Doing Deals in Asia - Pacific

Transcription

1 Doing Deals in Asia - Pacific By Richard Andersen, C.E.O., ShareVault Based on a webinar given by: Charles Comey, Partner, Morrison & Foerster & Co-chair of the China Private Equity Group

2 Introduction In recent years the economies of the Asia Pacific region have begun to soar and with that robust growth has come a significant increase in M&A transactions. Laws and regulations affecting foreign investment in the area are being transformed and entry barriers are falling. Coupled with this slackening regulatory landscape is the broadening range of exit strategies available to investors who are seeking opportunities in the area. But with this increased opportunity comes increased risk. In this type of climate it becomes increasingly important to not only be aware of the new rules that are governing cross-border transactions, but also to be certain that the due diligence process is informed, organized, comprehensive and secure. Along with the growth in number of transactions taking place in Asia Pacific comes a broader range of deals, including fundraising and IPOs, as well as Mergers and Acquisitions. Deal size is increasing as is the range of industries involved. This burgeoning economy obviously creates a wealth of opportunity. However, whatever the deal type, it s important to keep in mind that the regulatory landscape of the Asia Pacific region, and the approvals that must be obtained in order to close a transaction, have a significant impact on not only the structure of the deal, but also its timing. This white paper will explore both the opportunities and the challenges of doing deals in Asia Pacific. Although we ll focus primarily on China, many of the issues faced there will be universal throughout the entire Asia Pacific region. The Cross-Border Due Diligence Challenge Cross-border deals, by their very nature, require a greater depth and breadth of due diligence. They usually involve more documents which will often be in multiple languages. The teams reviewing these documents will most likely be global, potentially extending diligence timelines. This global climate also poses additional challenges to sharing information securely. These challenges aren t unique to cross-border transactions, however, China s very specific commercial, regulatory and cultural environment adds an extra layer of complexity at each stage of the deal process. You may find when pursuing an Asian-based target that it s the first time they re encountering western-style due diligence and that their definition of basic financial information differs significantly from yours. It s not uncommon during the diligence process to discover both missing and misleading information. Many Chinese companies lack adequate internal controls and often conduct business using insufficient or flawed data. When records are kept, the basis for how things are documented is often not standardized and can vary considerably. It s not uncommon at all for Chinese companies to maintain several sets of books one for the tax bureau, one 1

3 for internal use and perhaps a third to show the bank. Sometimes records of sales are intentionally not documented in order to avoid taxes. Yet another hurdle that is often encountered when doing deals in China is reaching a consensus on what the deal is worth. Sellers in China often have an inflated sense of what their assets are worth and in the absence of good financial data it can be challenging to arrive at a price that is acceptable to both parties. Often Chinese businesses have fairly lax attitudes about complying with regulatory requirements and this can sometimes translate into hidden liabilities. When dealing with regulatory officials you will sometimes get different answers depending on who you re dealing with, so identifying regulatory issues early and using a local advisor is recommended. Even for firms with years of experience in doing deals overseas, China presents many unique M&A challenges. Because of these challenges there s a greater need for comprehensive due diligence, early planning, good organization, and ongoing communication with investors, auditors and offshore partners. Understanding Regulatory Approvals When entering into a conversation with a counterparty and their advisors in China, it s important early on to get a thorough understanding of the regulatory approvals that are going to be required to move the deal forward. In China you will most likely need to obtain approvals from the ministry of commerce, but there can also be other separate ministry approvals required based on the industry sector of the target or the investee company. Having those regulatory approval milestones mapped out in advance will have a significant impact on how the deal is structured and the timeline in which it takes place. Tax Efficiency As you shape your transaction structure it s important to pay attention to the tax efficiency of the deal. In China, the State Administration for Taxation has taken an increasingly proactive and aggressive role in examining offshore holding structures that are often used when investing or making acquisitions in China. So, understanding the taxation equation becomes critical. It s also important to keep in mind that Chinese companies, as a result of sometimes exhibiting lax attitudes to regulatory compliance, can sometimes accumulate significant tax liabilities. And so it becomes extremely important that the due diligence process not only evaluates the tax efficiency of the deal, but also identifies any hidden back taxes or penalty liabilities. These types of issues can be important factors in negotiating price, but only if they re exposed early on. 2

