Lexology GTDT Market Intelligence provides a unique perspective on evolving legal and regulatory landscapes. This interview is taken from the Private Equity volume featuring discussion and analysis of emerging trends and hot topics within key jurisdictions worldwide.
1 What trends are you seeing in overall activity levels for private equity buyouts and investments in your jurisdiction during the past year or so?
According to statistics, the aggregate amount of investment by private equity funds in 2018 in China is approximately 1.08 trillion yuan, a 10.9 per cent decrease compared with that of 2017. The number of investment is approximately 10,000, a 1.2 per cent decrease compared with that of 2017. These downward changes could be due to the deleveraging campaign, crackdown on shadow banking and more stringent regulatory requirements on the asset management industry taken by the government in the past few years.
Generally, buyout funds are not as active in China as those in other markets.
In the past year, we have witnessed two major changes with respect to capital markets in China: the plummet of share price in A-share and the opening of a new stock exchange – the STAR Market (Science and Technology Innovation Board).
In 2018, the Shanghai Composite Index fell by more than 46.3 per cent. This has led to two significant changes in the private equity industry. First, lower public equity valuations are likely to depress private market valuations for comparable target companies. Second, exits through M&A or the Hong Kong Stock Exchange (HKEX) and US capital markets were a better choice for private equity firms in 2018. According to statistics, in 2018, 111 mainland companies were listed on the HKEX, constituting over 50 per cent of all companies listed on the HKEX that year, while in 2017, these numbers are 50 and 31 per cent, respectively. However, the recent political and trade relationship between China and the United States and recent protests in Hong Kong may have an impact on private equity firms’ exit strategies.
The SSE (Shanghai Stock Exchange) officially launched the STAR Market on 13 June 2019 for the purpose of supporting financing of Chinese companies in the industries of IT, high-end equipment, new material, new energy, energy saving, environmental protection, cloud computing, big data, AI and biomedicine. The STAR Market is expected to provide a new exit option for private equity funds.
2 Looking at types of investments and transactions, are private equity firms primarily pursuing straight buyouts, or are other opportunities, such as minority-stake investments, partnerships or add-on acquisitions, also being explored?
As mentioned under question 1, buyout transactions backed by private equity funds are not as active in China as in other markets and neither do we see many portfolio company activities in China.
Hotspot regions include more economically developed provinces and cities, such as Zhejiang Province, Jiangsu Province, Guangdong Province, Fujian Province, Beijing, Shanghai, Guangzhou, Shenzhen and Hangzhou.
Industrial sectors that attract most investment in 2018 mainly included IT, biomedicine, logistics, semi-conductor, integrated circuit and finance.
One important investment focus of private equity in China is a clear and fast exit strategy. Unlike private equity funds in other markets, which normally have a life span of approximately seven to 10 years, investment-to-exit period is much shorter in China, ranging from three to five years, which means that a clear and fast exit strategy is crucial for each investment.
3 What were the recent keynote deals? And what made them stand out?
Two deals. The first is the strategic buyout by Alibaba Group of Ele.me (the biggest online food delivery platform in China). This transaction is the biggest buyout transaction in China’s internet industry in 2018 with the deal value of US$9.5 billion. It provided exits for CITICPE, Sequoia China, MatrixPartners China, GSR Ventures and BHG, among others.
The second recent keynote deals is the listing of Xiaomi Corporation on the HKEX. It is the second largest initial public offering (IPO) on the HKEX in 2018, raising HK$24 billion. The listing provided exits for Morningside Venture Capital, IDG Capital, Temasek, Gaotong Capital, DST, All-Stars Investment, GIC and YF Capital, among others.
4 Does private equity M&A tend to be cross-border? What are some of the typical challenges legal advisers in your jurisdiction face in a multi-jurisdictional deal? How are those challenges evolving?
By way of background, cross-border M&A includes both inbound M&A and outbound M&A. For inbound M&A, it refers to investment in China by funds denominated in foreign currencies. For outbound M&A, it refers to investment outside of China by companies backed by private equity funds. With the Belt and Road Initiative, outbound M&A has been on the rise with the financial support of private equity funds.
