Private equity in Hong Kong: market and regulatory overview
A Q&A guide to private equity law in Hong Kong.
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-guide.
Similar to funds operating in other developed markets, large and medium-sized private equity funds operating in Hong Kong and Asia raise funds from limited partners who are predominantly pension funds, insurance companies, sovereign wealth funds and other government agencies, asset managers and other financial institutions, corporates, funds of funds and family offices. There are many small to medium-sized private equity funds that raise funds predominantly through family offices based in Asia and abroad.
The composition of the Asia-Pacific region's private equity investor base is changing. There is less interest from investors in investing through funds of funds and general partners are increasingly turning to family offices and high net wealth individuals who have a strong appetite for alternative investment asset classes (Bain & Company, Asia-Pacific Private Equity Report 2016).
Hong Kong remains a major part of the private equity landscape in Asia. Hong Kong ranked second in Asia for total capital under management in private equity funds, which amounted to US$120 billion as at September 2015. Hong Kong is currently home to 410 private equity firms (2016-2017 Budget Speech by Financial Secretary John C Tsang).
Although 2015 saw significant volatility in Asian equity markets driven by plunging oil prices, fluctuating currencies and slowing growth in China, private equity deal value across the Asia-Pacific region soared to US$125 billion (up from US$87 billion in 2014) and the average EV/EBITDA multiple for private equity backed transactions increased to 17.8x (Bain & Company, Asia-Pacific Private Equity Report 2016). The increase in transactions and valuations is likely to be driven by the significant amount of liquidity available to Asia-focused funds which are chasing a limited number of deals.
Despite a wall of dry powder available to Asia-based private equity funds (US$140 billion as at August 2015 -Preqin Special Report: Asian Private Equity September 2015), 280 of the region's 1,400 active private equity funds were seeking funds in 2015. They were seeking US$74 billion in fresh funding and raised two-thirds of that (Bain & Company, Asia-Pacific Private Equity Report 2016).
Between January and mid-December 2015, US$6.2 billion was committed to Asia-focused buyout funds, the lowest total since 2009 (Five Trends for 2016, Asian Venture Capital Journal, 15 December 2015).
The fundraising market remains a dual speed market with the larger and more successful funds being largely oversubscribed and able to dictate the terms of their limited partnership agreements and with other medium to smaller funds or those with average performance finding fundraising more challenging. In a Preqin survey of 61 Asia-based private equity and venture capital fund managers conducted in June 2015, the largest proportion of respondents (38%) stated that their biggest challenge for the next 12 months was the ability to meet fundraising targets (Preqin Special Report: Asian Private Equity September 2015).
In 2015 in Greater China, there were 1,062 private equity deals (worth in aggregate US$192.1 billion), an increase of 79% by deal number and 168% by deal value compared to 2014, and 2,735 venture capital deals (worth in aggregate US$4.4 billion), an increase of 105% by number and 227% in value compared to 2014 (PwC China and Hong Kong M&A 2015 Review and 2016 Outlook).
The internet and technology sectors remain the most important areas of focus. In the Asia-Pacific region in 2015, investors spent US$36 billion on 371 internet deals and another US$15 billion investing into 141 technology companies. Media, healthcare and financial services were also sectors of renewed interest (Bain & Company, Asia-Pacific Private Equity Report 2016).
The value of buyout transactions in the Asia-Pacific region soared from US$27 billion in 2014 to US$53 billion in 2015. In a survey conducted in January 2016 by Bain & Company, 75% of general partners in the Asia-Pacific region said that they expect buyouts will make up more than 80% of their portfolios over the next two to three years and 50% of general partners said that they expect growth deals will make up more than 80% of their portfolios (Bain & Company, Asia-Pacific Private Equity Report 2016).
In the Asia-Pacific region, the value of private equity investment exits declined to US$88 billion in 2015, from US$112 billion in 2014, with the decline driven predominantly by volatility in the Chinese equity markets. Overall there were 489 individual private equity exit transactions in 2015 (Bain & Company, Asia-Pacific Private Equity Report 2016).
