Traditionally, international private equity houses making growth capital investments in Chinese businesses invest in an offshore holding company (often incorporated in the Cayman Islands) holding (often indirectly through other intermediate holding companies in the British Virgin Islands (BVI) and Hong Kong) Chinese subsidiaries (called wholly foreign owned enterprises or WFOE). 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 such international capital markets as Hong Kong, London or New York, where the timing of listing depends on the issuer's performance and market conditions, but seldom on government policies. If the investor invests directly in a China-incorporated company and exits on the A-share market in Shanghai and Shenzhen, the timing of listing can in large part be driven by policies of the China Securities Regulatory Commission (the CSRC) and its sentiments on the capital markets.
In recent months, however, the substantially higher P/E ratios offered by the A-share market (compared to other markets around the world), as well as the anticipated continuing strength of the Renminbi, are attracting the attention of many 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 newsletter 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, the investors should remember that the move onshore is irrevocable – if the tide turns on 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 on 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. Even with such profitability, there is no assurance that the conversion will be approved or can be accomplished. Further, even after such conversion, and even with excellent financial performance and market conditions, 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 to 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 analyze these cross-jurisdictional differences, and get comfortable with potentially losing such rights as liquidation preference, anti-dilution, redemption or put rights, and so forth, 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, the lockup on a non-controlling shareholder is one year (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 restructure be accomplished by simply winding up the Hong Kong, BVI and Cayman holding companies and have the WFOE equity distributed 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, must the restructure involve the use of cash to purchase equity in the WFOE by the ultimate shareholders? 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 restructure. 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 not wound up, in a position to declare further dividend to the ultimate shareholders for such purpose? How much cash is needed – is that determined by the net asset value or other valuation of the WFOE equity? Are there concerns of such a process inadvertently cashing out the controlling shareholder at the expense of the financial investors? What are the tax implications for each shareholder in each jurisdiction?
Developing an overall restructure plan that works from a multi-jurisdictional legal, accounting, cash flow and tax perspective 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 restructure 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 as the way back onshore is a path of no return.