New foreign-ownership rules in China could make life more complicated for foreign private equity investors, a lawyer has warned.
Beijing laid out plans last month under its draft foreign investment law to formally recognise so-called variable investment entities (VIEs). These are structures that offshore investors use to circumvent investment restrictions on sensitive industries that are in theory off-limits to foreigners, such as technology and telecommunications.
Internet giants such as Alibaba or Tencent have used these structures to tap funds offshore by setting up two entities – one based onshore in mainland China and another offshore, such as in Hong Kong or New York. The onshore group signs service contracts that transfer some control and revenue to the offshore holding group, which foreign investors can buy into without directly owning the group.
However, the use of such structures has often left foreign investors in limbo regarding their legal status.
On the surface, formal recognition of VIEs would be a welcome change for overseas players, but will also mean they will have to face foreign-ownership restrictions like any other investor.
“VIE exists in a grey area which gives some flexibility and leeway for foreign investors in restricted areas,” said Kit Kwok, Shanghai-based partner for DLA Piper.
While the new regulations take VIE out of the legal grey area, he noted, they create new difficulties by making it hard for foreigners to control the firm they are investing in.
The draft rules also deal with the concept of ultimate control, and not just majority shareholding. For example, due to its dual-class share structure, e-commerce giant Alibaba is controlled by founder Jack Ma even though he only owns a minority of overall equity. Even if a foreign investor bought a majority of Alibaba shares in New York, the new investment law would still regard Ma, a Chinese national, as ultimately in control.
But if private mainland companies seek to offload businesses to foreign private equity firms, the two parties may find it difficult to operate under the new rules.
“As some founders have complained, the new rules mean they can never sell down [to a foreign investor],” Kwok said. "That might ultimately affect the potential exit of the company, if it turns out that you are looking to exit through a trade sale instead of an IPO."
“From an investors’ perspective, you go into investment looking for an exit. But if it’s never going to happen completely, then it potentially reduces the value of your investment,” he said.
The new law also imposes a national security review (NSR) on foreign investors in China, which could be a worry for offshore PE funds looking to tap the market.
First established in 2011, the review has been used in recent years only on an ad hoc basis, but now, with its incorporation into the proposed foreign investment law, it will be given formal status.
The NSR is modelled on the US Cfius (Committee on Foreign Investment in the United States), which reviews the national security implications of foreign investments in American firms. The Chinese version adds another layer of approval designed to screen foreigners investing in sensitive industries.
One worry for investors is the potential for arbitrary application of the review by authorities, said Kwok, noting that past investments deemed “sensitive” to national security included shopping mall developments in tier-one and tier-two cities.
“Everybody feels it potentially writes a blank cheque for authorities for when they can step in,” he said. “It opens up the possibility that Beijing authorities can declare national security at any time to stop a deal it if they feel it is not in their national interest.”