M&A Strategies in China: Acquiring a Domestic Entity

Deal Structures

The Classic FIE Route

The traditional route is for Webb & Co. to jointly establish with Shanghai Fabrics a new foreign-invested enterprise (FIE) in Shanghai (which we can name Fabrics JV) in order to manufacture and sell fabric products. As a foreign-invested enterprise, Fabrics JV will be a non-share issuing limited liability company, structured in the form of either an equity or cooperative joint venture. Webb & Co. will typically contribute cash in consideration for its equity interest in Fabrics JV. Shanghai Fabrics contributes its operational assets, such as land use rights, machinery and equipment.

The advantages of the structure are threefold. First, since this type of deal structure is so familiar to the Chinese authorities, the approvals necessary for the setting up of Fabrics JV should be relatively easy to obtain. Second, as the deal is essentially an assets sale, Webb & Co. would not assume the liabilities of Shanghai Fabrics. Finally, Chinese tax policies favour FIEs. Unlike an arm's length assets sale, the contribution of assets by Webb & Co. to the Fabrics JV may be PRC tax-free (if the target business is an “encouraged” category of foreign investment). Once Fabrics JV starts operations, it should also enjoy preferential income tax, dividend and other investment policies.

The disadvantages of the FIE structure are, unfortunately, many. They can be summarized as follows:

• Both the establishment of Fabrics JV and any future changes in equity ownership require approvals from the Chinese authorities. Although these are not necessarily difficult to obtain, the procedures absorb management time and involve transaction costs.

• Where Shanghai Fabrics is a state-owned enterprise, the asset contributions that it makes to Fabrics JV (and any subsequent change in its equity interest) must be independently valued by a PRC qualified valuer and verified by the Chinese authorities.

• Webb & Co. has to contribute a large amount of cash in order to acquire the 70% interest in Fabrics JV (basically equal to more than twice the value of the operational assets contributed by Shanghai Fabrics).

• Chinese law requires that Shanghai Fabrics be granted certain minimum voting rights in Fabrics JV. These voting rights can prove significant. For example, it is mandatory under Chinese law that Shanghai Fabrics has a veto right at board level (the highest governing body of a foreign-invested enterprise) over management decisions such as changes to the amount of registered capital (i.e. paid-in equity), the permitted scope of business and any future reorganization or liquidation of the venture.

• As an assets deal, Fabrics JV is not entitled to automatic inheritance of the customer base or distribution network of Shanghai Fabrics.

• Webb & Co.'s exit options from Fabrics JV are also limited. Both legal and market obstacles make any future IPO in China an unlikely prospect. The alternatives are either a third party trade sale or liquidation, both of which require the consent of Shanghai Fabrics and the approval of the Chinese authorities.

The classic route of setting up a new FIE is still a common deal structure in China. Nevertheless, as we can see, the approval issues and the limited flexibility of a foreign-invested enterprise as a corporate vehicle for joint venture projects make this type of deal structure frustrating for many foreign investors.

Direct Acquisition of a Domestic Company

Given the drawbacks of the classic route for setting up a new FIE, foreign investors have inevitably looked for other ways to structure their deal. One such alternative is for Webb & Co. to directly acquire a 70% equity stake in the existing target company. This can be done either by Webb & Co. acquiring the 70% interest itself, or Webb & Co.'s subsidiary in China (if it has one) acquiring the 70% interest. Both options are considered below.

(1) Webb & Co.'s Direct Acquisition

In the first scenario, Webb & Co. acquires a direct 70% equity stake in Shanghai Fabrics from China Fabrics Corporation, the parent company of Shanghai Fabrics, and thereby converts the company into a foreign-invested enterprise. The acquisition of the 70% stake could be achieved by way of a transfer of part of the equity interest held by China Fabrics Corporation or by a subscription for an increase in the registered capital of Shanghai Fabrics by Webb & Co. (In practice, Shanghai Fabrics is likely to have multiple shareholders since Chinese law requires a limited liability domestic company to have at least two shareholders.)

The advantages of the structure are as follows:

• Since it is an equity deal, Webb & Co. automatically assumes control of the business of Shanghai Fabrics. It should be noted that this may be viewed as a disadvantage in some circumstances; for example, where Shanghai Fabrics is in deep debt or has potential undisclosed liabilities that are difficult to ascertain.

• In the case of an equity transfer, Webb & Co. can inject a smaller amount of cash in order to acquire its 70% stake (since the monies go directly to China Fabrics Corporation rather than Shanghai Fabrics).

• Once Shanghai Fabrics has been converted into a foreign-invested enterprise, it will enjoy the various tax and other investment incentives available under Chinese law.

The disadvantages of the structure are:

• Apart from a few scattered references to this type of deal structure in earlier legislation (which are vague in their ambit), there is no clear legal framework at the national level regarding the conversion of a pure domestic enterprise into a foreign-invested enterprise. Despite this fact, the approval authorities are sanctioning an increasing number of such deals, and local government law and policy is encouraging the trend. In such cases, the approval authorities appear to be approving the conversion of the domestic enterprise into a foreign-invested enterprise by reference to the general regulations governing the establishment of, and equity transfers involving, FIEs. There are also favourable signals from the central government. For example, legislation issued this year that governs foreign investment in newly opened sectors, such as securities and fund management companies, contemplates direct investment in domestic enterprises. Furthermore, draft M&A legislation circulated for comment by MOFTEC last year expressly contemplates the acquisition of an equity interest in a pure domestic enterprise, either by way of share transfer or share subscription, thereby converting the enterprise to a FIE.

