Where’s the Exit? New Opportunities in China for Private Equity Firms
It has long been a well established exit route in developed markets for a private equity firm to sell its interest in a portfolio company to a listed company in exchange for shares in that listed company. Until recently, this was not a route that was used by acquirers that are listed on the local Chinese stock exchanges, and with more than 2,700 companies listed on such stock exchanges (each a “Listco”) this has effectively shut out a financing route for many potential acquirers. A key reason for this relates to the weaker capital markets in China, which meant that this was not necessarily an attractive route for private equity sponsors. However, with a deepening of China’s A-Share market this has become a more attractive route, although it has been unclear how on account of regulatory constraints, this could be achieved for foreign sellers. A recent transaction has thrown interesting light on this issue.
The key issue for a foreign owner of shares which might be acquired by a Chinese listed company is that there are significant hurdles that apply to a foreigner who wishes to acquire shares in a Listco. It was not at all clear whether the same restrictions that would apply to a cash purchaser of A-Shares would apply to someone who is receiving such shares in return for equity.
Generally speaking, it is possible for foreign investors to invest into a Listco through one of two regulatory schemes. First, China has developed the Qualified Foreign Institutional Investor (“QFII”) program, which is designed for investors that wish to trade listed shares, and which, amongst other things, permits acquisitions of 10% or less of a Listco’s shares. Second, there are rules allowing a strategic investor to make investments into a Listco pursuant to the Administration of Strategic Investment in Listed Companies by Foreign Investors (“Strategic Investment Measures”) provided that it is acquiring more than 10% of the Listco’s shares. However, high qualification requirements, long lock-up periods, and a cumbersome approval process are impediments to the popularity of both of these schemes among foreign private equity funds. For example, applicants under the QFII program are subject to a minimum assets under management threshold of US$500 million of securities assets (the authorities generally require these assets to be publicly traded securities) in its most recent accounting year, and any investment under the Strategic Investment Measures are subject to approval of both the China Ministry of Commerce (“MOFCOM”) and the China Securities Regulatory Commission (“CSRC”), and require a 10% minimum shareholding threshold and, of particular concern to a private equity firm, a three year lock-up period.
However, a recent development has suggested that neither of these two routes needs to be adhered to if, following a share-for-share exchange, the foreign private equity fund holds less than 10% of the shares of the Listco.
The Blue Gold/Kaile Transaction
In April 2015, Blue Gold Limited (“Blue Gold”), a Hong Kong company and the investment arm of a private equity fund, together with various other companies, proposed to sell Shanghai Fanzhuo Limited, a privately owned company, to Hubei Kaile Technology Co. Ltd (“Kaile”), a company listed on the Shanghai Stock Exchange, in exchange for newly issued shares in Kaile. Following completion of the transaction, Blue Gold would hold 3.04% of the publicly listed shares in Kaile.
Public documents relating to the transaction revealed that Kaile twice sought clarification from MOFCOM as to whether this transaction was possible and/or required any approvals from MOFCOM. On both occasions, MOFCOM stated that no such approval was required. Treading carefully, Kaile also sought out a clarification from its “local MOFCOM”, the Hubei Provincial Department of Commerce, which declined authority over the matter on the basis that the shareholding percentage would be below 10% following the completion of the transaction, informing Kaile that it should seek approval from CSRC. CSRC approved the transaction.
The initial conclusion is that a share-for-share exchange which results in a private equity seller owning less than 10% of the Listco falls outside of the ambit of the Strategic Investment Measures, and is possible even if the seller does not have a QFII license. MOFCOM has in practice adopted a flexible approach to regulate a foreign investor’s purchase of listed shares. In addition to providing private equity firms with a new exit route, this precedent could potentially open up an additional route for private equity firms to make private equity style investments into public equity securities (i.e. “PIPEs”), a route that has been hitherto restricted to investments in 10% or more of the Listco.
However, there remain a number of unanswered questions. The target acquired by Kaile was a Chinese company and the foreign private equity firm would have needed to have obtained MOFCOM approval at the time of its initial investment into that company. Some commentators have surmised that this was the basis upon which MOFCOM felt they did not need to approve the transaction. It is not clear whether this is the case, and by extension, it opens up an interesting question as to whether the share-for-share exchange would work if the Listco was acquiring a foreign company where no such approval would have been obtained. With many Chinese companies building their operations abroad through acquisitions, this would open up very interesting possibilities for expansion.
Another question relates to whether MOFCOM would take a similar approach if a syndicate of foreign private equity investors were to individually receive less than 10% of the shares in a Listco but collectively hold more than 10%. The wording of the various approvals would suggest that this would be permissible, but each approval was provided in the context of a transaction where this scenario did not arise.
We are aware that there are a number of similar transactions being pursued in the market at present, and further insights will no doubt be gained in due course. For now, private equity firms that have invested into Chinese companies can, at the very least, take comfort that an additional exit route appears to be available to them.