Private equity in China: market and regulatory overview
A Q&A guide to private equity law in China.
The Q&A gives a high level overview of the key practical issues including the level of activity and recent trends in the market; investment incentives for institutional and private investors; the mechanics involved in establishing a private equity fund; equity and debt finance issues in a private equity transaction; issues surrounding buyouts and the relationship between the portfolio company's managers and the private equity funds; management incentives; and exit routes from investments. Details on national private equity and venture capital associations are also included.
To compare answers across multiple jurisdictions visit the Private Equity Country Q&A Tool.
This Q&A is part of the global guide to private equity. For a full list of jurisdictional Q&As visit www.practicallaw.com/privateequity-mjg.
Most private equity funds with a presence in China are global funds from the Western private equity sector. They have traditionally been US$-denominated funds organised offshore but invested in China. However a considerable number of domestic RMB-denominated private equity funds (RMB funds) have recently formed in China. For example, in the first half of 2013, 64 new RMB-denominated private equity funds were formed and RMB-denominated funds accounted for 72% of new private equity investment during that time (http://research.pedaily.cn/report/pay/829.shtml). RMB funding mainly comes from various levels of government or government-controlled entities, such as:
The social security fund for general partners that have established a track record or good connections with large institutions.
Increasingly, private equity funds also raise money from wealthy individuals through private roadshows organised by the private bank divisions of commercial banks, securities firms, trust companies, and professional wealth management companies. These entities screen investment products such as private equity funds and raise money for general partners from their wealthy individual clients (many of whom are business owners).
Market activity remained high in the first half of 2011. Foreign general partners continued to explore RMB funds in China and good private equity deals remain sought after, with multiples being quite high. However, in the second half of 2011, the poor performance of the stock market in both A-share and H-share markets resulted in less ambitious private equity investment and lower multiples. A-shares refer to RMB-denominated stocks held almost exclusively by domestic investors, while H shares refer to stocks listed on the Hong Kong stock exchange.
With increased uncertainty over how the Eurozone crisis might affect the Chinese economy in the near future, private equity investment became more cautious while an increasing number of Chinese companies looked into acquisitions in Europe and other markets with the support of private equity funds taking advantage of low acquisition prices due to the European economic downturn.
Private equity investment slowed considerably in 2012, with the total investment in PE funds falling to US$25.3 billion from US$38.9 in 2011. However, the actual number of new funds created rose from 235 in 2011 to 369 in 2012 (http://research.pedaily.cn/report/pay/774.shtml). Significantly, IPO activity also began to languish in the summer of 2012 and is currently at an almost complete halt, leaving many PE deals without the exit they anticipated. Against this backdrop, mergers and acquisitions have been a key form of exit for PE deals in the first half of 2013, accounting for 14 of the 35 exit cases in that time (http://research.pedaily.cn/report/pay/829.shtml).
Although China's PE industry remains grounded relative to the peak it reached in 2011, it has experienced a small rebound from 2012. The first half of 2013 witnessed the creation of 70 new PE funds capable of investing in mainland China with a total valued at US$6.2 billion (by means of comparison, only 45 such funds collectively valued at US$ 2.7 billion had been created heading into the third quarter of 2012).
On the legal front, 2013 was notable because the Supreme People's Court supported a private company's claim for compensation in a dispute regarding the legitimacy of a contractual value added mechanism (VAM). Chinese law remains vague on this mechanism (which allows an investor to request a previously agreed upon compensation when the firm it invested in fails to deliver promised results), but the case represented the first time that VAMs had ever been deliberated in Chinese courts. While the SPC ruling agreed that compensation by the investment target to the investor under the VAM in the investor's contract would hurt other investors, it upheld a provision in the agreement obliging the investment target's parent company to compensate the investors. While it is unclear how or if this case will be applied in other circumstances, it could be a foundation for assessing the scope and legality of VAMs in Chinese private equity contracts.
The trend in fundraising is towards localisation, using RMB to raise funds. RMB funds are becoming prolific, increasing in both number and fund size. Potential limited partners include:
Social security funds.
Private business owners.