Typical challenges faced by legal advisers in China in cross-border transactions are similar to those in other markets. To name a few, they include the understanding and reconciliation of different cultures, political and legal systems, and business norms.
5 What are some of the current trends in financing for private equity transactions? Have there been any notable developments in the availability or the terms of debt financing for buyers over the past year or so?
In China, debt financing for private equity transactions is not as common as in other markets. This is because there are onerous eligibility requirements for buyout financing.
In practice, these loans are normally granted to large state-owned enterprises, industrial company groups or market leaders in a specific industry. We did notice several transactions where private equity firms successfully received financing support from banks. These firms have strong industrial backgrounds, such as CITIC PE or private equity funds set up by Lenovo.
We did not see any new developments in the availability or the terms of debt financing for buyers over the past year or so.
6 How has the legal, regulatory and policy landscape changed during the past few years in your jurisdiction?
There are several major changes with respect to the regulatory landscape affecting private equity firms during the past few years.
The first one is the Guidance on Regulating the Asset Management of Financial Institutions issued in April 2018 (Asset Management Guidance). The Asset Management Guidance is designed to curtail shadow banking activity, increase investor protection and reduce systemic risks. Major goals of the Asset Management Guidance include:
- limitations on mismatches of investment maturities and asset maturities;
- a reduction in number of intermediaries (layers) between fund managers and final investors;
- a ban on principal and return guarantees; and
- a ban on fund pooling and ‘channel business’.
In the short run, the Asset Management Guidance has created certain disruption and volatility in the fund raising and investment activities. However, in the long run, crackdown on shadow banking and unregulated financial products mean significant positive implications for investors, sponsors and financial markets.
Another significant change is the establishment of a comprehensive system regulating registration and reporting of private equity fund managers. To register with the Asset Management Association of China (AMAC), an applicant must have established various internal control policies and met certain stringent eligibility requirements. Once registered, a fund manager must launch its first private fund within six months from the date of registration with the AMAC. Otherwise, the AMAC may revoke the registration.
Next is the promulgation of Foreign Investment Law on 15 March 2019, which will become effective on 1 January 2020. This new law will impact private equity funds established as Sino–foreign joint ventures in China in at least the following areas:
- governance structure;
- profit distributions;
- deadlock resolution mechanism; and
- equity transfer restrictions.
According to the new law, foreign invested companies will be treated the same as domestic companies without any foreign investment except for market access and national security reasons.
On the tax side, the Circular on Income Tax of Individual Partners of Venture Capital Firms issued in January 2019 provides that individual limited partners in a venture capital fund have two options for calculating his or her income tax – the single investment computation and the annual income computation. Under the single investment computation, a 20 per cent income tax rate applies to all income distributed to such limited partner (including dividends and income generated from transfer of shares of portfolio companies). While under the annual income computation, such limited partner is obligated to pay a 5 to 35 per cent progressive income tax (progressive tax) for all income received from a venture capital fund.
Under the annual income computation, losses and costs of a venture capital fund, and management fees and carried interest paid to its management company in a single fiscal year may be carried over to offset its income at a maximum of five years.
7 What are the current attitudes towards private equity among policymakers and the public? Does shareholder activism play a significant role in your jurisdiction?
The Asset Management Guidance represents a concerted attempt by China’s regulators to curtail shadow banking and reduce financial risks. As discussed under question 6, the new rules have triggered disruption, uncertainty and volatility in the financial market, but in the long run, they will bring positive changes in how financial institutions operate, including independent asset management, transparent pricing and simplified structures.
In general, shareholder activism does not play a significant role in China.
8 What levels of exit activity have you been seeing? Which exit route is the most common? Which exits have caught your eye recently, and why?
Exit activity slowed down during the first six months this year. According to statistics, there were 492 exits, representing a 30.5 per cent decrease compared with that of the same time period in 2018.
In China, the most common exit is through capital markets. In the first half of 2019, 293 IPOs with the backing of private equity firms were completed, accounting for 59.6 per cent of all private equity exits. Other exit options include trade sales and buyouts.
