Hong Kong

Author: | Published: 4 Jan 2001
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In the last couple of years, amounts raised by Asian private equity funds have grown enormously. At the same time, the region is being targeted by non-Asian funds and investors, particularly from the US and Europe, looking to expand their investment portfolio bases. Clearly, many investors see great opportunities for private equity investment in this region.

However, the problem for venture capitalists in Hong Kong in recent years has not so much been in raising money, as in finding suitable investment opportunities. There are a number of positive reasons for believing that this situation is now improving as a result of changing economic conditions.

Mergers and acquisitions

Since the Asian crisis of 1996-7, there have been signs of increasing merger and acquisition activity in the region. For many years, this had been relatively light. Many companies in Hong Kong and elsewhere in Asia, including listed companies, are closely controlled and managed by family interests. Traditionally, these controlling shareholders have been reluctant to divest control of their businesses. In addition, many large companies are conglomerates with interests across a diverse range of business sectors. The corporate process of rationalization or disaggregation, which has been a leading driver of merger and acquisition activity in other major markets, as large corporates seek to focus on and enhance their core businesses, has not yet taken place in the region to the same extent. This has meant that a major market for buyouts, which have been a staple diet for investors in other regions, has been slow to develop.

In present market conditions, and given a prevailing distrust in international public markets of over-diversified companies, rationalization is likely to become a growing trend in the market, following the lead of successful businesses in other regions. Merger and acquisition activity is also encouraged by the fact that there are a number of regional industries in which the market may be served by too many competing businesses, and which are undergoing, or are perceived as being, ripe for consolidation. Growth in regional activity is already apparent.

Other sources of corporate funding

While other methods of obtaining external funding have in the past presented strong competition to venture capital investment, conditions are changing, and venture capitalists have the opportunity to show that they are able to meet deficiencies in the funding supply.

Bank lending

Before the Asian crisis, bank lending was readily available to regional corporates, and was attractive to companies with cash-generative businesses because of its lack of dilutive effect. Since the Asian crisis, banks in the region have been reluctant to lend, particularly to companies without substantial asset backing, and the new lending market has been slow to recover. This has been a particular problem in Hong Kong, where corporate assets were heavily centred on a booming real estate market which has since undergone a dramatic decline in value.

The public equity markets

More recently, initial public offerings (IPOs) have been extremely attractive to companies seeking funding, because of the kudos and profile involved in achieving a listing, the extremely favourable performance of stock markets both regionally and internationally, and the ease of access to capital on the public equity markets owing to rapidly increasing valuations. However, large falls in the values of listed stocks on most international stock markets following this year's bubble burst have shown recent levels of stock market performance to have been unsustainable. Asian public equity markets are often seen as being particularly susceptible to price movements arising out of shifts in regional or global opinion and political or economic conditions. The resulting volatility is evidenced by the fact that the stock market in Hong Kong has had a particularly rough ride in 2000, with large falls in value since early-year highs. The Growth Enterprise Market, which specifically targets earlier-stage companies, has encountered particular difficulties. In addition, smaller-listed company stocks suffer from a lack of liquidity, thus losing some of the perceived benefits of going public.

The combination of these factors may be good news for venture capitalists, encouraging smaller businesses to seek pre-IPO funding and to turn to private equity markets, larger companies to divest non-core businesses so as to raise capital and to enhance their valuations, and controlling shareholders of certain listed companies to seek to take their companies private. As well as these positive indicators for transaction flow for venture capitalists, there are other regional industry and economic developments which may work in favour of venture capital investors.

The new entrepreneurs

The combination of the internet-led boom of late 1999 and early 2000 and the bust which followed has created some changes to the business climate which provide opportunities for investors. Regional businesses have taken a leading role in technology development, and a new generation of entrepreneurs with management experience has been created, where there were previously shortages. Many of their businesses have survived and flourished, and others which have been less successful have been exposed to partnerships with the venture capital industry. While the relationships have not always been without pain, some of these new entrepreneurs are now looking to develop other business ideas, taking with them some of the lessons of the internet revolution, as well as technological expertise which may be invaluable to old-economy companies.

Investor focus

Private equity in Asia has always had a more truly venture capital focus than in western markets (where later-stage development capital and buyouts have played a larger part). In recent times, the combination of a lack of later-stage deal flow and the technology-led investment drive has drawn more venture capital funders into earlier, higher risk, higher return stages of corporate development for which other forms of funding are not available. This investment model appears to be continuing in the telecoms and technology sectors, though the recent hard lessons of overvaluation of start-up businesses are being applied, and the model may develop in new regional industries such as biotech and Chinese pharmaceuticals.