High net-worth individuals.
Private equity's public profile has grown in recent years and has attracted considerable attention. A new phenomenon has also emerged in which US$ assets owned by Chinese entities are being used in private equity funds that invest primarily in Chinese deals.
Investment in established and early stage businesses has increased, but investment in start-up businesses still dominates.
Primarily due to the difficulty of getting companies listed on Chinese mainland stock exchanges, there have been few public to private transactions. The listing vehicle itself is valuable in China, which has resulted in cases of industrial and private equity investors investing in non-performing listed companies, pending restructuring of the listed vehicles.
Initial public offerings (IPOs) are the most sought after form of exit for most equity funds in China. However, given the tight regulation and approval requirements for listing in the mainland A-share market, only certain investments can exit in this way. Nevertheless, due to the opening of the mid- and small-enterprise board on the Shenzhen Stock Exchange, this exit channel has been pretty active. Other forms of exit include mergers and trade sales.
In recent years there has been a clear shift in government policy towards developing the private equity industry and encouraging the diversification of capital sources for companies to include private equity investments, including:
Debt financing from financial institutions.
This has resulted in an easing of the regulatory and policy restrictions for foreign private equity players to enter and expand their operations in China.
Certain pilot programmes are exploring the boundaries of what is permissible. Pilot programmes for foreign-invested private equity funds and managers are now being implemented in Beijing, Shanghai and Chongqing. The detailed regulations vary but each pilot programme represents a major advance in China's effort to build an effective framework for the foreign-invested private equity industry. The programmes allow foreign general partners to access RMB funds, giving foreign private equity managers more flexibility than they have ever had previously. However, these measures are still in their early stages and the market will need to see more practical implementation of the pilot programmes to identify various issues and see how they will develop in the years to come. At the central level, the regulations on foreign invested partnerships provide a legal framework for foreign investors to become the fund manager or limited partner of a fund in the form of a partnership. However, in practice, the foreign exchange control on the capital invested by the foreign investors has resulted in the lack of obvious advantage of a foreign invested partnership over offshore funds.
In addition, offshore RMB availability may also introduce an additional new dynamic to the market. Detailed regulations issued by the Ministry of Commerce (MOFCOM) (or its local equivalent), the People's Bank of China and other relevant regulation authorities have opened the door to cross-border RMB direct investment. Further supporting measures are expected to be gradually introduced in the near future.
Private equity is subject to filing requirements under notices issued by the National Development and Reform Commission in 2011. Implementation measures for these filing requirements have been subsequently promulgated by many local governments. The improved rules on the regulation of private equity demonstrate China's determination to standardise the management of private equity enterprises and are expected to have a positive effect on the regulation of private equity markets in the long run.
China launched the Shanghai Free Trade Zone on 29 September 2013. Hopes are high relating to the liberalisation of cross-border capital flow and de-regulation of financial industry in the Free Trade Zone. However, almost one month after the launch of the Free Trade Zone, no specific favourable policies regarding the private equity industry have been promulgated.
Tax incentive schemes
Tax incentives for venture capital enterprises (VCEs) are nationally regulated. 70% of the amount of a VCE's qualified investment in medium- or small-sized high and new technology enterprises can be used to offset its income tax. In addition, when such offsetting amount exceeds the VCE's taxable income in the current year, the excess can be carried forward to the following tax years for offsetting purposes.
Various financial incentives have been set out for qualified private equity managers and funds in cities including Beijing, Shanghai, Tianjin and Chongqing, under the local cities' policy.
At whom directed
This national scheme is aimed at VCEs.
To qualify for the national VCE tax incentive the investment must fulfil all of the following:
Be made in unlisted medium- and small-sized enterprises that deal with new and advanced technology.
Be for a period of at least two years.
Satisfy certain conditions required by relevant authorities on the VCE's business scope, filing requirements and the invested enterprise.
Tax incentive schemes also exist at the local governmental level not only for VCEs but also for other forms of private equity. For example, under a regulation promulgated in Changsha, Hunan Province in 2011, a proportion of the enterprise income tax and business tax paid by a private equity enterprise registered in Changsha is refunded when certain conditions are satisfied.
