Private equity is very much in favour in China as other sources of finance have become difficult to access. Pressure on banks to maintain reserve requirements, dividend obligations at those banks and anti-inflationary government policies all limit the opportunities for small and medium-sized enterprises (SMEs) to raise sufficient finance through bank loans. Domestic, Hong Kong and US stock exchange listings take time and expense to complete, bring strict regulatory scrutiny, and subject issuers to periodic public disclosure requirements. In addition, Chinese companies that have undergone reverse mergers into listed shell companies overseas have become subject to attacks by short-sellers, effectively eliminating the reverse merger as a potential financing option.
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Loeb & Loeb
Given that PE capital is much in demand, there arises a natural temptation for PE funds to negotiate deal terms that are aggressively in favour of the PE investor. While there is nothing wrong with getting a good deal for one’s limited partners, certain provisions, although seemingly good on paper, may not be beneficial in practice. One set of these provisions used in the Chinese PE market is commonly known as ratchet provisions. Ratchet provisions are typically net income or revenue objectives for the portfolio company to meet, subject to certain adjustments, over a one- to three-year period. Failing to meet a ratchet will typically trigger a put option back to the company or a key shareholder at a high, often 30%, internal rate of return (IRR). Alternatively, a ratchet may be structured as a share pledge which would trigger a right to seize the shares of a key shareholder, or as a share adjustment mechanism, which would trigger a right to receive newly issued shares of the company at zero or nominal cost. This extreme type of remedy was originally a weapon of last resort for a PE investor in the event of a major breach or other extreme misconduct by a portfolio company. It has instead become tied to specific operating results. This appears to have happened because the relative lack of availability of debt funding in China decreases potential investment returns, causing funds to spread money around to increase the possibility of picking a winner. This tendency in turn decreases the time and resources a fund will devote to due diligence at any one given potential portfolio company. The fund may therefore place increased reliance on a put or redemption option or share pledge in favour of the investor if earnings or revenue targets are not achieved.
Clearly, puts or pledges triggered by ratchets have the potential to destroy the working relationship between the PE fund, the portfolio company, management and the other shareholders. If the earnings or revenue ratchets are not met, the investor may put its shares to the company at a 30% IRR and potentially bankrupt it, or seize all the shares of one or more principal shareholders and take over the company, or force the potential issuance of cheap stock which significantly dilutes everyone else. Thus disappointments in operating results, large or small, can cause the investor, principal shareholders and management to end up bitter enemies. Even the fear of such an outcome could drastically reduce incentives for transparency at a company when things begin to go wrong. And transparency is what a financial investor requires in order to be able to add the value that a portfolio company needs in times of trouble or when growth is not progressing as originally anticipated.
Frank Marinaro is a partner at Loeb & Loeb and the chief representative of the firm’s Beijing office. He may be contacted on +86 10 5954 3588 or by email at fmarinaro@loeb.com.cn
