This country-specific Q&A provides an overview to private equity laws and regulations that may occur in China.
This Q&A is part of the global guide to Private Equity. For a full list of jurisdictional Q&As visit http://www.inhouselawyer.co.uk/practice-areas/private-equity/
What proportion of transactions have involved a financial sponsor as a buyer or seller in the jurisdiction over the last 24 months?
Financial sponsors have continued to remain active in the China M&A market in the past few years. According to PwC M&A 2017 Review, the value of private equity and VC investments in China in 2016 and 2017 was US$224.8 billion (in 5,259 deals) and US$182.9 billion (in 3,662 deals) respectively, representing 40.21% and 32.04%, respectively, of the total value invested in China in these years, and the number of inbound deals in China sponsored by financial investors in 2016 and 2017 represented 50.57% and 40.56%, respectively, of the total number of inbound deals in these years.
PwC M&A 2018 Mid-year Review also indicated that in the first half of 2018, the number of deals by financial sponsors in China was 2,465 (with an aggregate amount invested of US$93.9 billion), representing a 32% increase from the deal volume in the first half of 2017 (i.e. 1,868) and constituting 45.86% of the total number of all inbound deals made by both strategic and financial investors, and 31.17% of the total value invested in China, during the first half of 2018.
What are the main differences in M&A transaction terms between acquiring a business from a trade seller and financial sponsor backed company in your jurisdiction?
Financial sponsors need to achieve a “clean” exit which allows them to upstream a clearly defined amount of proceeds from the transaction to their investors. The clean exit approach is important for both the purchase price mechanics and the warranty and indemnity coverage given by sellers. In many deals involving an acquisition from a financial sponsor seller, buyers receive very limited fundamental warranties (i.e. authority, capacity and title) with the optionality for buyers to take out a W&I insurance for operating warranties.
By contrast, in an acquisition of a business from a trade seller or from the Chinese founder(s), it would be more customary for the seller to agree to give a wide range of business-related representations and warranties and/or indemnities addressing specific issues uncovered during the due diligence. An acquisition of a business from the Chinese founder(s) is also more likely to include an earnout based on the performance of the company following the closing, which is almost never seen in an acquisition from a financial sponsor.
On an acquisition of shares, what is the process for effecting the transfer of the shares and are transfer taxes payable?
For all Chinese companies, the process for effecting the transfer of the shares to non-Chinese investors requires registrations with the State Administration for Market Regulation (“SAMR”) and the Ministry of Commerce (“MOFCOM”) or their respective competent local counterparts. Additionally, a pre-transaction MOFCOM approval is required for a non-Chinese investor’s acquisition of the shares in a domestic company engaging in a categorized business under the Special Administrative Measures for Foreign Investment Access (“Negative List”). A categorized business under the Negative List refers to a business in which foreign investment is restricted (e.g. telecommunications, insurance, securities brokerage) or prohibited (e.g. media, compulsory education, tobacco distribution).
In a private company context, the equity interest in a company is is usually evidenced with a business license specifying the registered capital amount of a company and the transfer process would customarily involve the parties executing a share transfer agreement. The seller would then submit the agreement to the Chinese tax authority within 7 days of the completion of the transfer and pay applicable Chinese taxes, including a withholding tax at a rate up to 10% on capital gains realized by a non-PRC tax resident seller (the tax basis for which is usually the company’s registered capital amount or the seller’s investment cost) and a stamp duty of 0.1% (which is equally shared by the purchaser and the seller).
In a public company context, shares are usually held in uncertificated form and transferred through electronic clearance systems maintained by China Securities Depository and Clearing Corporation (“CSDC”). CSDC maintains an electronic register of members and trades are effected electronically by CSDC transferring the ownership in the shares once it has received the payment for the transfer (including the transfer tax payable). Selling listed shares is subject to a stamp duty at a rate of 0.1% borne by sellers.
A PRC tax resident seller, for a transfer of shares in either a private or public company, is required to report a sale transaction in its monthly or quarterly corporate income tax filings and pay applicable corporate income taxes at a rate of 25%.
How do financial sponsors provide comfort to sellers where the purchasing entity is a special purpose vehicle?
