Chinese GPs take comfort from downside protection during regulatory overhaul

Managers are utilising mechanisms such as convertible debt instruments, put options and minimum returns to mitigate uncertainty over exits.

A greater number of Chinese private equity firms are incorporating downside protection mechanisms into their dealmaking processes in response to increased uncertainty over exits.

A series of regulatory actions last year, including a ban on private tutoring companies from raising capital and draft legislation requiring companies holding data on more than one million Chinese citizens to obtain approval for overseas listing, has made the private equity exit environment less predictable.

Sales to strategic buyers have also been impacted by foreign investment control concerns in the primary jurisdiction in which the target operates.

Maureen Ho Morrison & Foerster
Maureen Ho: exit mechanisms can lack teeth

“With these in context, in the deals that we came across, we have seen an increased number of PE investors, when making a new investment, taking the time to negotiate more rights to get the maximum flexibility in their future exits,” Maureen Ho, a Hong Kong-based partner at law firm Morrison & Foerster, told Private Equity International.

“That [can] include asking to invest in the form of [a] convertible debt instrument, asking for put options, minimum returns, exit demand rights and the ability to structure alternative exit strategies like transfer of economic interest associated with the equity in the portfolio.”

IPOs accounted for about 40 percent of Chinese private equity exits in 2020 and some 59 percent of exits in the first half of last year, according to PwC. About 9 percent of Chinese private equity-backed listings since January 2018 have been on US exchanges.

Downside protection mechanisms are common across Asia, particularly in minority transactions where the GP has less control over the means and timing of its exit. However, their execution can be fraught with challenges, as evidenced by an ongoing dispute in which a consortium comprising Affinity Equity PartnersIMM Private EquityBaring Private Equity Asia and Singapore’s GIC has been at loggerheads with the chairman of Kyobo Life Insurance over the price at which they can execute a put option.

A Korean court ruled in February that the investors and Deloitte Anjin accountants were not guilty of false reports and that a valuation report submitted in the course of the put option exercise was legitimate, contrary to the chairman’s claims. The group will seek further arbitration to exercise the put, according to a statement.

“As to how often [exit mechanisms] are actually used, the answer is not often, except that investors do exercise put rights when the portfolio business went very badly or they have come to the end of their permitted investment cycle and need to exit,” Ho said.

“One of the reasons… the lack of ‘teeth’ in using them – it is important to note that negotiating these rights and getting them into the investment documents is just the first step. But that isn’t enough: even if the PE investor exercises its put right and then a debt arises, founders may not settle the debt, if the investor’s claim is not backed up by security that, if enforced, would threaten the livelihood or at least the reputation of the founders.”

Protection in action

Downside protection isn’t a new concept in Chinese private equity. Hong Kong-headquartered Ascendent Capital Partners, for example, has built a reputation around the sophisticated use of such mechanisms across most of its investments. The firm was founded in 2011 by Leon Meng, who was previously the founder and chief executive of the DE Shaw Group’s Greater China private equity unit, and now has $2 billion of assets under management.

Leon Meng Ascendent
Leon Meng: best downside protection is a reasonable entry valuation

“When the world went through the financial crisis in 2008, I was running the China private equity practice at DE Shaw,” Meng told PEI. “The downside protection mechanisms we had structured and put in place proved to be extremely helpful. We invested over a billion dollars in China during that downcycle, generated good returns, and didn’t lose any money.”

Ascendent targets control and significant minority investments across the consumer, education, healthcare, advanced manufacturing and automation sectors across Greater China. The firm is currently deploying its $1 billion 2019-vintage Fund III.

“What we mean by downside protection is essentially when there’s an extremely adverse situation, then the investor would have the ability to pull out or to achieve a reasonable minimum return,” Meng said, noting that the firm shoots for typical private equity returns.

“We aim to structure a hybrid security that allows us to get strong downside protection without sacrificing upside. It’s not simply a redemption – it is about analysing the company’s cashflow and how to structure in priority in cash returns to the fund. Having one put in, for example, six years is fine, but a semi-annual mandatory coupon dividend is even better, and will allow you to recuperate or reduce your downside as you go.”

Though downside protection often carries negative connotations of a business in distress, its use can benefit all parties, Meng said, citing an example of a beverage packaging company previously in Ascendent’s portfolio that wanted to hold a domestic listing. Due to its investment horizon, the firm was reluctant to be locked up for several years post-IPO and instead exercised its put option at an 18 percent IRR. This enabled the fund to receive an attractive return and the business to pursue its own IPO timetable without pressure.

Appealing though they might be, downside mechanisms may not be suitable for every strategy. Venture capital, for example, typically invests in companies without the prerequisite cashflows. Likewise, buyout firms that acquire 100 percent of a business won’t have another party to sell their stake to via a put option or redemption rights.

“The number one thing in our mind when we’re underwriting is the entry valuation, because we believe the ultimate downside protection is actually the entry valuation,” Meng noted. “Even during very adverse situations or very down markets, a reasonable valuation protects you the best.”