4 Where s The Value? When entering into a strategic alliance it s important to focus on the key ancillary arrangements associated with the company, because they significantly impact the value of the deal. These arrangements can factor both as liabilities, and thus as a reduction to the purchase price, or as assets that add value. For example, if there are supply or other ongoing contractual commitments associated with the deal that pose a liability, these liabilities can become important factors in negotiating value. On the other hand, with respect to IP issues that add value, it s important that these are secured from the seller as you move forward. These can include not only key patents, but also the key technical employees that are associated with the business. There may also be other arrangements such as co-development alliances or other continuing obligations that should be documented in the deal to ensure that appropriate value is delivered at closing. The Role Of The Virtual Data Room In China, transactions with any kind of scale will typically have multiple entities involved and that usually translates into a greater volume of documents. This is due both to China s dynamic regulatory requirements and its unique local licensing requirements. Adding to this challenge is the fact that the documents associated with a deal will almost certainly be in more than one language and will often reside in multiple locations. Now, factor in that the current administration and senior enforcement officials with the U.S. Department of Justice have made it very clear that the Foreign Corrupt Practices Act (FCPA) is at the center of their radar and any Chinabased business is going to attract increased scrutiny and it becomes more important than ever that the due diligence process is comprehensive, organized and traceable. The best way to address the regulatory risks and attendant liabilities associated with cross-border deals is to use a virtual data room as a repository for due diligence documents. Using a virtual data room is a powerful tool not only for organizing due diligence materials, but for identifying and flagging, early on, any regulatory or other approval issues that need to be addressed. In addition, some virtual data rooms provide tracking and reporting features that can provide the traceability or audit trail that is required. Even in the best case scenario a well-prepared local management team will only provide you with part of the story. To do comprehensive due diligence in China it s imperative to see all of the relevant documents associated with the deal and be able to share those documents in a secure way with all interested parties so that they can understand the often complex relationships between the company and its suppliers and customers, as well as any ancillary arrangements that may be in place. The most effective tool for this kind of due diligence is a centralized virtual data room, and specifically one that can accommodate documents in any language. Today s leading virtual data rooms enable you to share documents in a secure, customizable and fully-searchable environment on a 24/7/365 basis with anyone, anywhere. This not only minimizes the time it takes to complete the diligence process, but also ensures that the process is as comprehensive as is possible. 3

5 Understanding Investment Structures In China Starting in 2006, there was an increase in M&A regulatory rules in the People s Republic of China which laid the groundwork for much of the economic growth we re seeing today. New rules concerning foreign investment partnerships broke down many previously existing entry barriers making China not only an easier place to invest, but also a much more attractive place to invest. Since then the government has also been actively diversifying and privatizing the ownership of many state-owned enterprises (SOEs) giving foreign investors a wide selection of investment opportunities. There are basically three ways to structure investments in China: Offshore Holding Structure Offshore to Onshore Variable Interest Entity Structure (VIE) Offshore Holding Structure If you have the ability, structuring offshore is an attractive option. Structuring offshore allows for preferred stock and the pre-ipo rights that investors often seek. Other benefits include valuation adjustment mechanisms, anti-dilution, invertible debt, the flexibility to list on U.S., Hong Kong, or other markets, and a clearer path to exit in terms of lockup requirements. Structuring offshore also provides the flexibility to do a major transaction without the need for implicating onshore PRC regulatory approvals, which will generally extend transaction timelines. This is clearer than the other approach. Offshore to Onshore The Offshore to Onshore scenario might consist of an equity joint venture where both foreign and domestic shareholders are involved. That entity might then be willing to pursue the possibility of an A-share listing. In this case that joint venture would be restructured prior to the IPO into something called a Foreign Invested Company and would be limited by shares. Being designated as a Foreign Invested Company requires additional approvals, but once achieved that company would have the ability to pursue and A-share IPO either in Shenzhen through the new ChiNext exchange or possibly on the Shanghai Exchange. Variable Interest Entity Structure (VIE) The third way to invest in China is via a Variable Interest Entity structure. In this scenario you basically have a captive domestic affiliate, which exists primarily for regulatory reasons and is usually for the purpose of limiting foreign ownership. This entity obtains the key licenses it needs, whether they re telecom related or otherwise. The entity is owned by friendly Chinese holders and then through a series of contractual relationships revenue is moved over to a wholly-owned foreign enterprise subsidiary. This structure allows for consolidated financial accounting while at the same time complying with PRC foreign ownership restrictions. 4

