Asia overview

Author: | Published: 4 Jan 2001
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You will see elsewhere in this publication, the analysis of different parts of a private equity transaction. But how does it all come together in practice? More particularly, how does it sometimes not all come together? What follows is a few examples of problems that we have come across both during and after transactions had been completed.

Pay no dividends

We came across a shareholders' agreement, relating to a private equity deal after the event to review the put-option arrangements. Fortunately, Johnson Stokes & Master was not involved in drafting the original documentation. One unusual provision was that the controlling shareholders had a veto over the payment of any dividends. Although this is unusual, it did not trouble the private equity investor at the time because it was looking for an increase in capital value as the method of obtaining a return. The investor expected to be able to arrange a trade sale or list the entity, and if dividends were accumulated within the company then this would either add to the capital value or be used to fund further expansion. The investment was successful. However, the controlling shareholder never permitted payment of dividends, even though there was no obvious use for the money being retained in the company.

The reason for this soon became clear. The controlling shareholder had a put option, allowing him to sell his interest to the private equity investor on his death or retirement. The sale price was to be the net asset value of the company. Again, at the time the deal was done this seemed unusual but harmless because the net asset value is normally below the market value of the company. The private equity provider was not worried about management succession issues following the retirement of the controlling shareholder, as proper arrangements had been put in place for when the controlling shareholder retired. But the point that was missed by the private equity provider was that with all dividends retained, the net asset value of the company mushroomed. As a result, the provider was forced to pay a very high price to the controller in order to acquire the shares as retirement loomed. It was clear that the controlling shareholder had prepared a trap for the private equity provider who had unwittingly fallen into it. Given the other complex discussions and negotiations that were going on at the time, it was easy to see why this was missed.

Texas shootout and Russian roulette

These are designed to be so called deadlock breaking provisions. Under Russian roulette, either party has an opportunity to issue a notice fixing a price for the shares. The other party can either buy or sell shares at that price. This is intended to produce a fair price, because anyone proposing a figure must be prepared to buy or sell at that price. With the Texas shootout, the first party offers to buy shares at a certain price. The receiving party can then either a) accept this offer or b) offer to buyout the first party at a higher price. This is followed by succeeding rounds of bidding (or a simple exchange of sealed bids once both parties have indicated that they wish to buy) until somebody wins.

Colourful though they may be, these arrangements have serious drawbacks in practice. The first drawback is that they only work (i.e. they only produce a fair result), if the financial position of the two parties is similar. For example, in a game of a Russian roulette, if the other party is weak and has no money, it is easy to force them to sell at a low price, because you do not need to worry that they will agree to buy your shares at any price, however low. While two parties may start out with equal bargaining power at the time they fall out, or there is a deadlock, this equality has often broken down. Indeed this is often the cause of the deadlock because the weakening of one party will change their ambition for, or interest, in the company.

The second weakness of these arrangements is that it is difficult to determine their trigger (i.e. when a party can start using the Russian roulette or Texas shootout process). Documentation normally refers to a deadlock event. This may be failure to agree on a budget, or the use of veto at board meetings by one of the shareholders.

But these events are not necessarily always a genuine deadlock. Just because the company decides against one particular opportunity or even a series of opportunities does not mean there is a deadlock that prevents the company from continuing effectively. There tends to be a vagueness in the drafting, attempting to describe the qualitative shift from disagreement to deadlock. A clear agreement (e.g. three consecutive vetos) may trigger the provisions too early ,or the trigger could be manufactured by putting similar issues repeatedly before the board, so this is hardly the solution. Very often, the whole process collapses into litigation over whether or not there has been a deadlock event. Such an unsatisfactory outcome is less likely to happen if there is a softer deadlock-breaking arrangement, such as putting the matter to the chief executives of the two parties, or to mediation.

Nuclear control switches

The Asian financial crisis exposed certain weaknesses in traditional private equity structures. In particular, if a private equity supplier lost confidence in the management of the company and no listing or trade sale had arisen, one of its exit routes was typically a put option, whereby it can sell its shares at a pre-determined price to the controlling shareholder (usually at a guaranteed per annum rate of return). Unfortunately, in the Asian financial crisis when such an exit became attractive, the controlling shareholder often lacked the funds to meet its obligations under the put option. This is because there was a very close symmetry between the personal wealth of the controlling shareholder, and the performance of the company. As any banker will tell you, in order to have effective security you need asymmetry between the value of the security and the value of the obligation that is being secured.

