China: Regulatory roadblocks

 In recent years China has increased its openness to foreign investment and indeed private equity, making it easier for alternative asset managers to access domestic opportunities. But it hasn’t always reduced the red tape when it comes to related rules and procedures.

The same can be said for its latest draft rules on foreign investment, which were released in January by China’s Ministry of Commerce (MOFCOM) and could have a significant impact on the private equity industry.

The proposals address three key areas: foreign investment approvals, national security with regards to foreign investment and variable interest entity (VIE) structures.

What seems a win for private equity would be a change allowing foreigners to be considered as domestic investors when investing in an industry that doesn’t appear on the country’s negative list (the list of industries not liberalised for foreign investment). This would benefit sectors such as manufacturing, dairy, or retail and consumer.

Currently, any foreign investor wishing to make an investment in China, even in liberalised sectors, must apply for MOFCOM approval, which can make domestic investors more competitive than foreign private equity players, Marcia Ellis, a partner at Morrison Foerster, explains.

Ellis notes that the new rules “will make it an even more playing field for foreign funds. The approval periods are not really that long, but you would be surprised at how many deals [are won by domestic firms because] a founder can be swayed by the fact that it is going to take longer for a foreign investor” to be approved.

While this is positive for foreign firms, on closer inspection China has also proposed broadening the scope of investments that could be deemed sensitive for national security, which would then require MOFCOM approval.

Since 2011, foreign acquisitions in specified industries can be subjected to review for national security concerns.

Under the new draft rules, a national security review can be triggered by any form of investment in any industry, with the list of security concerns expanded.

“When you’re doing a larger investment in anything that could even possibly verge on sensitive, you’re going to have to effectively do an approval process or at least go to MOFCOM for a pre-discussion about a potential NSR [National Security Review] application,” Ellis says. “In that way it is not helpful.”

Further confusion arises when considering the PRC’s take on the controversial VIE structure, a structure designed to allow foreign investment in China’s technology sector, which is protected.

The draft law acknowledges the legal status of VIE structures, used by a vast number of private equity firms and Chinese portfolio companies such as Alibaba Group, Tencent and Sina. However, MOFCOM has said that whether an investor using a VIE structure will be considered as domestic depends on who ultimately controls the business. Therefore a foreign private equity fund could be considered a domestic investor and forego the approval process as long as they give up ‘definitive influence’ on the company, which could be risky for funds depending on the exact definition of the term, lawyers believe.

“Definitive influence seems to include the minority protections included in just about every deal a private equity fund doing a minority investment would want to negotiate,” one Hong Kong-based source explains. “This would make the significance of this change much less than otherwise.”

Ellis adds that the power at the portfolio company would be further concentrated into the hands of the Chinese entrepreneurs if this is the case. “For foreign funds who are thinking about investing in [VIE] structures, it does give a lot more leverage to the founder because he would always have to be in control.”