In Greater China, private equity and venture capital-backed deal exits fared lower in 2015, due mainly to the turbulence in mainland equity markets. The number of private equity or venture capital-backed IPOs increased to 119 (from 114 in 2014), the number of trade sales decreased to 64 (from 81 in 2014), open market sales decreased substantially to 25 (from 62 in 2014) and the number of share buybacks increased to 11 (from 10 in 2014) (PwC China and Hong Kong M&A 2015 Review and 2016 Outlook).
For Greater China-focused private equity funds, A-share IPOs continue to be the preferred means of exit (given significantly higher exit multiples achievable on mainland exchanges), with the Hong Kong and US equity markets less popular. In 2015, Greater China private equity and venture capital backed IPOs numbered 60 on the Shenzhen Stock Exchange (up from 38 in 2014), 37 on the Shanghai Stock Exchange (down from 45 in 2014), 19 on the Hong Kong Stock Exchange (up from 17 in 2014) and one on the New York Stock Exchange (down from 13 in 2014) (PwC China and Hong Kong M&A 2015 Review and 2016 Outlook).
The ratio of the number of Greater China private equity and venture capital-backed exits to transactions continues to decline. In Greater China in 2015 there were 2735 venture capital and 1063 private equity backed investments and only 219 exits (compared to 1134 venture capital and 593 private equity backed investments and 260 exits in 2014) (PwC China and Hong Kong M&A 2015 Review and 2016 Outlook).
In 2015, the most significant legislative reform in Hong Kong affecting private equity funds was the extension of the profits tax exemption for offshore funds to cover certain private equity funds. The amendments were aimed at boosting Hong Kong's private equity fund industry by attracting more offshore funds. See Question 6.
The Hong Kong Competition Ordinance came into full effect on 14 December 2015. The Competition Ordinance prohibits three types of anti-competitive practices:
Entering into agreements or engaging in concerted practices which have the object or effect of, preventing, restricting or distorting competition in Hong Kong.
Abuse of a substantial degree of market power by engaging in conduct which has the object or effect of, preventing, restricting or distorting competition in Hong Kong.
With respect to telecommunications carrier licence holders, any merger which has, or is likely to have the effect of substantially lessening competition in Hong Kong. The Competition Ordinance could have an impact on portfolio companies and the decisions made as to how they are run, including how prices may be determined and the scope of any potential agreements or joint ventures with other market participants. Private equity firms operating in the telecommunications sector may also need to consider whether the restriction on anti-competitive mergers may affect any potential bolt-on acquisitions or trade sale exits.
The Shanghai-Hong Kong Stock Connect was launched in late 2014. It permits investors in each market to trade shares in the other market using local brokers and clearing houses. This has arguably reinforced the Hong Kong Stock Exchange's attractiveness as an exit forum for private equity fund managers (Speech by Financial Secretary Mr John C Tsang at the Asia Private Equity Forum 2016).
In July 2015, the mutual recognition of funds between mainland China and Hong Kong became fully operational. This allows qualified funds in mainland China and in Hong Kong to be offered directly to the public in each other's markets, potentially benefitting fundraising on each side.
In 2016, the Hong Kong Government proposed a legislative bill under which investment funds are permitted to take the form of an open-ended fund company, in addition to the unit trust format which is currently permitted.
Tax incentive schemes
In Hong Kong there are no tax incentives or schemes which are specifically aimed at encouraging investment in unlisted as opposed to listed companies. There is no withholding tax applicable to dividends paid by a Hong Kong company that is subject to Hong Kong profits tax. No capital gains tax is generally payable on capital gains made on a transfer upon an exit. However, if the sale is made in the course of a business carried out in Hong Kong, profits tax may be assessable.
At whom directed
See above, Incentive schemes.
See above, Incentive schemes.
Most private equity investment vehicles used by fund managers in Hong Kong are limited partnerships established in the Cayman Islands. It is uncommon for Hong Kong registered limited partnerships or companies to be used to structure private equity funds.
In a typical offshore limited partnership fund structure, an offshore limited liability company owned by the fund acts as the general partner who is responsible for the day-to-day management of the limited partnership. Investors in the fund acquire limited partnership interests and their liability is generally limited to the amount of their contribution to the limited partnership. The limited partnership enters into an investment management agreement with an investment manager who may hold a Securities and Futures Commission (SFC) licence to carry out asset management activities. However, many private equity funds based in Hong Kong which invest in unlisted securities do not carry out activities which would require an SFC licence.
