China: Private Equity

Based on the PwC China M&A 2021 Review, in 2021, the proportion of deals involving financial sponsors was evenly matched with that of strategic buyers, while the amount was still considerable, 7,189 out of 12,790, rising by 32% in contrast with 2020. The value of these deals, US$336.1 billion, on the other hand, reduced by 6%. Overall, financial sponsors still take an essential part in M&A deals considering the proportion, while the slightly dropping value figure may be explained by the economic slowdown we are currently experiencing. According to the PwC China M&A 2021 Review, for the first time PE is the largest category of M&A by value.

With respect to the trade sellers, as they are more familiar with the target company’s history and are deeply involved in the target company’s business development, buyers typically require a broader scope of representations and warranties made by them relating to the target company’s business operation, such as that the material contracts will not be impacted due to the acquisition and the target does not contain undisclosed or off-balance sheet liabilities. Accordingly, when negotiating the indemnification, buyers often require that the fundamental representations made by trade sellers shall survive perpetual and the survival period for operating representations is usually 12-24 months, matching at least one full audit cycle. Buyers may also seek specific indemnities from trade sellers for particular red-flag items they identified during due diligence. In the case where the buyer is a buy-out fund, it may also require trade sellers to keep managing the company post-closing by offering a minority shareholding in the target company to trade sellers or applying the earn-out payment scheme. Offering a minority stake is a more attractive stimulation for the trade seller compared with the earn-out payment scheme since it aligns both parties’ interests and provides trade sellers more economic upside potential. In the case where trade sellers face strategic buyers in the same industry, they may spend more time on negotiating non-competition and non-solicitation covenants as strategic buyers concern more on whether trade sellers would start a competing business in threaten of the target company.

With respect to the financial sponsor backed companies, a clean exit with good price is always the financial sponsor’s first priority. They are reluctant to make heave representations and warranties, and are only willing to make fundamental representations such as title of shares, due incorporation and due authorization. They are also being aggressive on negotiation of the indemnification by asking a shorter survival period and international standard limitations on indemnity.

For a PRC onshore acquisition, filing with Administrative of Market Regulation (AMR) is a must to reflect the change of shareholders for a private limited liability company as required by PRC law. The listed company , specially, bears a heavier burden of disclosure obligation and hence announcements concerning essential change of the group companies shall be made to the public. As for the state-owned company, internal authorities such as State-owned Assets Supervision and Administration Commission have a say on acquisition of shares, which usually takes more time.

Some special processes may also need to be cleared before effecting the share transfer in the M&A transactions in the PRC. If the business of the company requires indispensable permits from PRC authorities, such permits might need to be renewed or even reapplied before the share transfer depending on the requirement of laws and regulations in different business fields. In the event the foreign acquirers are involved, the target company falling into specific industries that affect or may affect national security is also subject to national security review before the share transfer. Last but not the least, where a concentration of undertakings concludes the threshold prescribed by law, it shall pass the anti-monopoly examination before transfer of shares.

Transfer taxes for acquisition of shares consist of income taxes and stamp duties. As per Enterprise Income Tax Law of the PRC and the Regulation on the Implementation of the Enterprise Income Tax Law of the PRC, 25% income tax applies to the PRC-resident corporate legal person on its worldwide income. For non-PRC resident corporate legal person that have no office or premises established in China or the income derived or accrued in China has no de facto relationship with such office or premises, the reduced income tax rate 10% applied. Where the sellers are natural person, the income tax rate is 20% on their income deriving from transfer of property. 5/10000 of the purchase price shall be paid as stamp duty for all parties signing share transfer agreements in China or outside of China if such agreements are to be used in China. For transferors of securities transactions, the rate of stamp duty is 1‰.