In smaller transactions, transactions in which the seller has limited negotiating leverage and/or transactions in which closing occurs concurrently with or soon after signing, sellers may agree to sign an agreement with a special purpose vehicle without formal legal recourse against an entity of substance. Otherwise, sponsors often provide the seller with equity commitments and, where the transaction is to be financed at least in part with debt, debt commitment letters prior to signing.
The equity commitment letters are usually structured as an irrevocable commitment given by the fund to the acquisition vehicle pursuant to which the financial sponsor commits itself to invest certain funds in the acquisition vehicle. The equity commitment letter is usually issued solely for the benefit of the purchasing entity but may be enforced by the seller on its behalf against the relevant fund entity.
How prevalent is the use of locked box pricing mechanisms in your jurisdiction and in what circumstances are these ordinarily seen?
China M&A transactions may involve either a locked box approach or a “U.S.-style” completion accounts construct (with a purchase price adjustment based on net debt and working capital at closing). In a transaction involving an acquisition of a Chinese company by a financial sponsor, a completion accounts construct remains in most circumstances the buyer’s preferred approach because this approach (i) requires less comfort on the balance sheet prior to signing, (ii) does not require the buyer to underwrite the risk of developments between signing and closing and (iii) potentially allows the buyer to benefit from purchase price adjustments that are not specifically negotiated with the seller (whereas under the locked box approach, the buyer would need to negotiate prior to signing how items on the balance sheet will affect the purchase price). In a transaction involving a sale by a financial sponsor seller, however, a seller in the China market would typically consider carefully with its financial advisor the pros and cons of each approach in light of the negotiation dynamics and the identity and sophistication of the buyer, rather than proposing either approach by default. According to Chinese local counsel, a locked box construct is increasingly popular among Chinese individual investors for smaller-sized or less complex transactions, where it offers the parties certainty of price and reduces deal execution costs.
What are the typical methods and constructs of how risk is allocated between a buyer and seller?
In the Chinese M&A market, the parties’ identity, level of sophistication and relative negotiating leverage are more likely to drive the approach to risk allocation than any particular market term. For example, with respect to the scope of representations, disclosure and conditionality, depending on the circumstances, the parties may follow either a U.S. construct (with extensive representations and warranties backstopped by an indemnity and qualified only by the disclosure schedules and negotiated closing conditions, including absence of a material adverse change) or a European construct (where representations are qualified by the content of the data room and the buyer has more limited conditionality than merely obtaining relevant regulatory approval). In competitive auctions and/or large transactions by financial sponsors, sellers are increasingly able to obtain very favorable terms, including no recourse against the seller following closing (other than for limited exceptions such as breach of fundamental warranties). In the case of investments in a Chinese company where the Chinese founder remains involved in operation of the business, it is more common for buyers to insist on broad representations and warranties back-stopped by an indemnity, although for attractive assets sellers have in recent years been able to negotiate limitations (e.g. in terms of cap and survival period) to their exposure.
How prevalent is the use of W&I insurance in your transactions?
In recent years, W&I insurance in M&A transactions has become increasingly popular and financial sponsor purchasers have used W&I insurance in auction processes to limit sellers’ potential exposure and thus make their offers more attractive. Given increased competition in the W&I insurance market, insurance policies have also expanded coverage from operating warranties only to title warranties, specific tax insurance and zero seller liability structures (i.e. no skin in the game by the seller) without incurring substantial additional premiums. However, insurance policies may include additional exclusions (e.g. bribery, FCPA compliance) for China businesses that are not always applicable for other businesses, and financial sponsors sometimes require sellers to provide an indemnity for certain material risks not covered by W&I insurance.
How active have financial sponsors been in acquiring publicly listed companies and/or buying infrastructure assets?