In recent years, large, well connected general partners have been finding opportunities to invest in some of the largest deals by linking up with sovereign wealth funds and institutional investors that are seeking new ways to partner with their general partners on better terms. This often means that the investor will co-invest alongside the private equity fund but it can also mean setting up a separate account, where the general partner invests funds from the single investor on special terms.
In the Asia-Pacific region in 2015, co-investments alone accounted for US$36bn in deal value (compared with an annual average of over US$9 billion in the last five years). General partners have raised more than US$2 billion into separate accounts over the past two years (Bain & Company, Asia-Pacific Private Equity Report 2016).
Prior to the 2015 changes, the profits tax exemption for offshore funds did not include transactions in private companies and required that the transactions were managed by SFC licensed fund managers. The main effect of the 2015 legislative amendments was to extend the profits tax exemption to cover:
Transactions in private companies incorporated outside of Hong Kong and which meet certain requirements for not carrying out business in Hong Kong or holding properties in Hong Kong.
Transactions carried out by qualifying funds (which would cover most private equity funds), not just SFC-licensed fund managers.
Profits from investments made by special purpose vehicles (SPVs) owned by offshore private equity funds (including offshore SPVs and Hong Kong incorporated SPVs).
Offshore limited partnerships which do not qualify for the profits tax exemption because they do not meet the criteria for a qualifying fund may be subject to Hong Kong profits tax. Such funds may consider carrying out their activities through an SFC-licensed entity in order to potentially qualify for the profits tax exemption.
Fund duration and investment objectives
Similar to private equity funds operating in other developed markets, Asia-focused private equity funds would normally aim to invest their capital within five years. According to research of Bain & Company, the median holding period for companies in Asia-Pacific portfolios as at June 2015 was 4.4 years (down from 4.8 years a year earlier) (Bain & Company, Asia-Pacific Private Equity Report 2016). Asia-focussed private equity firms are generally following the global trend of the average lifespan of a fund from fundraising to dissolution lengthening (on a global basis reaching 13.2 years) (Private Equity's Life Expectancy Increases, Financial Times, 5 April 2015).
Like many funds operating in other developed markets, many Asia-focussed buyout funds set a hurdle rate of approximately 8% and a target a return of 20% to 25% per annum.
Fund regulation and licensing
Whether a private equity firm is required to hold SFC licences depends on whether the firm engages in regulated activity under the Securities and Futures Ordinance (SFO). Regulated activities include dealing in, advising on and marketing securities. However, the definition of securities in the SFO does not include shares or debentures of a Hong Kong incorporated private company. For this reason, a large number of private equity firms in Hong Kong that do not invest in Hong Kong Stock Exchange listed companies do not hold SFC licences.
It is an offence in Hong Kong for a person to distribute to the public in Hong Kong advertisements, invitations or documents for a collective investment scheme which has not been authorised by the SFC, unless an exemption applies. A collective investment scheme is defined broadly to include investment products of a collective nature, which is likely to include most private equity funds.
An exemption to the general prohibition of financial promotion of a collective investment scheme exists where such financial promotion is made only to professional investors. Professional investors are defined to include certain intermediaries, banks, insurance companies, funds and high net worth individuals having an investment portfolio of not less than HK$8 million (or equivalent in foreign currency). Alternatively, if the offer to invest is made to no more than 50 persons and there is no public advertisement or any form of publication of the offering at all, an exemption may also apply. Certain other exemptions may also apply.
There are no regulatory restrictions or requirements on the types of investors who are permitted to invest in private equity funds. However, private equity funds often impose their own requirements, such as a minimum commitment amount and qualification as a professional investor, so that the fund can potentially qualify for the exemption from the requirement to register as a collective investment scheme (see Question 9).
The relationship between the investor and the fund is usually governed by the limited partnership agreement. Typical investor protections in limited partnership agreements include:
Concentration limits in relation to the fund's investments, which may relate to the percentage of total capital which may be invested in one portfolio company, geography or sector.
The right of limited partners to remove or replace the general partner if certain events occur.