Sellers mostly have concerns over the buyer’s funding ability where the purchasing entity is a special purpose vehicle. Generally, there are three approaches taken by sellers to ease their concerns. The arrangement of escrow account is most frequently chosen. If the time span between signing and closing is short, sellers may require 100% purchase price to be secured in the escrow account before submitting AMR filing to reflect the change of shareholders, as the completion of AMR filing is a customary closing milestone in our jurisdiction. For a longer transition period, sellers may require buyers to put a small portion of purchase price in the escrow account at signing to secure the transaction first and ask buyers to wire the rest of purchase price before AMR filing. Besides, sellers may require equity commitment letters or parental guarantee from buyers at signing to ensure funding capacity. Banks providing M&A loans to the buyer may be required to issue debt commitment letters at signing by the same logic. Finally, the transaction documents usually include sufficient fund representations and funding proof from the buyers’ parent company may also be demanded.

The locked box pricing mechanism is relatively less prevalent though compared with completion accounts pricing mechanism, it is still quite common for parties to choose such price adjustment mechanism in our jurisdiction, mostly in a pro-seller transactions and transactions seeking certainty, such as bidding transactions. When applying the locked box pricing mechanism, the parties fix the equity value of the target company at signing based on the balance sheet of the target company as of the locked box date. After the locked box date, the buyer shall bear the risk of the value shrinkage of the target company during the interim period unless such shrinkage is caused by the seller’s leakage (e.g., transfer of property at a markdown price to the seller’s related party). Unlike the locked box pricing mechanism, the parties under the completion account pricing mechanism set an estimated purchase price at signing and adjust such price at or after closing based on the balance sheet of the target company as of the closing date. Apparently, buyers rely on a stricter and more prudent financial due diligence before signing under the locked box pricing mechanism. Also, the parties shall not choose the locked box mechanisms if the target company is likely to experience a radical swing on business operation and financial state, for instance, a restructuring after the locked box date is under consideration. The buyer is also unlikely to accept the locked box mechanism if the target company owns a continuing losing business as losses occurred after the locked box date shall all be borne by the buyer, increasing its overall costs.

In the acquisition agreement, methods taken by the parties are usually tailored to different varieties of risks.

For the risks relating to the target’s historical operation, representations and warranties and disclosure schedule usually come in handy to resolve the information asymmetry between the parties. Buyers and sellers may bargain on materiality and knowledge qualifiers, supplemental disclosure, sandbagging, survival period, special indemnities and other customary limitations on indemnity with respect to the representations and warranties, attempting to shift risks to each other. Parties normally spend a lot of time on negotiating the representations and warranties as it is often the first part of the agreement to be negotiated and often sets the ‘tone’ for the negotiation of the entire acquisition agreement. To address the target’s operation risks for interim period between signing and closing, parties may heavily negotiate on the scope of the interim operating covenants to mitigate the risk, especially for the transaction that is subject to a fairly long interim period due to restructuring or governmental approvals, etc. Similarly, post-closing covenants assist to tackle post-closing operation risks. Plus, with respect to trade sellers, buyers may apply earn-out payment scheme to align interest with sellers and also transfer part of the post-closing operation risks to them as the deferred payment will only be made if the performance targets are met.

For the risks associated with deal certainty, sellers usually try to fight for a short list of closing conditions to safeguard deal certainty, by arguing whether an action item, such as IP transfer, should be a closing condition or post-closing covenant, and sometimes also request buyers to pay reverse termination fee to mitigate any government supervision risks such as anti-monopoly examination in China. On the contrary, buyers often ask sellers to abide by a no-shop or no-talk provision, which restricts sellers from negotiating with any other bidders during a certain period of time, and will also seek termination fee in the event sellers breach the contract and refuse to sell.

For the risks in connection with purchase price, parties may negotiate on the purchase price adjustment mechanism, in which buyers usually prefer the completion account approach whereas the sellers prefer the locked box mechanism (see more details in Question 5).

Risk allocation is always the key topic in each type of M&A transactions. Beyond the acquisition agreement, parties also have many other ‘routes’ to mitigate the deal risks such as a thorough financial and legal due diligence, a deep-dive investigation and W&I insurance, etc.