In addition to funds’ exits from Ele.me and Xiaomi discussed above, another notable exit is Centrium Capital’s exit from Luckin Coffee through its IPO on Nasdaq. There are a number of reasons why this exit stands out. First, the investment-exit period is 18 months, which makes it one of the fastest exits for private equity investment in China. Second, Centurium Capital, a Beijing-based private equity firm launched in March 2018, is the biggest institutional investor of Luckin Coffee. The fund cooperated with Luckin Coffee from its inception and invested as a lead investor in the first two rounds of fundraising with more than US$180 million.
9 Looking at funds and fundraising, does the market currently favour investors or sponsors? What are fundraising levels like now relative to the past few years?
The market currently favours investors due to the regulatory environment as discussed in question 6 above.
According to market statistics, the fundraising activity slightly slowed down during the first half of 2019, continuing the downward trend seen in 2018. Specifically, 917 funds raised about 480.37 billion yuan during the first six-month period in 2019, representing an 8.2 per cent decrease in the total capital raised and a 47.7 per cent decrease in the number of funds raised.
10 Talk us through a typical fundraising. What are the timelines, structures and the key contractual points? What are the most significant legal issues specific to your jurisdiction?
The fundraising timeline and structure of a private equity fund largely depend on the form of entity (limited partnership or limited liability company), location, size, the number and backgrounds of investors (eg, foreign investors, government guidance fund) and tax considerations, to name a few.
For instance, if an investor is a foreign-invested entity, it may take some time for the investor to meet regulatory requirements with regard to market access and national security concerns.
Generally speaking, the most common form of private equity funds in China is a limited partnership. Key contractual points, like in other markets, often include forms of contribution, governance structure, allocation of costs and expenses, scope of investment, distribution structure, transfer of partnership interests, procedures of participation and withdrawals from partnership, default events, liabilities for breach, choice of law, and dispute resolution mechanism.
As discussed in question 6 above, regulatory authorities started cracking down on shadow banking and taking other measures to reduce systemic risks a few years ago. Among others, the ‘three types of shareholders’, which means trust plans, contractual funds and asset management plans, in asset management products such as private equity funds, have been under strict supervision. This is because three types of shareholders may often result in opacity and complex shareholding structure, which may further lead to unconditioned guarantees and over leveraging. If an investor in a private equity fund is categorised as a three types of shareholder, there are at least two potential adverse consequences. First, the fund will be forbidden from investing in asset management products, except for public securities investment funds. Second, companies backed by such fund may likely face substantial obstacles for listing on domestic stock exchanges.
11 How closely are private equity sponsors supervised in your jurisdiction? Does this supervision impact the day-to-day business?
If a sponsor also serves as the manager of a private equity fund, such sponsor is subject to two major regulatory requirements. First, eligibility requirements, such as capitalisation threshold, scope of business, location of business and qualification requirements for management, personnel and shareholders; second, periodical reports, including semi-annual and annual reports with regard to operations of funds and monthly reports if funds managed by sponsors or managers are larger than 50 million yuan.
In the event that the sponsor and the manager of a fund are two separate entities, they must be related parties. The sponsor and the manager will be regarded as related parties under three circumstances. First, the sponsor and the manager control, jointly control or exercise significant influence on the other party. Second, the sponsor and the manager are subject to control, joint control or significant influence from the same party. Third, the management team and key personnel of the manager invest in the sponsor. The reason for this requirement is because the AMAC is concerned that sponsors may use fund managers as ‘channels’ through which sponsors may attempt to avoid the eligibility requirements and liabilities to the fund.
12 What effect has the AIFMD had on fundraising in your jurisdiction?
13 What are the major tax issues that private equity faces in your jurisdiction? How is carried interest taxed? Do you see the current treatment potentially changing in the near future?
Tax planning is always important in each jurisdiction for fund formation and private equity investment. This is no exception in China. In general, local tax authorities have different views on how certain income should be taxed and the tax treatment may be different for income generated from different sources and for income distributed to different types of investors. Finally, the tax treatment between funds formed as limited partnerships and as limited liability companies may be different. In addition to the tax issues discussed under question 6 above, five additional major tax issues have come to our attention.