Compared to internationally-formed funds, domestic private equity funds have the advantage of structural flexibility and not being subject to foreign investment rules. They typically adopt a limited liability partnership structure in which there can be no more than 50 partners, general or limited.
Trust-based private equity structures are also widely used in the private equity market. These structures have more flexibility to handle a limited number of investors than under the limited liability partnership structure. Domestic IPO exits for such trust-based private equity investments are currently impossible due to the restrictions of the China Securities Regulatory Commission.
Investors are also now exploring an alternative to trust-based private equity that combines elements of both a trust and a limited partnership. The typical practice is for investment companies or fund management companies first set up a partnership as general partners before trust companies issue trust schemes to raise trust funds. After the trust schemes are set up, the trust funds invest in the partnership enterprise as limited partners. However, near the end of2011, a notice from the National Development and Reform Commission (NDRC) further restricted such structures. Other alternatives are still being explored to address this new change.
A qualified foreign-invested private equity manager under the Shanghai and Chongqing pilot programmes (see Question 4) serving as general partner of a private equity fund, can invest up to 5% of the private equity fund's total capitalisation from foreign exchange funds. This investment does not affect the legal status of the fund as an RMB fund or the domestic investor.
Typical western-style private equity fund structures are used for offshore structured funds investing into China.
Regardless of the regulatory hurdles to foreign investments, the majority of offshore private equity investments are made through offshore special purpose vehicles (SPVs). Such structures allow additional flexibility in terms of share valuations in different rounds of capital raising and for future offshore IPO or private sale exits.
Under the limited liability partnership structure, the partnership is tax transparent for income tax purposes. Limited partners are typically subject to either 20% capital gains tax for individuals or 25% corporate income tax for companies' total taxable incomes. General partners are usually companies and subject to the 25% corporate income tax. Some provinces tax individuals who are limited partners at 35%, the highest progressive tax rate for individual business owners, although this is generally regarded as an obsolete piece of law applicable to an individual limited partner in a private equity limited partnership. There are, so far, very few foreign partners acting as the limited partner in domestic private equity funds. Such foreign partners would be subject to Chinese withholding tax because their investment gain would be regarded as income originating from China. The general rate is 20% but in most cases it is reduced to 10%, and sometimes to 5%, when the foreign investor is from a jurisdiction that has a tax treaty with China.
The law is silent on the taxation of investors into a trust plan that is a limited partner in a private equity fund. It is a general practice, however, that neither the limited partnership nor the trust company withholds tax on the gain from investment. Conversely, limited partnerships must usually withhold tax directly before distributing investment gains when limited partners are individuals.
A withholding tax of 10% (or lower as provided by the relevant tax treaty) is levied on dividends paid by the domestic enterprise. There is also an income tax of 10% on capital gains obtained by the foreign investor from a share transfer.
A seller must make a tax filing for an offshore share transfer or sale if the tax rate in the domicile of the offshore target company is less than 12.5% or income tax is not levied on the income derived offshore by companies in its domicile (Tax Authority Circular 698). The filing does not itself trigger tax payment obligations.
Most private equity funds focus on medium- to long-term investments. The return on the investment sought is typically an increase in company value due to expansion in the target company's business. The average life of a private equity fund is five to seven years.
The average success rate of private equity funds is only around 10%, but the returns on investment from a successful investment are much higher than the losses from an unsuccessful investment.
Fund regulation and licensing
Nationwide regulations do not automatically require special licences. However, local practices vary. Typically, an enterprise must register with the State Administration for Industry and Commerce (or its local equivalent) to include private equity investment management or other equivalent descriptions in its business scope to serve as a private equity manager. In addition, certain licences or registrations may be required due to local regulations or the enterprise's proposed activities.
Private equity funds are not regulated as investment companies. Foreign-invested investment companies are regulated under specific legal mechanisms that are separate from those for private equity. Domestic entities are regulated by the Chinese authorities, with the limited liability partnership being the most common form of organisation for private equity funds (see Question 6). Unless they engage in investment management or consulting in China, offshore funds are regulated by the law of the jurisdiction where the fund is domiciled and/or formed.