The W&I insurance is still relatively nascent in China; however, China’s W&I insurance market has become active in the past 3-4 years. There has been not only a big uptick of inbound and outbound transactions, but also domestic activities in China.

Most of the players in China’s M&A market, who have baked the product into the process, are private equities and MNCs as they are more familiar with W&I insurance and have incorporated the usage of W&I insurance into their transactions. Recent years have witnessed a significant rising amount of Chinese SOEs/POEs considering using W&I insurance in both domestic and cross-border transactions. This is heavily promoted due to the wider understanding and usage by parties and especially lawyers. The clients who discuss the product at the start of a process are commonly from the industries of real estate & infrastructure, consumer, manufacturing, renewables, and mining.

The factors contributing to the increase of W&I market in China include (a) greater awareness of the product; (b) more PE or Chinese SOE sellers; (c) more buy-outs with founders remaining in the business which means buyers are reluctant to sue key employees for breach of warranties; and (d) more sellers pursue a clean exit and more buyers do not see value in suing for the breach of warranty. Also, the sale processes in China are increasingly aligning with international standards thus there are more auction processes which lead themselves to sell-buy W&I flips.

Financial sponsors have become increasingly active in investing in or acquiring publicly listed companies in recent years, although the trend slowed down in 2022 due to COVID-19 situation and lockdowns in China. Minority investments by financial sponsors in Chinese companies listed in domestic or overseas stock markets have been common. While buy-out or take private transactions are traditionally not very prevalent for Chinese companies listed in domestic stock market, financial sponsors have been active participants in buyer consortiums in buy-out and take private deals in respect of Chinese companies listed in the U.S., Hong Kong, or other overseas stock markets. They typically team up with the founders or the controlling shareholders of the publicly listed companies to form the buyer consortiums.

The Law of the People’s Republic of China on Foreign Investment provides national treatment to foreign investors unless the investment is made in any industry on the negative list. In general, foreign investment controls no longer apply to foreign financial sponsors if the investment is not made in an industry on the negative list. Nevertheless, foreign investors still need to go through national security review if the contemplated investments might have impact on the national welfare, such as military industry and important aspects of agriculture. Further, China has its foreign exchange control regime so the inflow or outflow of funds from or to foreign investors under capital account is subject to clearance by the government.

If anti-trust review is triggered in buy-out transactions, normally financial sponsors would require the merger clearance as a condition precedent to closing. As the cases where deals were blocked or remedies were imposed by the Chinese anti-trust authorities are still a small percentage out of all the merger filings made with the Chinese anti-trust authorities, break-up fees or reverse termination fees are used only when the parties deem anti-trust risk as significantly high.

Notably, under the Chinese merger filing rules, minority investments by multiple financial sponsors in the same target might constitute joint control of the target by such financial sponsors if these financial sponsors have significant veto rights on operational matters of the target. As such, when making minority investments in a target, some financial sponsors would intentionally avoid having veto rights at the board or shareholder level if such veto rights would trigger the need to obtain merger clearance.

1. The number of minority investments undertaken by financial sponsors in 2022 declined due to the uncertainty of exit via overseas IPOs and the general impact of COVID-19 and lockdowns in China. Most minority investments are structured as equity investments with minority protections. Some minority investments are structured as convertible note or other debt-like instruments with rights to participate in the equity upside.
2. Continuation funds and GP-led S transactions have become more active since 2020, as the first batch of RMB funds have gradually approached the end of their terms and there is a conflict between GP’s desire to extend the term and LP’s desire to seek exit.

The answer may differ depending on the structure of the company. For companies incorporated in China, their registered capital cannot be ‘reserved’ under incentive plans like what the offshore companies typically do. As such, management incentive pool is typically structured as one or multiple limited liability partnerships which own the equity interests issued by the company. Typically, a founder of the company would act as the general partner vested with full voting rights on behalf of the partnerships, and all the other participants would act as the limited partners without voting power. By doing so, the founder can control the voting rights and the participants will enjoy the economic benefits of the incentive equity.