First, local tax authorities have different views on the tax treatment for domestic institutional investors with respect to income generated from dividends distributed from portfolio companies (dividends income). Domestic institutional investors may need to pay 25 per cent enterprise income tax on dividends income distributed from private equity funds structured as limited partnerships while such investors may not need to pay such tax if the funds are structured as limited liability companies. Specifically, for a fund in the form of a limited liability company, dividends income distributed to the fund from portfolio companies is exempt from taxation if both the fund and the portfolio companies are ‘resident enterprises’. When such income is distributed to domestic institutional investors by the fund, such income is exempted from taxation as well because both the fund and the domestic institutional investors are resident enterprises. In contrast, for a fund in the form of a limited liability partnership, the exemption may not apply.
Second, with respect to income generated from sale of equity and assets of portfolio companies (assets transfer income), in general there is no substantive difference for the tax treatment for domestic institutional investors in funds formed as limited partnerships and limited liability companies.
Third, local tax authorities have different views on the tax treatment for income received by individual investors and sponsors. If such income is categorised as dividends income or assets transfer income, a tax rate of 20 per cent will apply. If such income is categorised as income from production and business activities as if such income were earned by individual business, progressive tax rates (5 per cent to 35 per cent) will apply. It is likely that progressive tax rates (5 per cent to 35 per cent) apply to income received by individual sponsors. Please see our discussions in question 6 with respect to the tax treatment for individual investors in venture capital funds.
Fourth, local tax authorities have different views on the tax treatment on income generated from carried interest. Some local tax authorities categorise carried interest as income from investment, in which case a tax rate of 20 per cent will apply to individual sponsors and a tax rate of 25 per cent will apply to institutional sponsors; in contrast, other tax authorities categorise it as income from providing financial services, in which case progressive rates (5 per cent to 35 per cent) plus 6 per cent value added tax (VAT) will apply to individual sponsors and a tax rate of 25 per cent and 6 per cent VAT will apply to institutional sponsors. If sponsors are also fund managers, it is more likely that local tax authorities will impose an additional VAT on carried interest. This is because fund managers must pay VAT on management fees and carried interest may be categorised as considerations for management services.
Fifth, for foreign institutional investors that are ‘resident enterprises’, a tax rate of 25 per cent will apply for income from funds. If they are non-resident enterprises, a withholding tax rate of 10 per cent will apply, unless a tax treaty provides for a lower rate. If such investors and sponsors are residents of countries or regions with tax treaties or arrangements with China, more favourable treatments under such treaties or arrangements will apply.
14 Looking ahead, what can we expect? What might be the main themes in the next 12 months for both private equity deal activity and fundraising?
Please see our discussion in question 6 and question 7 above.
The Inside Track
What factors make private equity practice in your jurisdiction unique?
China is the second largest economy following the United States and has the second largest private equity investment amount at US$94 billion in 2018. According to the AMAC, as of the end of April 2019, the number of private equity and venture capital management companies registered with the AMAC has reached a record high of 14,702 and the aggregate amount of funds raised reached 8.16 trillion yuan in 2018. China continues to remain a most attractive destination for private equity investors worldwide.
What should a client consider when choosing counsel for a complex private equity transaction in your jurisdiction?
Being commercially savvy and solution-driven are especially important considerations for choosing counsel for complex transactions in China. In our view, this is one way how counsel adds value to a complex transaction. The regulatory environment affecting the private equity practice continues to evolve very fast. In this context, the ability to navigate through the complex regulatory environment and find solutions for clients is critical. Second, for lead counsel on a cross-border transaction, the ability to manage and collaborate with the entire legal team is equally important. This is because complex transactions tend to be cross-border with the involvement of multiple counsels from different jurisdictions.
What interesting or unusual issues have you come across in recent matters?
The divestitures of assets of Anbang, Dalian Wanda, and Hainan Airlines both in China and overseas have created buyout opportunities for strategic and private equity funds. Second, Chinese sovereign funds and government guidance funds have played an active role in China’s private equity markets for both domestic deals and cross-border transactions. Under the Belt and Road Initiative, outbound investment will continue to generate opportunities for private equity funds. On the fundraising side, we continue to see the impact of the Asset Management Guidance. Existing assets management products must come up with a plan with the goal of bringing the products into compliance by 31 December 2020.