There are no specific exemptions applicable to private equity funds.
The number of fund investors for a private equity fund must:
Not exceed 50 shareholders for a limited liability company (Company Law).
Number more than two and less than 50 partners for a limited liability partnership (Partnership Enterprise Law).
If investors are collective fund trusts, partnership enterprises and other institutions that are not considered a legal person, efforts must be made to verify whether the ultimate natural and legal person owners are qualified investors, and to count the total number of such investors (other than funds of funds).
In addition, some local regulations further restrict the number of investors. In Shanghai, a private equity fund in the form of an unlisted company limited by shares (another form of company under Company Law, which is not popularly used in setup private equity funds) cannot have more than 200 shareholders.
There are no general restrictions on funding sources.
There is no limit on maximum or minimum investment periods.
The central government does not limit the amount of investment in a domestic private equity fund.
The threshold issued by local governments varies. A foreign-invested private equity fund registered in Shanghai must have more than US$15 million in subscribed capital, with capital contributions to be made in cash only and the capital contribution of each limited partner being not be less than US$1 million.
Transfers of investments
Generally speaking, , the transfer of an interest in a private equity fund for a purely domestic private equity structure is reasonably straightforward. If the investor is a foreign investor, the transfer may be more complicated, as the transfer may convert a domestic private equity fund into a foreign-invested one, or vice versa, where regulations on both types of funds must be complied with.
Private equity funds in China are typically limited liability partnerships incorporated in China. General partners have unlimited liability while limited partners have limited liability up to their investment into the fund. The relationship between investor and fund is governed by the partnership agreement. The terms of the limited partnership agreement can vary a great deal depending on the strength of the general or limited partners' negotiating power. A few institutional limited partners have broad rights that effectively limit the general partner's power to choose which projects to invest in. However, the terms can also be very narrow, giving the limited partners very little recourse if the general partner does a bad job or even acts dishonestly. This area of law and practice is still developing and the rules remain to be tested.
Interests in portfolio companies
If a private equity fund invests in a Chinese business with an offshore structure, it has the choice of receiving either:
If a private equity fund invests directly in a Chinese entity, it usually receives either debt or equity.
Advantages and disadvantages
Among the advantages of equity investments are that:
Capital increases usually improve the company's debt-to-asset ratio, which can be necessary if the investment is geared towards an IPO.
Return is usually higher than a debt investment if an exit goes as planned.
Among the disadvantages of equity investment are that:
Equity investment is riskier than buying debt instruments.
The private equity fund usually has no control over the portfolio company's business operations if the equity stake is in a minority'.
The advantages of buying debt instruments include that it is less risky and quicker to execute, with fewer formalities. Among the disadvantages of debt are that the downside risk is not much lower and the return is usually not as high if no good security is given,.
Convertible bonds are commonly preferred by private equity funds when investing through an offshore structure. Investors can usually choose to convert bonds to equity interests if the performance of the target company is good. However, this is not an easy option in a company registered in China because it must be done through a contractual option. Exercising the option requires converting debt to equity, which requires various other procedures and involves considerably more uncertainty.
If shares are state-owned or have indirect state ownership, it is usually necessary to go through an equity exchange and a valuation report. This adds cost, takes moretime and increases uncertainty the transaction. If investment is in certain restricted areas, prior approval by the supervising authority may also be required.
Generally, limited liability company shareholders have a right of first refusal. The consent of more than half of all shareholders is required where a shareholder transfers his shares to a person other than a shareholder. A shareholder who intends to transfer his shares must notify the other shareholders in writing and seek their approval. Failure by those shareholders to respond within 30 days of the receipt of the written notice is deemed to be consent to the transfer. Where more than half of the other shareholders do not consent to the transfer, they must purchase the shares to be transferred. Failure by those shareholders to make this purchase is deemed to be their consent to the transfer. Where the shareholders consent to the share transfer, other shareholders have the pre-emptive right to purchase the shares to be transferred on equal terms and conditions.