6 RMB Funds The domestic investor environment is still developing in China and will be for some time. Local investors are still learning about the proposition of other people managing their money. But the government is leading the way and the climate is changing. One of the reasons there s been so much activity recently in the local fund area is that the Chinese government is actively promoting the development of not only domestic stock exchanges like the newly-formed ChiNext Exchange but, in order to fuel innovation, they also see the need to promote a vibrant and viable domestic venture capital industry. Obviously, it makes the most sense that the vehicles for this industry be onshore. So, larger funds are being created in China that are wholly domestic. These are the vehicles that serve as the channels for investments to be made into domestic companies, which can then be listed on the A-share market. In 2009, the Chinese central government, as well as several municipal authorities, enacted a number of rules and regulations, which facilitated the formation, and operation of RMB funds. RMB funds are investment funds whose capital commitments and contributions are denominated in Renminbi (RMB), the official Chinese currency. Since 2009, the RMB fund has become the fund platform of choice for China's private equity market. The advantage of RMB funds is that they provide the ability to raise funds from Chinese local investors, onshore companies, government fund of funds, insurance companies and social security funds, and for the possibility of making investments without foreign exchange controls or foreign investment approval requirements. The benefits of RMB Funds: RMB funds are expected to continue to appreciate. Through the RMB currency it is now possible, subject to tax bureau approval, to get flow-through tax treatment for the onshore vehicle. Government approval process is more streamlined. There are tax benefits that apply depending on the nature of the business you re in. For example, there s a tax deduction equal to 70% of investment in non-listed small/medium high-new technology companies held for 2 years. There are also local incentives. Local governments are increasingly partnering with foreign funds in order to offer an incentive for the funds to locate in their specific location. The A-share exit. Many Chinese founders still view the cache of a NASDAQ or New York listing as something desirable. Many of them are simply focused on the multiples and the differential that they perceive between the A-share market and foreign markets. 5

7 RMB Fund Caveats: Domestic LP ecosystem is improving, but remains at an early stage sophistication varies widely year fund life may be too long for PRC investor appetite. Safe 142 Restrictions continue to apply (prohibits conversion of foreign exchange into RMB for investment purposes.) PRC tax treatment of relevant funds flows; important uncertainties exist. Onshore Investment Caveats Going onshore in China has some unique challenges that are not always found in other jurisdictions, namely that there is significantly less financing flexibility. Shareholder rights, preferences, and privileges are difficult to structure into a domestic joint venture or LLC. In general, there is only a single class of equity, no preferred, and that tends to be more complicated. It s also difficult to structure ratchets and other value adjustment mechanisms that would be customary in an offshore holding. Puts, calls and options require approval at the time of exercise and it s unfeasible to pre-agree on price. Exits require further approval. (CSRC for IPO / listing). The effectiveness of onshore security varies by asset class and registration venue and can present additional challenges. Also, once you re onshore it s very difficult to get offshore. Or vice versa. So a decision about what is planned in terms of an IPO or an M&A exit is necessarily made during the initial structuring. The A-share IPO approval process is not one that s highly transparent for the onshore company at this point. There s still a lot of uncertainty in terms of timing and there s a lot of local lobbying that s involved. For these reasons using a local advisor is recommended. Foreign-Invested Partnerships (FIPs) Another significant development for the foreign investor looking at China are the new foreign-invested partnership rules that came into effect in March of These new measures allow foreign companies and individuals to directly establish foreign invested partnerships (FIPs) in China. This is a more flexible vehicle that offers an alternative legal structure that was previously available only to domestic individuals and entities. Traditionally, all forms of foreign investment in China have been subject to review and approval by the Ministry of Commerce (MOFCOM) and its local counterparts, and only upon approval by MOFCOM could an FIP be established and registered with the State Administration of Industry and Commerce (SAIC). However, under the new FIP Measures the establishment of an FIP does not require MOFCOM approval. Rather, the applicant can simply register the establishment of the FIP directly with SAIC, which then simply notifies MOFCOM of the registration. However, should 6

