Recent PRC regulatory measures designed to curb investment inflows from offshore may have discouraged some bigger private equity deals, but private equity lawyers say investors continue to find China attractive - as they return to the old days of direct onshore investment

Back in September 2006, several PRC regulatory agencies jointly issued M&A rules which have amounted to a near prohibition on the method customarily used for offshore PE investment into China. This "round trip" method involves the creation of an offshore holding company in a jurisdiction such as the Cayman Islands in which both foreign PE investors and Chinese owners would hold interests.

The M&A rules were followed in May 2007 by Implementation Notice 106 from the State Administration of Foreign Exchange (SAFE) which described extensive new requirements to be met for the registration of such transactions.

The more restrictive approach seems to have stalled some PE deals. Majority acquisitions are rare these days, but it's not having a major effect on the quantity of work for PE-related law practices.

Conyers Dill & Pearman works on the offshore side of PE deals, assisting with the setup and organization of offshore holding companies.

"I think the number of transactions has come down a bit, and a lot of that is due to the need for SAFE approvals," says Christopher Bickley, partner with the firm's Hong Kong office. 

"From what I've heard on the grapevine it's very difficult to get approval. Perhaps over the last 3 or 4 months we've seen a bit of a slowdown."

Even so, he says work flow in 2007 was "very strong".

Lawyers who are focused more on the PRC legal issues share a similar view.

"There has been slightly less deal flow," says Basil Hwang from Dechert / Hwang & Co. "Investors have become more cautious partly as a result of the credit crisis in the US and Europe,  but we're very busy nonetheless."

Hwang says there is still a lot of investment in "follow-on rounds" of companies that were restructured before the extra regulatory hurdles came in.

Jeanette Chan, partner and head of the China Practice Group with Paul Weiss, likewise observes that those companies that completed their offshore restructuring before the regulations were introduced are very attractive, and provide ongoing work.

"There are still a lot of those companies around so they are very valuable as investment targets," says Chan. "But you find more and more PE firms actually have come around to the idea of having to make a direct investment into China, and basically localizing their investments."

Back to the future: direct investment
Major law firms are reminding their clients via their legal bulletins that in the early days of foreign investment into China, multinational companies invested via onshore joint ventures with local Chinese partners using cooperative joint venture structures or equity joint venture structures.

"A lot of those structures are now being revisited by a new audience - the PE community," says Thomas M. Britt III, partner with Debevoise & Plimpton in Hong Kong. "They are looking at some of those structures as a means by which an investment can be made into China without having to go through the processes of registration with SAFE or approval of MOFCOM."

When it comes to making the return to onshore structures work for clients, Britt says one of the key issues for a PE firm considering using a traditional FDI structure is ensuring some of the same protections they had become accustomed to under offshore companies.

Examples of such protections are minority shareholder rights and liquidation preferences -- i.e. who gets their money first if the company is dissolved.

"People are utilizing some of these structures and getting themselves comfortable that there is a sufficient level of protection on these issues within the current joint venture regime in China. There was a bit of a holdup in the months immediately following the adoption of the new rules as people figured out how to navigate within the new regime, but I think 18 months after the fact, people have become a bit more comfortable."

Basil Hwang of Dechert / Hwang & Co. observes there has been a lot of talk about the setting up of local renminbi PE funds but this has yet to take off in a major way.

One structure he has been working with but which is less commonly adopted for non-technology or media companies is the CCF - China-China-Foreign - structure already familiar in the Chinese internet sector.

"It has been adopted by companies like Sina, Sohu and Shanda since about 1999-2000, and more recently has been used by a number of companies in traditional industries as well. There's a very long precedent for this kind of structure with internet companies. Those investors that have been in the technology space for a long time tend to be a bit more comfortable with it," says Hwang.

Although this approach gives effective foreign control over Chinese companies, Hwang believes that lack of action by Chinese regulators against internet companies, despite high profile listings over the last 8 years, means investor nervousness about this structure post-M&A rules could subside with time.

"There is always a risk that the Chinese authorities could clamp down on this structure, but by now probably too much water has gone under the bridge for the Government to want to take action. It would just cause too much disruption to companies already listed overseas and their investors."
 
Jeanette Chan of Paul Weiss believes the PRC Government continues to be engaged in a big push to encourage foreign direct investment.

"Once China's stock exchanges and public market become more mature, you'll see that foreign investors won't even think about using offshore structures anyway," she says.

She cites her firm's work on last year's minority stake acquisition by PE giant Kohlberg Kravis Roberts (KKR) of Chinese cement producer Tianrui as an example of onshore deals that will now be more common.

Top PRC law firms are also increasingly competing with international firms on the same PE turf.

"[In the past] international firms would typically be responsible for the documentation of the transaction and the role of Chinese counsel was just to help with regulatory issues and due diligence," says Richard Guo, partner with PRC law firm Fangda Partners in Beijing.

"Nowadays more and more PRC firms are capable of doing documentation to international standards," he says. "With more PE deals moving onshore, PRC practitioners who understand both international norms and local practice and regulatory regimes are getting the momentum."

As for whether more regulatory changes are on the way, nobody really knows.

According to Guo, in 2008 MOFCOM might open the door to approvals of offshore "round trip" investments - "but it's just a rumour, it could go the other way."

So while the policy landscape is a shifting one, the enormous opportunities continue to attract.