During the past few years, the performances of renminbi funds have drawn more attention, and the Law on Securities Investment Funds, which is currently being amended, will offer an even better legal framework for the development of renminbi funds. The question is then, what are the legal issues involved in the various means of exit available to renminbi funds?
Means of exit
Exit via initial public offering (IPO) means that a renminbi fund directly invests in a company that is proposed to list and realises exit through the listing of the target company and the sale of that company’s shares. According to publicly available statistics, in 2011, 135 out of 150 exits by renminbi funds were realised by way of an IPO (98 of which were realised by way of a domestic IPO), accounting for 90% of all kind of exits. In the first half of 2012, 84 exits were realised by renminbi funds, 75 of which were realised by way of an IPO (and 68 of which were realised by way of a domestic IPO), accounting for 89.3% of all exits.
Exit via asset restructuring means injecting the assets of a target company into a listed company by way of a share swap or asset acquisition, and then exiting on the secondary market. This can reduce the investment lead time and give rise to relatively high returns. However, asset restructurings by listed companies have long been subject to the Measures for the Administration of Material Asset Restructurings by Listed Companies. An asset purchase or sale by a listed company that exceeds a certain percentage requires submission to the merger, acquisition and restructuring committee of the China Securities and Regulatory Commission (CSRC) for review. At a conference held in September, a senior official of the CSRC’s listed company regulatory department indicated that, for the purpose of realising the philosophy of “easing controls and enhancing service”, and promoting acquisitions and restructurings, the CSRC was considering the gradual elimination of administrative permissions for acquisitions and restructurings, and that at present more than two-thirds of acquisition and restructuring transactions only need to carry out the listed company information disclosure procedure.
Exit via equity transfer means that the fund invests in the target company, and through its upstream and downstream industries carries out integration, thereby increasing the value of the target company, and then at an appropriate time transfers the target company to another party. The transferee could be another investment institution or the target company’s original shareholders and senior management personnel. This method is the more common method in the foreign PE investment world.
The legal issues that a fund realising exit by way of an IPO faces are relatively numerous, e.g. the lawful existence of the enterprise, the operating qualifications of the enterprise, the lawfulness of the enterprise’s assets and the obtaining of land, the employment contracts and payment of the social insurance premiums of the enterprise’s employees, etc.
Many renminbi funds, when making an investment, will execute with the target company’s actual controller a “valuation adjustment provision”, stipulating that where the performance targets are not achieved or listing is unsuccessful, the investor will have the right to demand that the company’s shareholders buy back the company’s equity held by the investor.
Concerning the validity of such a provision, in the Haifu Investment Valuation Adjustment Agreement Invalidity Case, the Gansu Provincial Higher People’s Court ruled that of Haifu Investment’s RMB20 million investment, with the exception of the RMB1.15 million counted as part of the registered capital of Shiheng, the remaining RMB18.85 million was “an investment in name but a loan in reality”. Accordingly, Shiheng was required to repay that amount plus the attendant interest.
Final outcome pending
Haifu Investment has submitted an application for a retrial to the Supreme People’s Court. The final outcome of this case will have a definite effect on investments by renminbi funds in companies that intend to list. However, the CSRC has not come out completely against valuation adjustment mechanisms, instead requiring prior screening and a detailed disclosure.
When realising exit by way of an asset restructuring, one has to note whether it constitutes a material asset restructuring of a listed company. The measures specify that a “material asset restructuring” requires the performance in accordance with the law of the disclosure obligation and is subject to review.
Where a material asset restructuring is constituted, it is necessary to determine whether the transaction is in compliance with environmental protection, land administration and anti-monopoly laws, and administrative statutes, to pay attention to whether the lawful rights and interests of the listed company’s shareholders would be harmed, and to perform disclosure obligations in strict accordance with the Measures for the Administration of Information Disclosures by Listed Companies, i.e. whether a connected transaction is constituted, whether there are persons acting in concert, the nature of the transaction, etc., so as to avoid approval being withheld due to non-compliance or incomplete information disclosure.
If a material asset restructuring is not constituted, there is no need to undergo a review, however it is still necessary to pay attention to the determination of the value of the equity to be transferred, performance of the closing obligations, the payment deadline and method, and other contractual terms.
When realising exit by way of an equity transfer, attention needs to be paid to: first, the pricing of the equity to be transferred shall reflect not only the history and current state of the enterprise’s assets, but also its future returns; second, if there are state-owned shares in the target company, the approval of the transfer price by the state-owned assets regulatory authority in the course of the transfer is required to avoid the risk of a determination that state-owned assets are being squandered, resulting in the procedures for registration of the change being impossible to carry out.
Kevin Zhu is a partner at the Beijing office of Zhonglun W&D Law Firm and vice-chairman of its private equity fund practice; Fan Liangliang is an associate at the Beijing office and a member of its private equity fund practice
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