It is not common for buyouts of private companies to take place by auction in China, except for cases in which the target company is a state-owned enterprise. The sale of equity interests in state-owned enterprises generally takes place by auction. The Interim Measures for the Management of the Transfer of the State-owned Property Right of Enterprises and Auction Law of the People' s Republic of China apply in these circumstances.
Usually, to protect itself, the private equity fund requests the sellers and/or management in the investment agreements to redeem its equity interest if the portfolio company fails to launch an IPO and/or the private equity fund fails to transfer its equity interest to any other third party.
To incentivise the management and protect the investor's interests, a private equity fund may also provide an incentive payments scheme to the management and/or sellers. Under such a payment scheme, the seller and/or management typically obtain incentive payments if the profits of the target company reach an agreed level. An equity percentage adjustment clause may also be stipulated in the scheme in order to protect the private equity fund's interests. Under such a clause, if the par value in the subsequent series financing is lower than the par value in the current series, the private equity fund is entitled to adjust its equity percentage according to the lower par value.
The non-contractual duties that portfolio company managers owe include a:
Duty of diligence.
Duty of loyalty.
Duty of confidentiality.
Obligation to report shares they hold in the portfolio company and observe the limits on share transfers.
It is possible that portfolio company managers may negotiate a low consideration for shares to be bought by portfolio company managers alongside outside possible investors such as private equity funds, when approaching possible investors in relation to an MBO. This can prejudice the interests of the company's existing shareholders and may amount to a breach of the managers' duty of diligence and loyalty.
Acquisition finance is rare other than under special exemption rules. Offshore private equity funds must also provide security to offshore creditors and therefore there is very limited room for financial assistance. A common approach for typical offshore private equity funds is to secure bridge financing through a fund guarantee or other collateral. After the completion of the acquisition, the bridge financing must be refinanced.
Debt financing generally takes the forms of secured loans or convertible loans.
Common forms of security include:
buildings and other attachments to land;
buildings under construction;
construction land use rights;
existing and future production equipment, raw materials, semi-finished products and/or products;
contracted land operation rights;
vessels or aircraft under construction;
other properties that are not prohibited from being mortgaged by Chinese laws and regulations.
negotiable instruments (such as bills of exchange, promissory notes and cheques)
bonds, certificates of deposit, warehouse receipts and bills of lading;
transferable equity interests;
transferable fund units;
transferable property rights in the intellectual property rights;
toll collection rights for highway bridges, tunnels, ferries and so on;
other property rights that are not prohibited from being pledged by Chinese laws and regulations.
Guarantees provided by the investor of a company or a third party in favour of the lender.
Contractual and structural mechanisms
The main contractual and structural mechanisms include:
Assignment. A company can assign its assignable rights under contracts to the lender.
Subordination. The indebtedness owed by a company to its other creditors can be contractually subordinated.
Escrow account. The accounts of the invested company can be placed in escrow to ensure that the lender is able to monitor and control the company's cash flow.
Veto powers and other controls. The lender has veto power over material decisions of the board and can also appoint representatives to certain key positions in the company. In China there is little potential liability for the lender for stepping into the operation of the company.
Financing directly from a domestic non-financial institution is generally not allowed under Chinese laws, regardless of the purpose of this financing.
Before the shift of policy in 2008, loans granted by financial institutions for the purpose of assisting mergers and acquisitions were (with some rare exceptions) also prohibited by Chinese law as well. In principle, the security requirements for merger and acquisition loans are higher than other kinds of loans and banks are required to show extraordinary prudence when the equity interests of the target company are pledged to secure the repayment of the merger and acquisition loan (Guidelines on Merger and Acquisition Loan Risk Management for Commercial Banks).
There are no specific exemptions.
In a liquidation, the company or partnership pays off its debts in the following order:
Wages of its staff and workers.
Social insurance premiums and statutory compensations.
Any remaining property is distributed among the investors in accordance with laws or agreements.
A creditor who has a mortgage or pledge over assets of a liquidated company has priority in being repaid with the mortgaged or pledged assets.