Limited partners' rights to information about investments and to inspect financial records.
Limited partners' rights to appoint persons to investment or advisory committees.
Restrictions on changes in senior personnel and on the transfer of the general partnership interest.
Interests in portfolio companies
Most common form
Private equity funds most commonly invest in the form of equity securities issued by portfolio companies.
It is not uncommon for private equity funds to invest in preference shares, shareholder loans, loan notes or other securities convertible or exchangeable into equity.
For a Hong Kong incorporated portfolio company which is not listed on the Hong Kong Stock Exchange, there are very few statutory restrictions imposed on the issue or transfer of shares. Under the Companies Ordinance, the directors of a Hong Kong incorporated company can only exercise the power to issue shares (other than by a pro-rata rights or bonus issue) if they have approval in advance given by shareholder resolution. A private company in Hong Kong is also not permitted to have more than 50 shareholders.
Where the target company is listed on the Hong Kong Stock Exchange, an issue of shares (other than through a pro-rata rights issue or open offer) must fall under the company's general mandate or specific mandate to issue shares approved by the shareholders of the company under the Listing Rules. An acquisition of shares in a Hong Kong Stock Exchange listed company may trigger an obligation to make a general offer under the Takeovers Code if certain thresholds are exceeded.
Generally, there are no capital gains or withholding taxes imposed in Hong Kong. However, where shares are bought and sold as a trade or business carried out in Hong Kong, profits tax may be leviable.
It is not uncommon in Hong Kong for buyouts of private companies to take place by auction, particularly when there are many investors chasing a limited number of assets.
The Competition Ordinance generally prohibits anti-competitive agreements, an example of which is bid-rigging in response to a request for bids. The prohibition of bid-rigging would potentially apply in the context of an auction sale of a company.
Public to private transactions are not very common in Hong Kong, although there have been a number of high profile attempts in recent years. A public-to-private transaction involving a Hong Kong Stock Exchange listed company structured in the form of a takeover offer is subject to the Code on Takeovers and Mergers.
Privatisations can also be effected by a scheme of arrangement implemented in accordance with the Companies Ordinance.
For a buyout of a private company in Hong Kong, the principal documents are a share purchase agreement and potentially a shareholders' agreement if only part of the target company will be acquired and there will be a relationship with the other shareholder(s) of the target company which is governed by the shareholders' agreement.
For a buyout of a Hong Kong Stock Exchange listed company by takeover offer, the principal documents are the announcement of a firm intention to make an offer, the offer document issued by the offeror and the target board circular (which will often be combined in one composite document where the transaction is recommended by the target's board). For a buyout effected by a scheme of arrangement, the principal documents are the scheme document and the scheme of arrangement to be approved by the court and the shareholders.
In buyouts of private companies, private equity funds often require contractual protection under the share purchase agreement in the form of representations and warranties about the shares to be acquired and the business. Where due diligence has uncovered specific issues, indemnities are often sought from the sellers and/or management against losses which may arise from such identified issues.
It is not uncommon for part of the purchase price to be retained or put into escrow against which warranty or indemnity claims may be satisfied. In Hong Kong, retention of a proportion of the purchase price pending the satisfaction of certain future earn-out milestones is not uncommon, particularly where management retain a stake in the company and continue to run the business.
In the case of a management buyout, sellers are often reluctant to give a full set of warranties about the business unless they are qualified by the awareness of the seller (which may be limited if the seller was not involved in day-to-day management).
It is less common for a private equity fund to be able to obtain warranty protection in the context of a buyout of a listed company. It may be possible to include limited warranties in agreements entered into with the target company (for example, a break fee agreement or transaction implementation agreement) or with a controlling shareholder (for example, an agreement to purchase its shares before an offer is made or a scheme is proposed, or an undertaking to accept an offer or vote in favour of a scheme proposal).
If a portfolio company manager is a director of a Hong Kong incorporated portfolio company, he will need to fulfil his directors' duties under the Companies Ordinance and in general law. Such duties include the directors' duties of care, skill and diligence, to act in good faith for the benefit of the company as a whole, to use their powers for a proper purpose and to avoid conflicts of interest. The articles of association of the portfolio company may also place additional duties on directors.
