The logistics of directing investment into China has always been complex and reliant on off-shore structures that have a number of significant shortcomings. The traditional strategy for investing in private equity in China has been through one of two routes, explains Jonathan Reardon and Stephen Ye at the Shanghai office of Pinsent Masons: The first route has been through setting up a fund, typically as a limited partnership, in an overseas jurisdiction. The second is through a so-called “round trip” offshore structure.” But they argue that the future of private equity in China will increasingly involve onshore RMB funds.
In the traditional fund route, the offshore funds invest in each Chinese company through offshore single purpose investment vehicles and these are subsequently converted into joint ventures or other forms of “foreign invested enterprises” (FIE) under Chinese law. The shortcomings of this approach include the fact that each investment requires government approvals which are onerous and uncertain and the issue that IPO exits are difficult for FIEs.
The second traditional route, the round trip structure has many advantages. The background to this, Reardon explains, is that from the early 1990s many Chinese domestic entrepreneurs established shell companies in offshore jurisdictions such as Hong Kong, the BVI or Cayman Islands, and then used such vehicles to reinvest in China by setting up Greenfield FIEs, or even acquiring their originally owned operating businesses. Whilst this structure enabled Chinese owners to obtain the tax privileges that FIEs were accorded, it also facilitated investment by offshore private equity companies and the offshore listing of such companies in locations such as Hong Kong, Singapore, London or NASDAQ. The benefits include a more flexible transaction structure; the minimisation of exposure to China’s foreign exchange regulatory environment; and the ability of investors to exit through IPOs of the round-trip vehicle in overseas capital markets. However, the Chinese Government’s concern over the use of such structures to enable Chinese companies to move outside the scope of Chinese taxation and foreign exchange controls, has led to a number of regulations that now effectively restrict this approach.
Given the problems with the offshore routes, foreign private equity investors need to consider domestic RMB denominated funds. The most straightforward approach according to Reardon, is based on regulations allowing the setting up of a “foreign invested venture capital investment enterprise” (FIVCIE). A FIVCIE is allowed to make equity investments in unlisted companies without having to obtain government approval, providing the company is within the permitted categories of foreign investment. FICIEs are allowed to repatriate capital and all profits back to investors. As a result, use of a FIVCIE has a number of advantages: foreign exchange can be converted faster and capital can be redeployed onshore in RMB; deals can be completed quickly with the streamlined government approval process; it obviates the requirement for complex offshore structures; it opens up possibilities of listing in China’s domestic stock exchanges; and it allows foreign fund managers to have a legal structure to raise RMB capital onshore from Chinese institutions such as securities firms, insurance companies and government industrial guidance funds. The drawbacks to the structure however, Reardon points out, include the fact that investments are limited to specific sectors and in particular, new technology industries and secondly, as the foreign investment partnership law was only first introduced in December 2009, many global PE houses are waiting for a clear regulatory framework before setting up an RMB fund.
There are alternative structures for RMB funds that are also being considered, and the regulatory environment is getting clearer for them. Reardon points out that many of the provincial and municipal governments compete fiercely to attract private equity and sophisticated international managers to their locations. As a result, there are opportunities in specific locations such as Shanghai, where local regulations have been made to allow foreign private equity managers set up and manage domestic private equity funds.
Reardon sees that it will not be long before foreign private equity firms can set up RMB funds with parallel onshore and offshore vehicles. Such a development would enable firms to attract both domestic and foreign capital. The opportunities are clearly very large, but the challenges still remain, for private equity managers. Perhaps the biggest, as Reardon argues, is that with too much money chasing too few Chinese deals, foreign sponsors have to demonstrate their professionalism, experience and innovation to be able to compete with local private equity firms and satisfy the PRC government that they really can add value to target companies.