Portfolio company management
In practice, private equity funds usually provide management incentives such as shares or share options in a portfolio company. An employee share option plan company is usually set up to hold a fraction of the equity interest of a portfolio company for the purpose of transferring this equity interest to the company management in the future.
Option schemes are available to portfolio company managers investing in their company as an incentive.
The tax reliefs available to portfolio company managers investing in their company are:
With the consent of the relevant tax authority, the senior managers of listed companies can pay individual income tax by instalment in such a way that within six months of the date on which senior managers exercise their share option.
If the price of the shares in the listed companies held by the employee (including the senior managers) at the date on which the employee sells the shares is higher than the price of the shares when the employee exercised the share option, the employee is exempted from individual income tax.
The general restrictions on dividends by a portfolio company to its investors are:
The portfolio company must put 10% of its profit after tax into a statutory fund before it pays dividends to its investors.
The profit after tax must be used to make up for previous years' losses if the portfolio company's statutory fund is not sufficient to cover the losses of previous years.
Forms of exit
Private equity funds usually choose IPOs to realise their investment in a successful company. If the portfolio company fails to launch an IPO, the private equity funds usually choose to transfer the equity interest to other investors.
Advantages and disadvantages
Launching an IPO usually provides a better return for the private equity fund but there are higher thresholds and more uncertainties in doing so.
Forms of exit
Typically, a private equity fund contractually obliges the founder(s) of an unsuccessful portfolio company to redeem the equity interest with an agreed price. If there are any new investors intending to invest in the portfolio company, the private equity fund may choose to transfer the equity interest to the new investors.
Advantages and disadvantages
In the event of redemption, the private equity fund cannot make any profits from the investment in the portfolio company. However, since the company is unsuccessful, it may be hard to find new investors who wish to take over the portfolio company.
Private equity/venture capital association
China Venture Capital Association (CVC)
Status. CVC is a voluntarily constituted non-profit, non-governmental organisation established in 2009 with the support of the relevant government departments.
Membership. CVC has more than 10,000 members including professional institutions, enterprises and social groups engaged in venture capital investment, investment management and financial services.
Principal activities. Since its establishment in 2009 CVC has:
Organised eight financial investigations groups in Hong Kong, Shanghai, Beijing, Qingdao, Chengdu, Guizhou and other cities.
Held more than 50 forums.
Trained more than 8000 people for venture capital investment.
Organised more than 500 financing meetings.
Zhong Lun Law Firm
Professional qualifications. US (Illinois) 1999; China 1995
Areas of practice. M&A; private equity; banking and finance; real estate; restructuring and insolvency.
Representing TPG in connection with its RMB funds and investments in China.
Representing RREEF in the exploration of its RMB funds business in China.
Representing a sovereign wealth fund in connection with its investment in Dalian, China.
Representing MSREF and Gaw Capital in connection with their investment in Xuzhou, China.
Representing MSREF in connection with its investment in Hangzhou, China.
Representing CVCI in exiting six subsidiaries in China.
Zhong Lun Law Firm
Professional qualifications. China; US (New York State)
Areas of practice. M&A; general corporate; foreign direct investment; debt and equity financing; complex restructurings; real estate.
Representing Warburg Pincus for its RMB2 billion investment in two real estate projects in Zhengzhou, China.
Representing Nobao in its first round private equity financing of US$25 million from Tsing Capital's China Environment Fund.
Representing a Chongqing-based e-wallet solution start-up company in its first round VC financing by NTT Docomo and Sony.
Zhong Lun Law Firm
Professional qualifications. China; US (New York State)
Areas of practice. M&A; general corporate; foreign direct investment; PE/VC investments; structured financing; environmental.
Representing a Shanghai-based PE fund in investing in various alcohol, mining, pharmaceutical, biotech, chemical and manufacturing companies.
Representing Shanghai-based PE fund on investing in an automobile parts company.
Representing Hong Kong based VC fund on its investment in and exit from an Internet retail company, including establishing a VIE structure without limits for the target company to give it access to the ICP licence.
Representing HSBC Private Equity on investing in a forestry company in China.