If the portfolio company manager is a director of a portfolio company which is listed on the Hong Kong Stock Exchange, under the Model Code for Securities Transactions by Directors of Listed Issuers, the director is restricted from dealing in securities of the listed company within certain "blackout" periods prior to the publication of interim and final financial results and when he or she is in possession of inside information.
Management employment contracts often include non-competition, non-solicitation and confidentiality covenants. Management are often required to invest in or are granted equity interests that may be subject to vesting when performance conditions are satisfied, or may be subject to forfeiture upon the occurrence of certain events.
Where a takeover offer is made, a private equity bidder must be careful with what benefits are offered to management who are existing shareholders. Such benefits may amount to special deals which may be prohibited under the Takeovers Code if they are not granted to all shareholders, unless such special deals are approved by the shareholders.
Private equity funds often require the right to appoint directors to the board of portfolio companies as well as certain senior management positions. Certain board decisions or actions may also be subject to the prior approval of the private equity fund. These controls are usually incorporated in the shareholders' agreement and/or the articles of association of the portfolio company.
Where a private equity fund obtains control of a portfolio company, it will often restructure its debt facilities and may increase leverage. The principal sources of debt are senior debt from bank lenders, generally in the form of a secured term loan and working capital facilities. Junior debt in the form of mezzanine finance, second lien or structurally subordinated debt is less common.
Part of the private equity fund's investment can also be made in the form of debt, which is often convertible into equity in the portfolio company.
It is less common for the private equity fund to obtain debt financing at the fund level for its investment. However, margin loans are not an uncommon form of financing for private equity fund investments in minority stakes of Hong Kong Stock Exchange listed companies.
Secured lenders usually prefer to take security closer to the operating assets of the business. Such security often takes the form of a share charge and/or security over specified assets, including mortgages over real property. A lender may often take all assets security (usually by a fixed and floating charge) over a portfolio company's assets.
Contractual and structural mechanisms
Facility agreements for debt financing provided by private equity investors include typical contractual restrictive and financial covenants, a breach of which would normally allow the private equity investor to call for repayment of the debt. The private equity investor may require the portfolio company and other lenders to enter into an intercreditor agreement in order to establish the priority of the private equity investor's debt claims vis-à-vis those of other lenders.
A Hong Kong incorporated company and its subsidiaries are generally prohibited from giving financial assistance to a person acquiring the shares of the Hong Kong incorporated company, before or at the time of the acquisition or for the purpose of reducing or discharging a liability incurred by any person for the purpose of acquiring the shares. Financial assistance is broadly defined and can take many forms, including the target's group companies granting security over their assets to secure the acquisition finance loan of the private equity fund or any subsequent refinancing.
It may be possible for the companies who propose to give what would otherwise be unlawful financial assistance to undertake "whitewash" procedures to enable the financial assistance to be given lawfully, requiring, in most cases, board approval, solvency statements to be given by the directors and the approval of the financial assistance by the shareholders. Shareholder approval may not be required if the financial assistance (including previous financial assistance granted under such exemption that has not been repaid) does not exceed five per cent of shareholders' funds.
In an insolvent liquidation of a Hong Kong incorporated company, the ranking of creditors may depend on the particular circumstances. The general order of priority of creditors is as follows:
Secured creditors. Debts owing to secured creditors are paid out of the proceeds of sale of secured assets. Legal mortgages rank ahead of equitable mortgages. Fixed charges over the same asset will rank in order of time of creation.
Costs and expenses of the liquidation.
Debts due to preferential creditors. The main categories of preferential claim are debts owed to employees and certain debts owed to the government.
Floating charge holders. Floating charges over the same asset rank in order of creation.
Unsecured creditors. Unsecured creditors rank equally for payment and are paid proportionally if the remaining proceeds of sale of the assets are insufficient to satisfy their claims in full.
It is not uncommon for debt investments to carry rights to convert the debt into equity or to have warrants or options attached. See Question 13 in relation to potential restrictions on the issue or transfer of equity.
Portfolio company management
It is common for private equity funds to require management to hold equity in the portfolio company so that their financial interests are aligned with those of the fund. Equity ratchets which increase the share of management equity on the achievement of performance targets are also commonly included in shareholders' agreements alongside detailed provisions relating to planned exists such as qualifying initial public offerings (IPOs).