For Chinese companies that adopt an offshore holding structure (e.g., having their group holding companies incorporated in the Cayman Islands), the management incentives are typically reserved by the offshore group holding company for future grants to the employees. Due to the hurdles of the Chinese foreign exchange control regime, prior to the company’s initial public offering in an overseas stock exchange, the Chinese employees cannot freely exercise the stock options or awards granted to them under the incentive schemes even though they have been fully vested. Trust structure is frequently used to enable the senior management in such Chinese companies to exercise their stock options when the company gets close to its initial public offering.

Under the Chinese tax rules, the exercise of incentive equity will be treated as a taxable event and the difference between fair value of the incentive equity and the exercise price will be taxed as salary income of employees (i.e., at a progressive tax rate ranging from 3% to 45%), under which circumstances the company is obligated to withhold and pay the corresponding individual income taxes on behalf of the employees. It is therefore advisable to build in the withholding feature in the incentive schemes adopted by the Chinese companies. When employees transfer their incentive equity after exercise, their gain will be taxed as capital gain at a rate of 20%.

Senior managers are typically subject to non-competes. In most cases, non-compete obligations will last throughout the senior managers’ entire employment with the company and two (2) years following the termination of such employment. Employers need to pay severance to the employees for their observance of the non-compete obligations. It is noteworthy that the Chinese laws will not support post-employment non-competes for a period longer than two (2) years.

The sponsor corporate governance rights are typically provided in the shareholders agreement, which stipulates the sponsor’s entitlement to board seats, right to appoint/remove senior management, and right to decide or veto certain material matters. A sponsor could also by board or shareholder resolutions introduce (i) the setup of corporate departments, (ii) delegation of powers to the relevant management; and (iii) a set of corporate policies regarding the regulation of the governance of the portfolio company.

The sponsor can introduce a management incentive plan under which the management’s satisfactory performance is made a condition to their right to receive the incentives. Failure to carry out shareholder or board decisions, or violation of corporate policies and procedures by management may lead to forfeiture of or delay of granting incentives.

It is common for a Chinese company to use a management pooling vehicle, typically in the form of a limited liability partnership, to hold shares in the company that are reserved for management incentive purposes. The GP of such pooling vehicle is usually an individual that the financial sponsor trusts (either nominee of the sponsor, or a key management member of the portfolio company). One or more partners in the pooling vehicle would initially hold the entire interest in the vehicle as a nominee on behalf of the future grantees of equity incentives. Management would be granted with options or restricted “shares” on top of the pooling vehicle. Once a management member exercises its options into, or is granted with, interests in the pooling vehicle, the nominee partner would transfer the corresponding interests in the pooling vehicle to such grantee.

In PRC, private equity transactions (particularly small and medium ones) are predominantly funded by equity, while certain large transactions involve debt financing from banks. Such debts financings are normally structured as bilateral loan with a single bank or syndicated loans with several banks.

Financial assistance is not a legal term provided for under PRC laws, there are no conventional restrictive rules as to financial assistance. However, in the context of investment in listed companies, the board of directors of a target listed company are prohibited from providing financial assistance from the company’s resources to the buyer for the purchase of the shares of the listed company, and similarly, the target listed company needs to disclose information on whether its supervisors and senior management team provide financial assistance to the investor/buyer.

Banks normally use their respective standard forms or their own precedent documentation as a start point, and facility agreements based on APLMA template are also widely accepted in the PRC market. Normally, negotiations are material around deal specific requirements, among which, certain substantial discussions may be around the bank’s specific focus/requirements.

Negotiation has been most significant around security structure. Provisions such as prepayment, financial covenants, information undertaking, events of default are normally negotiated more heavily than others.

It is not usual in the PRC market to use private equity credit funds as sources of debt capital.