This kind of problem can be dealt with in two ways. One way is to have weighted voting rights on the occurrence of certain events, so that the private equity provider effectively obtains control of the company without having to buy any controlling stake, and without having to fill the board of directors with nominees. Because this is a subtle change with limited external effect, it can help to prevent the loss of face that is often important in the Asian business context. Secondly, the private equity provider's shares could be issued as preference shares rather than ordinary shares, perhaps convertible into debt on the occurrence of certain events. This has two benefits. Firstly, it makes the assets of the company available for repaying the private equity's investments, in addition to the personal assets of the controlling shareholder (although this does not help create the asymmetry referred to above, it does extend the asset pool). Secondly, if liquidation of the company occurs, it will ensure the private equity investors' rights rank higher than all the other shareholders, and at least pari passu with other unsecured creditors. This type of structure may mean the difference between getting $0.50 on the dollar and nothing. This is perhaps not the best situation, but it is better than nothing at all.

The trouble with technology

One of the early problems exposed in the Hong Kong domain name registration system is the fact that it is not possible to transfer domain names. Very often the founder of a business will register the domain name before he incorporates the company which will eventually own it. When a private equity investor comes on board or at the time of an IPO, it will be necessary for the founder to transfer the domain name to the company. Because a transfer is not possible, the process requires a de-registration by the owner and a new registration by the company. The risk is that in between the de-registration and new registration, a third party could pop in and grab the domain name. Sometimes this creates a dilemma. Keep the domain name in the founders' name or risk losing it entirely. Also knowing that the value of the domain name (and therefore the risk of losing it) should increase over time (although in practice, prices have fallen, this year at least). Hopefully, this problem will be removed if transfer procedures are installed for .hk domain names.

Another problem is software. Unlike trademarks, which are registered, software is protected under copyright law. However, there is no formal registration of copyright. Accordingly, it is difficult to discover on a due diligence exercise whether or not a target in fact is the owner of the copyright of its software. Effectively the investor is forced to rely on warranties to this effect. Another problem is that senior management may not know that there is a potential copyright dispute. Their code writers may have borrowed a code from other entities in producing software for their new employer, and it is very difficult for the management to keep control of this. Some say that a protection against this type of risk is the fact that the software has a very short shelf-life so that the economic value of code falls sharply over time. This makes it less and less worthwhile for anyone to raise the point, even though they have discovered that their code had been used in another's products. However, if a product is profitable, then there must still be value to be shared, which will encourage litigation. This is a risk that is difficult to eliminate using normal due diligence procedures. One area which we have found is particularly sensitive is where the original research work for a particular technology has been done, either through a university or through some other government-funded institution. Often the former employees of these universities or institutions effectively take the technology with them to a start-up company for commercial exploitation. Given the lack of formal legal documentation, it is often difficult to understand who has the intellectual property rights in these circumstances. Traditionally, in our experience, government-funded institutions and universities are less concerned about who shares the spoils, they are more concerned with developing the technology as an end in itself. However, this view is changing, which at least brings with it better documentation of the original technology rights, but it also increases the risk for any party that ignores them.

Offshore vehicles – sometimes you have to go there

There are many times when offshore vehicles are used in private equity structures. These bring flexibility, tax efficiency and perhaps limited liability firewalls to a deal. However, they can also bring problems. Particularly, if the target company is incorporated offshore. We were involved in an investment where the target was incorporated in the Turks and Caicos Islands. A dispute arose over whether certain transfers of shares had occurred under the law of Turks and Caicos Islands (which was the lex situs given that that was where the company was incorporated). This turned out to be expensive. Flights are infrequent and the courts only open intermittently. On a more down-to-earth level, there is only a choice of two hotels. Accordingly, the process was much longer than it would have been, had it taken place in Hong Kong (or an onshore jurisdiction), and was far more expensive with forced periods of idleness on location and travelling two working days just to get there. It may sound like fun. It is not. The cost of such choices must be weighted against the benefits at the time the deal is structured.


Of course, these sort of problems are mercifully rare. But the occasions are made rarer with the ability to learn from others or one's own earlier experiences. Particularly bad experiences.

Johnson Stokes & Master

16th – 19th Floors Prince's Building
10 Chater Road
Hong Kong

Tel: 852 2843 2211
Fax: 852 2845 9121