Between 2011 to 2015, there was a surge of going-private transactions involving China-based U.S. listed companies and a number of them have completed their re-listings in China’s A-share market (e.g. Focus Media, Qihoo 360). As to foreign investments in Chinese publicly listed companies, strategic investors remain the dominant players as such investments are subject to MOFCOM approvals for foreign strategic investments, which are more often granted to strategic investors or financial sponsors teamed up with strategic investors. In the past few years more financial sponsors teamed up with strategic investors (including their portfolios companies) to acquire minority or majority stakes in Chinese publicly listed companies (e.g. Focus Media/Carlyle, Qihoo 360/RMB funds, Shandong Luyang/Unifrax & American Securities) and financial sponsors are reviewing public deal opportunities much more actively.
The infrastructure market has been active in China due to the central government’s investment-driven policies but state-owned companies and strategic investors remain dominant players in the infrastructure market (e.g. BOT projects, PPP).
Outside of anti-trust and heavily regulated sectors, are there any foreign investment controls or other governmental consents which are typically required to be made by financial sponsors?
Foreign investment in a sector listed in the Negative List requires a pre-closing approval by MOFCOM. Additionally, an acquisition of a Chinese company by a non-Chinese investor is subject to a national security review by a joint committee led by MOFCOM and NDRC in case of (i) a non-Chinese investor’s acquisition of any stake in a military enterprise, a supplier to a military enterprise, a company located near sensitive military facilities, or any other company relating to national defense, or (ii) a non-Chinese investor’s acquisition involving control of a Chinese company the business of which involves key agricultural products, energy and resources, infrastructure, transportation services or technologies or manufacturing of equipment and machinery affecting national security. Moreover, China has foreign exchange control and cross-border currency remittance relating to capital account transactions is subject to the approval by and registration with the State Administration of Foreign Exchange (“SAFE”). These regulatory requirements apply to not only financial sponsors but strategic investors.
How is the risk of merger clearance normally dealt with where a financial sponsor is the acquirer?
Non-Chinese parties to a share purchase agreement, to the extent they have leverage, would seek to shift the PRC antitrust risk onto the Chinese party by requiring the Chinese party to pay a termination fee if the agreement is terminated as a result of a failure to obtain PRC antitrust approval. Where the buyer agrees to pay such a termination fee (e.g. in the event of a sale from a non-Chinese seller to a Chinese buyer), the seller may request the buyer to deposit an amount equal to such termination fee in escrow at the time of signing the purchase agreement.
Have you seen an increase in the number of minority investments undertaken by financial sponsors and are they typically structured as equity investments with certain minority protections or as debt-like investments with rights to participate in the equity upside?
Minority investments by financial sponsors have been very common in China M&A market for many years, particularly given regulatory restrictions on control investments in certain industries and because many Chinese founders want to retain control of their businesses. Equity investments are made with customary minority protections in both onshore and offshore China-related transactions and debt-like investments with rights to participate in the equity upside (e.g. convertible bonds) have been used mainly in offshore China-related transactions.
How are management incentive schemes typically structured?
Most management incentive schemes are structured on an equity or equity-like basis granting the managers indirect equity interests (through a vehicle holding such equity on behalf of the management team) in the target company. Equity-based incentive schemes for Chinese national managers need to be carefully structured and implemented in light of China’s foreign exchange control issues. Non-equity incentive schemes (e.g. bonuses, phantom stock, stock appreciation rights) are more common in programs involving many Chinese national participants because equity incentive schemes in such circumstances would be too burdensome. If structured properly, equity incentive schemes result in gains that are subject to capital gains tax unlike exit bonus or phantom share schemes which attract higher rates of individual income tax.
Are there any specific tax rules which commonly feature in the structuring of management’s incentive schemes?
A specific set of Chinese tax laws and implementation rules promulgated by the State Administration of Taxation govern the tax treatment of equity and non-equity incentive awards. In general, equity incentive awards (e.g. stock options) are taxed at the time of exercise (which typically are treated as ordinary incomes subject to progressive individual income tax rates) and at the time of sale (gains generated from which are subject to capital gains taxes at a lower rate), and non-equity incentive awards are often treated as ordinary income (subject to progressive individual income tax rates) at the time of payment.
Are senior managers subject to non-competes and if so what is the general duration?