• In practice, where China Fabrics Corporation is a state-owned enterprise, the Chinese authorities are likely to require an independent valuation of the existing assets of Shanghai Fabrics. The valuation will then serve as the basis for determining the amount of money to be paid by Webb & Co. in exchange for its 70% equity interest.

One additional twist possible with this type of deal structure is to convert the target business into a foreign-invested company limited by shares. A foreign-invested company limited by shares is a different type of corporate animal from a normal FIE, and bears a closer resemblance to the share-issuing corporations that are more familiar in Western jurisdictions. One of its principal attractions to a 70% shareholder is that it is generally possible for a shareholder with this amount of equity to acquire greater voting control over a foreign-invested company limited by shares than over a traditional foreign-invested enterprise. Thus, it would be a potentially attractive corporate vehicle for Webb & Co. There is also a clear legal basis for converting a state-owned enterprise into a foreign-invested company limited by shares. Despite these attractions, there are relatively few deals which have been done to date that involve a conversion into a foreign-invested company limited by shares. Special conditions need to be satisfied and approvals are required in order to do the conversion and government policy has been slow to support a more generalized adoption of this type of corporate vehicle for foreign investment.

(2) Acquisition via Webb & Co. (Beijing)

Suppose that Webb & Co. already has a 100% owned subsidiary incorporated in China, called Webb & Co. (Beijing). If this is the case, then Webb & Co. could acquire the 70% interest in Shanghai Fabrics indirectly through Webb & Co. (Beijing).

The legal advantages of the structure are twofold. First, there is already a clear legal basis for a FIE such as Webb & Co (Beijing) to make an investment in another domestic enterprise like Shanghai Fabrics. Second, since the business of the investee company, Shanghai Fabrics, is categorized as “permitted” for the purposes of foreign investment, no approvals are generally required from the Chinese authorities for the transaction.

But there are a couple of disadvantages to this structure. For one, Webb & Co (Beijing) needs to satisfy certain pre-conditions before it is permitted to invest in Shanghai Fabrics. The main pre-condition is that its aggregate investments do not exceed 50% of its net assets. Secondly, as the investors of Shanghai Fabrics after completion of the transaction will both be domestic companies, Shanghai Fabrics will not enjoy the status of a FIE (and therefore will not enjoy the normal tax and investment incentives available to a foreign-invested enterprise). The only exception to this rule is where Shanghai Fabrics is located in the middle or western regions of China, in which case it would be treated as a special case and the same tax and investment incentives would be granted as to a foreign-invested enterprise.

In practice, we have found this type of deal structure of more interest to those clients who are engaged in the services sector and are located outside the special investment zones especially set up for FIEs. These companies therefore already miss out on many of the tax incentives commonly available to manufacturing-oriented foreign-invested enterprises and, as a result, care less about the lack of FIE status of the target company after the closing of the transaction.

Investing through an Offshore Entity

One other potential structure worth highlighting is an offshore acquisition. An offshore acquisition is a viable option where the target business in China is held through an offshore company. Typically, the target business is part of a wider corporate group where the ultimate parent company is listed on an offshore stock exchange (in Hong Kong or New York) or the target business is privately-owned by PRC returnees who have chosen to hold the target company through an offshore vehicle for tax or funding reasons (for example, in the Cayman Islands or British Virgin Islands).

In our case study, suppose that Shanghai Fabrics is held through the offshore company, China Fabrics (HK). In this case, Webb & Co. can choose to acquire a 70% stake in China Fabrics (HK), thereby indirectly acquiring control of Shanghai Fabrics.

The main advantages of the structure are threefold. First, since the target company, China Fabrics (HK), is an offshore-incorporated company, the joint venture contract can be governed by foreign law. As such, Webb & Co. and China Fabrics Corporation (US) are freer to negotiate more flexible terms on management control, future share transfers, price determination and other terms. Second, the exit options for Webb & Co. are much better. For example, a third party trade sale, an IPO or the liquidation of China Fabrics (HK) are all more viable options and procedurally simpler. Third, there exist the usual advantages associated with a share sale, such as the automatic assumption of the target business.

The main drawback is that the number of target companies in China that are already part of a wider offshore corporate group structure is still relatively small. Furthermore, it is often difficult for the Chinese seller to obtain the approvals necessary if it wishes to set up an overseas company specifically for the purpose of facilitating an offshore sale to a foreign partner (particularly if the target business involves state-owned assets). As a result, this type of deal structure is typically only seen where the Chinese seller is a large corporation with the necessary clout to set up a “window” company in an offshore jurisdiction, or where the target company is a small, privately-held business (such as in the IT sector, where PRC entrepreneurs have built up considerable market presence) with individual shareholders.

Looking Ahead: The Future of M&A Deals

Compared with other jurisdictions, M&A deals in China are still in their infancy. Still, both the pool of target companies and the legal environment are gradually improving. Areas to watch out for in the future are the final promulgation of the long awaited M&A regulations by MOFTEC (expected at the end of 2002), which should provide a clearer legal framework, and in the longer term the opening up of a private equity market for unlisted shares in China's listed enterprises. In the meantime, foreign investors can take encouragement from the recent comments of one government official that they “experiment in all possible ways in M&A transactions to the extent not prohibited by law”.