New Listing Rules Benefit Foreign Private Equity Investment in China

Under the current legal regime of the PRC, FPE Investors usually adopt one of the following options to structure an onshore investment in a pre-IPO Chinese company:

Option A – One or more FPE Investors subscribe newly-issued share capital of a Chinese domestic limited liability company, thereby converting the domestic company to a Sino-foreign joint venture. Then, the joint venture will be converted into a foreign invested stock company (also known as a foreign invested company limited by shares, or FICLS), which will be the vehicle of a domestic listing.

Under the existing Mofcom regulations, a joint venture shall have at least three years of profit-making history before applying for conversion to an FICLS. (Some recent cases indicate that Mofcom may waive such profit-making period on a case-by-case basis; however, the chances of obtaining such a waiver remain unpredictable). Moreover, after the FICLS is listed at a domestic stock exchange, shares held by an FPE Investor therein will be locked up for a one-year period. Taking into account the time for preparation of the domestic listing (which is eight to 10 months in normal circumstances), the actual waiting period will be at around five years, which is far more than acceptable most FPE Investors will find acceptable.

Option B – One or more FPE Investors subscribe newly-issued shares of an unlisted domestic stock company, thereby converting the target company into a FICLS. Afterwards the FICLS can seek an IPO on the Chinese domestic stock market.

Option B is deemed to be a more cost- and time-efficient way for FPE Investors because their investments in the target company can usually be completed within 12 months before the contemplated IPO. However, under the Old Listing Rules, if a non-controlling shareholder of a stock company has held shares in that stock company for 12 months or less before the latter's listing, its shares in the stock company will be locked up within three years after the listing. As such, the actual waiting period for FPE Investors will be around four years, which is a little bit shorter than that under Option A but still longer than the generally accepted lead time of private equity investors worldwide, which is about three to four years.

Lock-up Period under New Listing Rules

On September 4 2008, the Shanghai and Shenzhen Stock Exchanges released their New Listing Rules which will took effect from October 1 2008. The New Listing Rules specify, among other things, that non-controlling shareholders of a domestic listed company shall be subject to only a one-year lock-up period, regardless of the time of their investment in the stock companies before the IPO.

While this change is not tailored for FPE Investors specifically, it does provide leeway for FPE Investors to use Option B in a more time-efficient manner; for example, FPE Investors would be able to subscribe newly-issued shares of an unlisted Chinese domestic company in the last eight to 10 months before the latter's IPO, and then successfully exit from the post-IPO target companies immediately after the one-year lock-up period. That way, the exit lead time for a foreign private equity investment at the onshore level can be shortened to two years or less.

As the new lock-up period enables FPE Investors to manage their investment and exit strategy within the generally recognized exit lead time, the implementation of the New Listing Rules from October 1 2008 will have removed the roadblock for most of the FPE Investors planning their onshore investment in China. As to the deal structure issue, Option B seems to be more and more attractive because it can offer a speedier exit, while Option A will still be subject to the three-year profit-making period as required by the exiting regulations of Mofcom, rather than by the New Listing Rules.

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