Practical operation involved in quasi-equity investments by private equity funds

By Eric He Xin, PacGate Law Group

It is common in a private equity investment for the fund to extend a bridging loan to the target company before making the investment. This is because the target company may often be experiencing a funding shortfall and the investment will usually take some time to complete.

Bridging loans, also known as quasi-equity investments, take two forms. The first is a short-term loan that the target company will usually repay to the fund after the investment concludes. The second is a convertible debt, namely a loan that can be converted into company equity when the fund invests in the target company.

There are two aspects to the legal relationship involved in a bridging loan: the ordinary claim-debt relationship, and the debt to equity relationship between the private equity fund and the target.

Lawfulness of loans

A bridging loan involves an inter-enterprise loan. Before the Supreme People’s Court issued the Regulations on Several Issues Concerning the Laws Applicable in the Trial of Private Lending Cases (lending regulations) on August 7, the opinions on this issue in industry circles were not unanimous.

何欣 Eric He 百宸律师事务所 律师 Associate PacGate Law Group
Eric He
PacGate Law Group

Pursuant to article 61 of the General Rules on Loans issued by the People’s Bank of China in 1996, outwardly or covertly conducting loan financing between enterprises in violation of state regulations is prohibited.

Private equity funds may not extend loans pursuant to the National Development and Reform Commission’s (NDRC) Notice on Further Efforts to Manage the Filing of Equity Investment Enterprises (filing management notice).

Further, private equity investment funds are strictly prohibited from engaging in debt financing pursuant to the State Council’s Notice on Issues Relevant to Strengthening the Oversight of Shadow Banking (shadow banking notice).

However, the NDRC website, the agency which promulgated the filing management notice, does not have any announcements on penalties imposed on private equity funds for the illegal extension of loans. Further, the shadow banking notice neither sets out a definition for “debt financing business” nor does it spell out the consequences of violation.

Article 32 of the Regulations on the Administration of Foreign-invested Venture Capital Enterprises stipulates: “A foreign-invested venture capital enterprise may not engage in … extending loans to, or providing security for, third parties, with the exception of corporate bonds with a term of at least one year of their investee enterprises or investments of a bond nature that can be converted into the equity of their investee enterprises.”

The author would argue based on the above that a private equity fund can extend an enterprise a loan that can be converted into equity. Further, the Supreme People’s Court has publicly indicated that not all inter-enterprise loans are prohibited. Trial practice in various regions would seem to be largely consistent with this indication.

In practice, before completing an investment in a target company, the company will often need to secure a bridging loan for the transition period. Prior to the lending regulations, private equity funds would either opt for an entrusted loan through a bank, or funds would extend a bridging loan to the founder whereupon the founder would provide the loan to the target company for its operations.

Article 11 of the lending regulations stipulates: “Where entry into a private loan contract between legal persons, between other organizations or between a legal person and another organization is required for production or operational purposes and a party asserts that the private loan contract is valid, the people’s court shall uphold the same unless a circumstance as specified in article 52 of the Contract Law or article 14 herein applies.” The foregoing provision recognizes the lawfulness of loans between enterprises which fall within the specified interest rate range, and it provides the legal basis for private equity funds to extend bridging loans.

Debt to equity relationship

The debt to equity relationship specified by a bridging loan has also been sorted out with the implementation of the lending regulations. But obstacles remain at the administration for industry and commerce (AIC) end. Although article 7 of the Regulations on the Administration of the Registration of the Registered Capital of Companies, issued by the State Administration for Industry and Commerce in February 2014, expressly states that a creditor may convert a claim that it lawfully has against a company established in China into equity of that company, the AICs in different regions take an inconsistent attitude toward the registration of these conversions.

The AICs in Beijing and Suzhou will not accept the applications, while those in Shenzhen and Hangzhou are more enlightened and do accept them. The author was unable to ascertain whether the Shanghai AIC permits such conversions, but its website has reports about these conversions. This inconsistency may have an effect on whether accountants or auditors recognize that shareholders have paid in their capital contributions.

In practice, private equity funds will often require that the target company first repay the loan then inject the capital increase into the company, regardless of whether a bridging loan provides for a debt to equity conversion, thus evading financial or business registration issues. However, this is not very convenient for the parties. With the lending regulations, hopefully there will be a change in AIC attitude toward debt to equity conversions.

From the perspective of actual need, the provision of bridging loans by private equity funds to target companies should be endorsed and supported by all concerned. The lending regulations have had a good start, and it is anticipated that the private equity funds regulator will also set out its position in due time. Hopefully local AICs will also give legal recognition to the registration of debt to equity conversion.

Further, if a private equity fund is to carry out quasi-equity investment, it needs to expressly stipulate the same in its articles of association or partnership agreement. If it does not, it will be unable to persuade its custodial bank to release funds for quasi-equity investment.

Eric He Xin is an associate of PacGate Law Group.