Asia Monitor: What’s VIE-able?

An offshore fund administrator recently remarked to PEI that, for the first time ever, the private equity industry was confronting an increasing number of simultaneous regulatory and policy changes globally. It used to be that countries more sportingly took turns in giving the industry a kicking.

That last statement is perhaps a bit unfair: post-Lehman Brothers, it’s mostly been Europe and the US wading in. Relatively unregulated and misunderstood in those markets for years, private equity firms ended up bruised and battered by politicians and policymakers keen to (over)regulate the whole of the financial services industry to prevent future crises and stem public outrage (besides pandering to shrill media headlines).

The story has until now been different in China, where the government has been moving rapidly to create policies for its swiftly growing private equity industry. Market sources say the momentum has been less about reacting to the global financial crisis, as recent regulations have been in the West, and more about proactively putting best practice principles in place that bring it in line with developed markets. 

For example, earlier this year, China’s National Development and Reform Commission outlined plans requiring firms managing more than RMB500 million ($79 million; €59 million) to register with it. It also put fundraising marketing restrictions in place similar to the US Securities and Exchange Commission’s ‘Regulation D’. The moves caused only moderate reaction from fund managers, many of whom were presumably already used to complying with such measures in other jurisdictions.

But what GuoShuqing, chairman of the China Securities Regulatory Commission, recently confirmed his agency was looking into now has industry players and entrepreneurs much more concerned (and bracing for a bruising). Indeed, the top read story in the past month on affiliate news site was one that noted the securities regulator was pressing central authorities to review variable investment entity (VIE) structures, which are frequently used by foreign investors to back Chinese companies.

VIEs are used to work around Chinese regulations which bar foreign investors from owning domestic assets in sensitive sectors including telecoms, internet, media and mining – all particularly hot sectors for private investment. Typically employed for overseas listings, VIEs use a series of commercial agreements through an offshore holding company to allow foreign investors to invest or take control of Chinese companies without owning the business outright. Roughly 42 percent of US-listed Chinese companies use the structures, Peking University researchers have found, with high-profile examples including search engine giant Baidu and online marketplace Alibaba.

The expectation is that sometime next year, the VIE structure would no longer be permitted for Chinese companies listing abroad or might be regulated so as to require approval of foreign investment. Some market participants feel the purpose behind the potential policy change is really about encouraging more Chinese companies to list onshore, as some of the requirements for an A-share listing would likely be loosened at the same time – and may be the Chinese regulator’s response to the fraud allegations that have plagued many US-listed Chinese companies – rather than an attempt to further restrict foreign investment. 

Still, it presents an interesting challenge to venture and private equity funds keen to invest in Chinese companies in those aforementioned hot sectors. Some entrepreneurs and companies plan to raise capital quickly before any new policy is implemented – which could trigger a flurry of activity in coming months – but not all fund managers may be willing to risk investing in US-listed companies with VIE structures until the government’s policy becomes clear.

Some GPs may instead move to make more investments via renminbi-denominated funds, which notably enjoy deal execution advantages in terms of approvals needed to transact and sectors in which they are permitted to invest.

What the best option will be to continue to back China’s most promising companies will be hard to know until the country’s regulator puts an official policy in place. But it’s clear that the smartest fund managers will be working hard to find viable alternatives that prevent any regulatory action from bruising their potential returns.