest, the requirements of PRC's economic development and environmental protection. The sector restrictions on foreign investments under existing PRC regulations and policy will apply to the same extent to foreign-invested partnerships.

Only domestic partners in partnerships may make capital contributions by way of labour services. More importantly, all partners must make their respective capital contributions in a single lump sum within 90 days of the establishment's approval. The strict time limits imposed on fund-raising for foreign partnerships are in sharp contrast to the flexible approach taken towards domestic partnerships, in which the amount, mode and time for making capital contributions are left to contractual arrangement between the partners.

Foreign GPs are required to file a list of their major assets with the approval and registration authorities; the asset-list shall form part of the partnership's registration information available for public searches and inquiry, and must be promptly updated when changes occur. The requirements potentially pose a significant compliance burden for foreign GPs.

Other than providing a potentially more tax efficient form of investment structure, the Foreign Partnership Regulations do not appear to ease the restrictions and administrative procedures on foreign investors entering the PRC market. Indeed, the PRC authorities could well treat this new investment structure with caution and be relatively stringent in the approval process.

It is no simple feat to strike a balance between government supervision and market forces in the dawning of a new industry. The draft Rules for Pilot Implementation are being fine-tuned as new PEs are being set up. This appears to be the modus operandi of NDRC – to fine-tune the law through practical experimentation. While the simultaneous drafting-and-implementation of any rule is bound to cause uncertainty, it is hoped that a trial-and-error approach will lead to the promulgation of a clear set of rules, which effectively addresses the issues underlying the industry.

Author biographies

Melissa Thomas

Freshfields Bruckhaus Deringer

Melissa Thomas is the managing partner of the Shanghai office of Freshfields Bruckhaus Deringer. She has broad experience in PRC M&A, joint ventures, finance and restructuring, with an emphasis on transactions relating to financial institutions. Thomas qualified in Ontario, Canada in 1990 and is a graduate of McGill University. She joined the firm's Beijing office in 1997 and became a partner in 1999. Previously she practised as an associate and then a partner with a major Canadian firm in Toronto and Hong Kong. She has been published in The China Business Review, International Power Finance Review and China Law & Practice. She speaks fluent Mandarin and French.

Alan Wang

Freshfields Bruckhaus Deringer

Alan Wang is a partner based in the Shanghai office of Freshfields Bruckhaus Deringer. He has broad experience in cross-border mergers and acquisitions, private equity, corporate restructuring and financial services. He has been with the firm's China business group since 1998 and has also worked in the Beijing and London offices. He became a partner in 2007. Wang obtained bachelor degrees with honours in both law and economics from the Australian National University. He also holds a Master of Laws degree from Harvard Law School. He is admitted in the State of New York and the State of New South Wales. He speaks fluent English and Mandarin.