Portfolio management

Partly in the light of recent difficulties, investors are beginning to take a more active role in the management of their investments than was previously the case in this region, both by demanding and exercising management rights and by seeking to achieve synergies across their portfolios. Many see real opportunities for investors who are able to import technological, sector and management expertise into Hong Kong's regional market, or to bring together these elements and synergies from technology and old-economy investments within existing portfolios. In other economic centres, investors have actively sought to put together complementary investments within their portfolios so as to build critical business mass, and a secondary market has developed between institutional investors in trading their investment assets. As this secondary market becomes more international, there is no reason to believe that it should not extend to the Hong Kong region.

China and the WTO

China's accession to the WTO is now imminent, and many observers are optimistic that some of the considerable hurdles and obstacles to overseas investment in mainland China will be removed or mitigated in the relatively short term. As the largest direct investor in China and a leading financial centre with access to vast sums of investment capital and close political and economic links with mainland China, Hong Kong is well placed to take advantage of these developments.

Transaction structures and issues

Having considered the opportunities which prevailing conditions present for private equity investments, we will now examine briefly how investments are structured and some of the issues which are encountered at the different stages at which a company might seek equity funding.

Structures

The structure of the investment will depend on a number of factors, such as its amount and type, and the jurisdictional home of the investee company. For example, where early stage or development capital is provided, that capital will be required for use in the operating company which the investor is backing. In Asia, however, it is often necessary or desirable to channel such an investment through a holding company for tax or legal reasons. In mainland China for example, while overseas investment is increasingly encouraged, there are a number of legal restrictions on foreign investment into, and disposals of, domestic companies, and traditional venture capital funding structures are difficult to accommodate. Investments made into China therefore have to be carefully structured, and will often involve investment through an offshore (ie non-mainland China) holding company, which may be incorporated in Hong Kong or another offshore (usually common-law tax haven) jurisdiction. Investments in other Asian jurisdictions are also often made through common-law jurisdiction vehicles, because investors choose to use the familiarity and protection of their company law rules and tax regimes. In a buyout or buy-in transaction, funding is required not for working capital, but to fund an acquisition of the operating company, and the investment will be made into a specially formed acquisition vehicle in which management and investors will hold shares.

Investments can be made by way of a number of instruments ranging from debt (which may be secured or unsecured and first-ranking or mezzanine) to share capital (which may take the form of preference shares (preferred stock) or ordinary (i.e. equity) shares with or without enhanced rights). Debt investment is unusual for early-stage fundings, and venture capital investors will usually subscribe for some form of preferred or enhanced right shares. Where larger amounts of capital are required, for example to fund a management buyout, the investment may involve a combination of different types of instrument, with the majority of the funding taking the form of debt. Almost invariably, the management shareholding in the investee company will take the form of ordinary shares.

Investment return

Private equity investments, by their nature, carry a risk in terms of uncertain future value. Start-up and early-stage funding is particularly risky as investors may be backing little more than an untested business plan, perhaps based on a product, service or technology. At later stages of a company's development, this risk is mitigated to some extent by the availability of a track record on which a business can be judged. The higher the risk attached to the investment, the greater the return an investor will seek. Investors will often provide for a fixed entitlement to dividends, which accrue until the company is able to pay, and would usually expect rights to dividend in priority to holders of other classes of shares. However, dividend rights are likely to be less important on early-round funding where the company is expected to reinvest its income and may take some time to achieve profitability, and the investor's principal expectation of return is likely to be in terms of capital growth in the value of the investment reflecting the early stage of the investment.

Downside protections

Capital returns may be protected by a liquidation preference or preferred return attached to the investors' class of shares, which sets a minimum amount which must be paid or repaid to the investors in priority over other shareholders as a return on their shares, in the event of any return of capital, or sale or merger transaction. Typically, investor shares will also be convertible into ordinary equity on the occurrence of those and other events (such as a listing) so that investors are able to participate in any upside available for ordinary shareholders. Warranties are also likely to be required by investors from the company and often its director shareholders, so that investors have a right of recourse if the value of the company or the state of its business has been misrepresented to them.