Yes. The maximum term typically is no more than two years after employment termination (as Chinese courts would be unlikely to enforce a non-compete with a longer term). An employer is required to pay the employee certain compensation (e.g. at least 30% of the employee’s average salary amount in the past 12 months) in order to enforce post-termination non-compete obligations. If the manager is also involved either as seller or a shareholder in the purchaser’s acquisition structure then it is possible to extend the non-compete protections in those scenarios.
How does a financial sponsor typically ensure it has control over material business decisions made by the portfolio company and what are the typical documents used to regulate the governance of the portfolio company?
Normally the key documentation that drives governance and behavior is the shareholders’ agreement (or joint venture agreement) and the portfolio company’s articles of association. These documents usually specify corporate governance (e.g. shareholders’ meeting, board meeting and management structures, including right to appoint certain key executives) and voting arrangements (e.g. reserved matters for shareholder’s or board’s approval). Sometimes, additional agreements (e.g. framework agreement, IP license agreements, supply agreements) are also used to offer non-Chinese investors additional protection on enforcement and recourse.
Is it common to use management pooling vehicles where there are a large number of employee shareholders?
In the event a large number of employees are participating in the management incentive schemes, a limited partnership is usually used as a management pooling vehicle as these can be controlled via the general partner which is held or controlled by the majority shareholder. In general, as management of such equity participation programs and vehicles becomes more complex and complicated, the more managers and employees are involved, and investors usually try to limit the number of participants and implement instead exit bonus schemes or phantom entitlements for additional employees.
What are the most commonly used debt finance capital structures across small, medium and large financings?
Third-party debt financing continues to be available for acquisitions of Chinese companies by private equity investors. One key challenge, however, is that a PRC target does not generally have the ability to give credit support (by way of guarantee or security over its assets) to a lender of offshore acquisition finance debt. Many of the going-private transactions of US-listed Chinese companies have involved debt financing, but their terms have showed little consistency, reflecting varying commercial and structural challenges. The acquisition debt has typically been borrowed by an offshore acquisition vehicle with the borrower giving security over its assets (including shares in its offshore subsidiaries) to secure repayment of the debt. The lenders have been a wide range of financial institutions, from international investment banks (such as BNP Paribas, Credit Suisse, Deutsche Bank, Goldman Sachs and JPM, alongside China Minsheng Bank and ICBC International in the case of Giant Interactive) to policy banks and other PRC banks (such as Ping An Bank Co., Ltd. and Shanghai Pudong Development Bank Co., Ltd in Wuxi Pharma, China Development Bank in Harbin Electric and CITIC in Tongjitang).
Is financial assistance legislation applicable to debt financing arrangements? If so, how is that normally dealt with?
Shareholders of Chinese public companies cannot pledge their listed shares to borrow money for purposes of acquiring listed shares. Equity holders of private Chinese companies, however, may pledge their equity interests for purposes of securing debt borrowed by the shareholders. Due to regulatory hurdles on lien perfection, Chinese companies cannot mortgage their assets as collateral to secure offshore borrowing by their shareholders.
For a typical financing, is there a standard form of credit agreement used which is then negotiated and typically how material is the level of negotiation?
As the PRC financing market is still developing, the terms of the financings and forms of documentation are often more bespoke than in more developed financing markets. Traditionally, PRC banks used their standard form credit agreements without the involvement of external counsel and permitted minimal negotiation. The terms contained in those standard form loan agreements tend to be broad-brush and lack specificity from a common law standpoint. With the increasing influence of international players in this market and growing demand from private equity sponsors and more sophisticated borrowers, borrower friendly precedents and highly negotiated credit agreements are becoming more prevalent.
What have been the key areas of negotiation between borrowers and lenders in the last two years?
Financial covenants remain a hot topic among borrowers and lenders, with a push towards relaxation of covenants, less testing frequency and more flexibility in sponsor’s equity cure rights. Borrowers are also keen to build in flexibility for exit strategies such as an IPO of the group up front.
Have you seen an increase or use of private equity credit funds as sources of debt capital?
Credit funds are increasingly active in the PRC debt capital markets. They provide an alternative to banks and are sometimes able to offer more flexibility and faster execution. They have limited ability, however, to offer onshore RMB loans and facilities of a revolving nature or letters of credit.