Exit strategies

A tried and true method for taking Chinese companies public may no longer be at the disposal of foreign investors.

Round-tripping – whereby the owners of Chinese firms set up parallel offshore companies known as special-purpose vehicles (SPVs) along with foreign investors, usually with a view to an easier share sale abroad – is being blocked by progressively stringent mergers and acquisitions (M&A) rules.

This has left venture capital (VC) and private equity (PE) funds groping for other ways out.

The Ministry of Commerce’s most recent batch of M&A rules, which were implemented in September 2006, requires that Chinese firms looking to make round-trip deals comply with an elaborate approval process. Since the approvals have not been forthcoming, late-stage deals set up since then have been effectively prevented from listing offshore, said Rocky Lee, a partner at DLA Piper in Beijing.

Then in May, the State Administration of Foreign Exchange (SAFE) issued an internal document requiring firms to submit three years of financial records to register for a foreign-exchange deal.

“Just about every early-stage internet company will have difficulty satisfying that requirement,” said Lee.

Under pressure

Although it is too early to tell how strictly the SAFE rules are being upheld, the risk of being denied has put pressure on foreign investors to make sure their Chinese partners comply. An investigation could stop a deal cold.

Chinese companies are still technically allowed to swap shares with an offshore SPV shortly before a listing, but in practical terms, the rules often don’t allow enough time for this to happen.

The pipe has not been sealed off completely. There are still a couple of ways of putting together a deal that allow for share sales without ministry approval.

One approach, commonly taken by internet companies such as Baidu and Ctrip, involves using a wholly foreign-owned enterprise – set up by an SPV owned by the foreign investment fund – to take over the Chinese operating company while the Chinese parent company keeps the equity, said Guillaume Rougier-Brierre, co-managing partner at Gide Loyrette Nouel in Beijing.

This roundabout route highlights just how difficult it has become to take a Chinese company offshore.

The new rules have “taken a very complicated system and made it even more complex,” said Andrew McGinty, a partner with Lovells in Shanghai. “In the old days, you could just go to Hong Kong, open a shelf company and off you went.”

Running scared

Fears that yet more regulations are on the horizon have led to VC and PE deals already underway being rushed through while the door remains open.

The introduction of stricter rules is seen by some as a response to criticism that Chinese assets are flowing out of the country too quickly, as well as a desire to promote domestic listings for large state-owned firms. But the regulators have not tried to shut off foreign exits entirely – at least not intentionally.

“I think they intended to slow down deal flow and cool the economy … but I don’t think they realize how far they’ve gone,” Lee said. He expects Beijing to take corrective measures when they see data showing foreign M&A deals slowing to a trickle, probably in early 2009.

A potential exit strategy may be the A-share market, though it is generally unpopular with foreign investors.

Mandatory lock-up periods mean capital can’t be taken out for one or three years (depending on who is interpreting the rules), and even then, the money must be converted into foreign currency before being repatriated. McGinty adds that, while the market is doing well, it is still “primarily dominated by the state, which plays a dual role – player and referee.”

For the moment, A-share plays are in an experimental phase, with several funds allocating a small amount of capital for investment in the Shanghai market.

“People have to get comfortable with the idea [of mainland listings] before they go down that path,” said McGinty.