8 the FIP s business scope involve activities that require approval by specific government authorities, then the FIP must first obtain the relevant approvals before it can register with SAIC. The new FIP measures are significant for foreign Private Equity and Venture Capital funds, which traditionally have been organized as limited partnerships. Because the Chinese Partnership Law did not permit foreign investors to establish partnership enterprises, there was no structure for investing onshore funds in China. Now it s possible for a foreign investor to act as a general partner or limited partner of a limited partnership in China. The FIP Measures are certainly an important development in China s foreign investment regime, however, they are fledgling in nature and are still lacking in providing comprehensive guidance on the formation and operation of FIPs. There s still a need for local capital markets to continue to mature and more company law reform needs to be put in place before we ll see some of the more investor-friendly mechanisms and provisions that are present in other jurisdictions. It s therefore still somewhat unclear as to how the new FIP Measures will be interpreted and implemented by the government authorities at various levels and departments. However, the key takeaway in the pre IPO funding area with RMB funds and RMB investing is that they are here to stay. The growing number and size of these funds sends a message to the foreign investor that the fund holders are committed to the market and have confidence in its continued growth. ChiNext Developments An exciting new development in China is the launch of the ChiNext exchange. This is an exchange that the Chinese hope will develop in a way that the Hong Hong Growth Enterprise Market Board has not. This is an exchange that may be comparable to NASDAQ in terms of identifying new high-tech companies that are on the rise. This is a way to keep companies from listing overseas and thereby leaking value offshore. However, from an investor standpoint, it s important to understand some of the exit issues. You can expect at least a one-year lockup at the time of the IPO and if you re deemed to be a controlling shareholder, it s possible that the CSRC, which is the counterpart to the SEC in China, could seek a three-year lockup. Conclusion Cross-border deals in China, although not unlike cross-border deals elsewhere, do present unique challenges. Because of new and slackening regulatory requirements, opportunities for investors in China abound. However, with these increased opportunities comes increased risk. It s imperative when investing in China to stay current on applicable laws, regulations and requirements and to focus on good communication and flexibility. These rapid changes in the commercial and regulatory environment highlight an intensified need for good planning and comprehensive due diligence. 7

9 About the Author Richard Andersen Richard Andersen is founder and CEO of Pandesa Corporation, dba ShareVault, the innovation leader in virtual data rooms for due diligence and other secure document sharing applications. Richard is an experienced Silicon Valley software entrepreneur who has held management positions at ebay, MarketFirst Software, Ernst & Young Consulting and Apple Computer. Richard has been working in enterprise collaboration and messaging since leaving Apple in 1992 to lead a pioneering productivity software firm. He has an MBA from the University of California, Berkeley. Based on A ShareVault Webinar By Chuck Comey of Morrison & Foerster The content of this white paper was written based on a ShareVault webinar of the same title by Chuck Comey of Morrison & Foerster. Visit to view a recording of the webinar. Charles Comey is a corporate finance partner at Morrison & Foerster. His experience includes working in Asia for 16 years, where he served as Managing Partner of the firm's Shanghai office and also worked in Morrison & Foerster's Tokyo office where he specialized in cross-border mergers and acquisitions and strategic alliances. Currently, as co-chair of the China Private Equity Group, he now advises clients on venture capital, private equity, mergers and acquisitions and strategic alliances, as well as RMB fund formation and Cleantech matters. He has also counseled public companies on FCPA issues and internal investigations. Mr. Comey is recommended as a leading lawyer for China-based private equity and venture capital investments by IFLR 1000 and PLC Cross-border Which Lawyer? for his expertise in private equity in Asia and China. He reads and speaks Mandarin ShareVault. All rights reserved. ShareVault is a registered trademark of Pandesa Corporation 8