Anti-dilution

Where early-stage funding is provided, it is often anticipated that a number of rounds of investment will be required to finance the company. Early-round investors will be concerned that they should not be diluted by subsequent investment at a lower price, and will usually require pre-emptive rights to subscribe on future share issues. They may seek a veto on future share issues (though not unless they expect to be involved throughout the company's private equity-raising history) or insist on a minimum price per share for future issues, and 'down round' provisions may also be included, giving investors protection (by way of catch-up rights) against dilution caused by lower value fundings in these circumstances.

Share transfers

Typically, restrictions will be imposed on transfers of shares by shareholders of venture capital-backed companies. Management shareholders may be prevented from making any transfer of shares (other than perhaps within their families) until investors have been able to realize their investment. Alternatively, or in addition, rights may be included which give shareholders the right to pre-empt any sale by another shareholder to a third party.

Management incentives – sticks and carrots

It is generally acknowledged that quality and commitment of management is the most important asset for a venture capitalist. Providing appropriate management incentives is, therefore, important. The best incentive is usually the equity stake which key managers hold in the business, but other incentives such as bonus schemes, share options and ratchets (see Exit provisions below) may also be used. Covenants are usually required from managers not to compete with the business, or to interfere with employees, customers or suppliers. It is also common (particularly where managers obtain relatively cheap equity interests as an incentive) to include provisions requiring any management shareholder who ceases to be employed in the business to offer his shares for sale (the shares may be needed to provide an incentive to a replacement). The price which such a shareholder can obtain will depend on the circumstances of his leaving.

Minority protections

Although venture capitalists will often seek representation on the board of an investee company, the day-to-day operations will be in the hands of executive management. The investor shareholders will therefore usually reserve rights of veto over certain types of conduct by the company. These might include changes to constitution, share issues and grants of options, adoption of business plans and budgets, certain types of expenditure outside of budget, appointment of new directors and senior managers, arrangements with management and connected parties, and often many more. The executive directors will wish to ensure that these veto rights do not interfere with their ability to run the business properly, and it is essential that efficient channels of communication and management reporting are established.

Exit provisions

Private equity investments are made with a view to disposal at a profit within a relatively short timescale. However, such investments are by their nature illiquid, there being no market in private company shares. The ability to exit, usually by way of a trade sale or listing, is critical. However, there can never be a guarantee that an exit route will be available. Even a listing may not constitute a true exit, because it is unusual for a venture capitalist to be able to dispose of its entire stake at, or in, the short term aftermath of an IPO (at IPO, priority will usually be given to raising new money for the company, rather than providing a selling market for its shareholders; in the aftermarket, substantial sales will either be prohibited or will be counter-productive, since such sales are likely to impact adversely on the share price). Venture capital investment documentation often, therefore, seeks to provide means to help a realization. These may include:

  • tag along and drag along - tag along means that in the event an offer is made for a shareholder's shares, that offer must be extended to other shareholders; drag along means that if a prescribed number of shareholders (or perhaps the investors) wish to accept a third-party offer, the remaining shareholders may be compelled to do so;
  • rights for investors to participate in any US registration of shares in the company;
  • priority rights for investors to sell shares on an IPO;
  • ratchets – these are a means of adjusting relative shareholdings between investors and management shareholders, and are often used to reward management for achieving an exit by enhancing their equity participation, for example if a certain valuation or investor return is achieved;
  • step-in rights – sometimes investors will reserve rights if an exit has not been achieved within a target timescale to engage a financial adviser (on behalf of the company) to seek a suitable buyer or advise on the potential for IPO;
  • redemption rights – investor shares may be redeemable by the company at the end of the intended investment period. This is an alternative realization method, but in Hong Kong and other common-law jurisdictions, any redemption of shares other than out of accrued distributable profits or the proceeds of a fresh issue of shares, is subject to strict rules designed for the protection of creditors.

Conclusion

The venture capital industry in Hong Kong is looking forward with some confidence at the beginning of the new millennium. It has money to spend, and good reasons to hope that investment prospects are on the increase. The market conditions and outlook of late 2000 present opportunities for private equity investors. Markets appear to be developing both in the buyout sector and in early-stage funding of technology companies. Development capital opportunities may also increase as the lure of the stock market fades. The Hong Kong venture capital community will be hoping that the momentum of increasing transaction flow will continue to build as these market opportunities develop.




CMS Cameron McKenna

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