Traditionally, international private equity houses making growth capital investments in Chinese businesses invest in offshore holding companies, often incorporated in the Cayman Islands, with Chinese subsidiaries (referred to as wholly-foreign-owned enterprises or WFOE). These WFOEs are often indirectly owned through other intermediate holding companies in the British Virgin Islands (BVI) or Hong Kong. Together, these holding and operating companies form what is commonly known in the market as a "quasi red-chip" corporate structure.
In addition to some tax considerations, one main advantage of the quasi red-chip structure is to enable the Chinese businesses to list in international capital markets such as Hong Kong, London or New York at a time dictated by the issuer's performance and market conditions, rather than by government policies. If the investor invests directly in a China-incorporated company and exits through the A-share markets in Shanghai or Shenzhen, the timing of the listing can in large part be driven by the policies of the China Securities Regulatory Commission (CSRC) and its sentiments about the capital markets.
In recent months, however, the substantially higher price-to-earnings ratios offered by the A-share market (compared to other markets around the world), as well as the anticipation of a continued strengthening of the renminbi, have attracted the attention of both issuers and international investors, and many have instructed Orrick to explore the possibility of dismantling the quasi red-chip structure so that the portfolio businesses can list in Shanghai or Shenzhen. This article discusses some initial steps in this "return home" process.
Do you really want to do it?
- While the A-share market may appear attractive at this time, investors should remember that the move onshore is irrevocable – if the tide turns with regard to the strength of the A-share market or the renminbi, or if the CSRC imposes a moratorium on public offerings, it will be extremely difficult to return to the quasi red-chip structure.
- When the foreign investor becomes an equity holder of the Chinese company, the Chinese company will likely convert into an equity joint venture. Before it can list in the A-share market, the equity joint venture must be converted into a joint stock company. This conversion requires the company to have been profitable for the preceding three years, but even with such profitability, there is no assurance that the conversion will be approved or can be accomplished. Further, after such a conversion, even if the company's financial performance and market conditions are excellent, there is still no assurance that the company can list if the CSRC's policy needs dictate otherwise.
- Chinese joint venture and company laws generally offer less protection for equity holders than what international investors are used to as preference shareholders under the company laws of the Cayman Islands, BVI or Hong Kong. Investors should carefully compare and analyse these cross-jurisdictional differences, and get comfortable with potentially losing rights like liquidation preference, anti-dilution, redemption or put rights, when the prospect and timing of listing is uncertain and the process is irreversible.
- Upon conversion to a joint stock company, all shareholders face a one-year promoter lockup, making it difficult, during that one year, to pursue a trade sale (even if an attractive offer surfaces) or a sale of a shareholder's own stake (in the event that the listing does not proceed as expected). Further, after the listing, a one-year lockup is imposed on non-controlling shareholders (in addition to the promoter lockup), which is longer than the typical six months in other markets. On occasion, to facilitate the listing, some investors have found themselves having to agree to an even longer post-IPO lockup.
Assuming you want it, how do you get there?
Dismantling a quasi red-chip structure involves a complex interaction of corporate and tax laws of each jurisdiction in which an entity within the corporate group has been incorporated, as well as accounting and cash flow issues.
For example, can the restructuring be accomplished by simply winding up the Hong Kong, BVI and Cayman holding companies and distributing the WFOE equity to the ultimate shareholders? What solvency tests and director fiduciary duties must be satisfied in each jurisdiction for such winding-up distribution? Are there tax implications for such distribution?
Alternatively, does the restructuring have to involve the use of cash to purchase equity in the WFOE by the ultimate shareholders? And if so, where would these shareholders locate funds for such a purchase? Certainly it would be challenging for many fund investors to initiate a capital call for such a restructuring. Is the WFOE in a position to make a dividend distribution (after satisfying solvency and other tests)? Is each holding company up the chain (i.e., Hong Kong, BVI, Cayman), if they haven't been wound up, in a position to declare further dividends to the ultimate shareholders for such a purpose? How much cash is needed – and is that determined by the net asset value or other valuation of the WFOE equity? Are there concerns that such a process may inadvertently result in the controlling shareholder cashing out at the expense of the financial investors? What are the tax implications for each shareholder in each jurisdiction?
Developing an overall restructuring plan that works from a legal, accounting, cash flow and tax perspective in multi-jurisdictions is far from straight-forward, and involves very tailored analyses. There is no "one plan fits all". In many instances, the factual circumstances simply make it impossible for the restructuring to occur on terms acceptable to all the parties involved.
Bringing offshore ownership back onshore in China is not simple, and puts the parties on a crossroad of laws of several jurisdictions. As parties with different needs, risk tolerance, potential rewards and cash positions navigate through this myriad of often conflicting rules, they will need a chief architect to develop an overall plan that integrates the multiple facets of the project, since the way back onshore is a path of no return.
Orrick's private equity practice in Asia
Covering all aspects of the private equity business cycle from fund formation, regulatory issues and capital raising, to investment, company representation and management, as well as exits via listings or trade sales, Orrick's Asia private equity team is comprised of seven partners and 15 associates based in our Hong Kong, Beijing, Shanghai and Tokyo offices. Orrick's Asia private equity lawyers represent global private equity investors on a wide range of activities across the Asia-Pacific region.
Clients include Mount Kellett Capital, Warburg Pincus, Morgan Stanley, HSBC, One Equity Partners, and PineBridge Capital (formerly AIG Investments).
Maurice Hoo, the author of this article, is a partner and co-head of Orrick's private equity practice.
For information, please contact:
Partner, Hong Kong
+852 2218 9130