A Hong Kong incorporated company can only make a distribution out of profits available for distribution. A Hong Kong Stock Exchange listed company must comply with an additional statutory requirement; it can only make a distribution if its net assets are not less than the aggregate of its called up share capital and distributable reserves and the distribution does not reduce those assets to less than that aggregate.
It is not uncommon for share purchase or subscription agreements to include specific warranties from the target company about its compliance with relevant anti-corruption and anti-bribery laws. Shareholders' agreements also often require the business of the portfolio company to be carried out in compliance with applicable laws.
Under the Hong Kong Prevention of Bribery Ordinance (POBO), unless a defence applies, it is an offence for any person to offer an advantage to a public servant or prescribed officer in certain circumstances. The POBO also creates offences in relation to bribery of an agent acting for a principal in the private sector.
The maximum penalty for bribery of a public servant is ten years' imprisonment and a fine of HK$500,000. For all other bribery offences under the POBO, the maximum penalty is imprisonment for seven years and a fine of HK$500,000.
Anyone convicted of a bribery offence under the POBO can be prohibited for a period not exceeding seven years from taking up or continuing employment as a professional, a self-employed person, or a manager of a corporation or public body.
Forms of exit
Private equity funds often fully or partially exit from their investments through:
An IPO of the portfolio company's shares.
An on-market sell-down after listing.
A sale to a strategic or financial buyer.
Exercise of a put option to other existing shareholders.
Advantages and disadvantages
In buoyant equity markets, private equity funds may achieve high exit valuations via an IPO. However, a private equity investor commonly does not achieve a full exit via an IPO and may often agree to a lock-up over its shares (typically for six months after the IPO). The Hong Kong Stock Exchange does not generally permit special rights for a shareholder to survive listing. A private equity fund could achieve a full exit through a sale to a strategic buyer or another financial buyer or through the exercise of a right to put its shares to one or more existing shareholders.
Forms of exit
The most common forms of private equity fund exit from an unsuccessful or distressed company include a sale of the shares or assets to a strategic or financial buyer or a liquidation and winding up of the company.
Advantages and disadvantages
A sale of shares or assets to a strategic or financial buyer will likely preserve the value of the portfolio company's business as a going concern and may achieve a higher valuation than the liquidation of the company's assets. Under the Transfer of Business (Protection of Creditors) Ordinance, whenever a business is transferred, the transferee will become liable for all of the debts and obligations arising out of the carrying out of the business by the transferor, except in certain specified circumstances and unless a notice is duly given and has become complete in accordance with the Ordinance.
Private equity/venture capital associations
Hong Kong Venture Capital and Private Equity Association (HKVCA)
Status. The HKVCA is a non-governmental association.
Membership. HKVCA membership is generally open to companies and individuals involved in the venture capital and private equity industry.
Principal activities. Organising industry conferences and events as well as continuing education for professionals in the industry.
Published guidelines.The HKVCA has published a corporate governance guideline which is available here: http://web.hkvca.com.hk/en/corporate-governance-guideline.aspx.
Hong Kong Private Equity Finance Association (HKPEFA)
Status. The HKPEFA is a non-governmental association.
Membership. HKPEFA membership is generally open to CFOs, COOs, controllers, finance managers and legal counsel from the private equity industry.
Principal activities. Organising events and seminars for its members.
Bilingual Laws Information System
Description. Maintained by the Department of Justice of the Government of the Hong Kong Special Administrative Region.
Chin Yeoh, Counsel
Ashurst Hong Kong
Professional qualifications. Hong Kong, Solicitor (2014); England and Wales, Solicitor (2006); Barrister and Solicitor of the Supreme Court of Victoria (2004); Barrister and Solicitor of the High Court of Australia (2013)
Areas of practice. Private equity; mergers and acquisitions; joint ventures and securities regulation.
Non-professional qualifications. Bachelor of Laws (Honours), The University of Melbourne (2003); Bachelor of Commerce (Honours) (University Medal), The University of Melbourne (2003); Diploma in Modern Languages, The University of Melbourne (2003)