What China's IPO crisis means for PE investors

The unwillingness of founders and other controlling shareholders to cede control means that they are typically uninterested in transactions like trade sales that permit the private equity sponsor to exit but result in a change of control of the portfolio company. Likewise, a desire to use available capital resources to fund the growth of the company's business means that there is usually little interest in other alternatives for exit such as leveraged recapitalisations or repurchases of the private equity investor's stake by the company that require new debt or equity financing by the company or the controlling shareholders to fund a return of capital to the private equity sponsor, even without taking into account the technical impediments to such alternatives that are discussed in greater detail below.

As a result, IPOs have tended to be the only path to exit for a private equity sponsor that is acceptable to the controlling shareholders of the portfolio company. In the past few years, this has also primarily meant domestic IPOs, as overseas equity markets have become less receptive to mainland Chinese issuers for various reasons, including widely publicised accusations of accounting fraud and other improprieties that have been levelled against a number of these companies.

In the case of the Hong Kong IPO market, these obstacles have also included difficulty in obtaining required CSRC approvals. However, there have been recent indications that the CSRC is encouraging mainland issuers to pursue Hong Kong IPOs, and that the CSRC may consequently relax these approval requirements. This could result in Hong Kong becoming a significant IPO window for sponsor-backed mainland issuers, alleviating some of the exit pressure caused by the CSRC moratorium on domestic Chinese IPOs.

|

Searching for other exits

Given heightened doubts about the domestic Chinese IPO market as a reliable means for exit, what are the prospects for the greater use of alternative exit techniques, and what are the likely implications for private equity sponsors?

Trade sales

Trade sales have historically represented the primary alternative to IPO exits for Chinese portfolio companies. They have commonly been used in situations where the private equity sponsor was in a position of control or in circumstances where, for deal-specific reasons, the interests of other shareholders of the portfolio company were strongly aligned with those of the private equity sponsor in favouring a trade sale exit. As noted above, trade sales are much less likely to occur when a founder or other controlling shareholder is unwilling to give up control of the company. In addition to this obstacle, trade sales present other challenges for private equity sponsors. For example, because private equity sponsors use limited partnerships and other pooled investment vehicles, or funds, with limited a lifespan (typically a maximum of 10 years for international sponsors and usually much shorter periods for domestic renminbi funds), when participating in the sale of a portfolio company they face constraints on agreeing to the kinds of lengthy post-closing obligations that buyers often require. These post-closing liabilities can include claims for breaches of seller representations and warranties, purchase price adjustments and special indemnities where the sellers agree to make the buyer whole in the event of the occurrence of certain contingent risks. These constraints are particularly problematic for trade sales that occur very late in the remaining lifespan of the fund, and can adversely affect the private equity sponsor's exit in a number of different ways.

Similarly, higher selling pressure on the part of a private equity sponsor can give rise to conflicts with other selling shareholders if the trade sale involves a choice between buyers paying cash (which private equity sponsors will tend to favour) and buyers offering a higher price but using illiquid consideration. Trade sale exits are also commonly beset by other recurring problems, such as difficult-to-bridge differentials in valuation expectations between the private equity sponsor (who may have significantly lower expectations because it is under greater pressure to sell due to the need to return capital to investors) and the other selling shareholders (who may be under much less pressure to sell and may therefore have much higher valuation expectations). In addition, trade sales may face obstacles arising as a result of Chinese foreign investment controls, anti-monopoly review and other regulatory restrictions that may not be impediments to an IPO or other exit alternatives.

Direct secondary sales

Direct secondary sales of stakes in Chinese portfolio companies – the disposition by a private equity sponsor of its stake in a portfolio company to a third party, often another private equity sponsor – are in theory a viable exit alternative but the number of these transactions to date has been relatively low compared with the volume of direct secondary sales in other markets such as the US and Europe. This is in part a consequence of the much shorter track record for private equity in China as compared to more mature markets, because the development of a secondary sale market tends to lag somewhat behind the growth of the market for primary investments in a given region. The development of a direct secondary market for Chinese private equity stakes may have also been impeded as a result of the relative attractiveness to sponsors of the domestic IPO markets, from their reopening in early 2009 until the imposition of the CSRC moratorium late last year.

The problems associated with the domestic IPO markets have caused a number of observers to predict a sharp upturn in volumes of direct secondary sales, including in a widely cited study released earlier this year by China First Capital. China First Capital persuasively argues that the problems with the domestic IPO exit route, coupled with the disadvantages of other alternative exit mechanisms, will lead to significantly increased volumes of secondary sales. This prediction may very well prove correct, but significant growth in the market for direct secondary sales will have to overcome a number of obstacles. Secondary buyers often face difficulties in conducting due diligence on these investments, particularly where the portfolio company lacks an incentive to cooperate. Uncertainty as to the seller's motive for disposing of the investment can also impact the buyer's valuation or willingness to enter into a secondary sale. This problem can be exacerbated by the reluctance of some private equity sponsors to reveal that they are under selling pressure because of looming deadlines to dispose of investments and wind up their funds. In addition, secondary sales can face resistance from institutional investors that are active in private equity as limited partners of a wide variety of fund managers concerned with the risk that they are invested in both the buy side and the sell side of any direct secondary transaction. Institutional investors may also argue that sellers necessarily leave money on the table, when selling to other private equity sponsors with similar investment hurdle requirements.

Leveraged recapitalisations

In a leveraged recapitalisation, a portfolio company will substitute its equity for debt by borrowing or issuing bonds and using the proceeds to pay a special dividend or repurchase its outstanding shares from its investors. While this structure allows the existing controlling shareholder to potentially maintain control of the company and may have certain tax benefits when compared to a trade sale or direct secondary sale, it involves an increase in leverage by the portfolio company with the usual risks that this entails. However, leveraged recapitalisations are viewed as unworkable for portfolio companies that are entities organised under Chinese law, in light of the legal restrictions on their ability to distribute capital back to shareholders through a special dividend (dividends are limited in an amount equal to retained earnings net of certain deductions), and the legal and practical limitations in creating effective security interests over their equity and assets. In addition to these limits, for a variety of reasons, it is extremely difficult to source debt financing for leveraged recapitalisations of Chinese domestic companies, including historically tight controls on the ability of domestic banks and insurance companies to engage in this kind of lending. The absence of alternative sources of onshore debt financing such as a domestic bond market and the impact of China's system of capital and foreign exchange controls and other restrictions on the ability of experienced foreign lenders to provide this type of financing also adds to the difficulty. These limitations look likely to persist, although efforts to liberalise restrictions on acquisition finance in China, coupled with recent successes in structuring debt financing for several, large going-private transactions involving US-listed Chinese companies may be an indication that leveraged acquisition financing, including financing for leveraged recapitalisations, may become available in China in the future.

|

How to structure investments

Private equity sponsors often seek to structure into their investments other exit mechanisms, usually as a type of fallback or last resort, to be used in the event that an IPO, trade sale or other more conventional exit cannot be accomplished within a certain time period. Their real usefulness is often not so much as an actual exit mechanism but as a bargaining chip to persuade the portfolio company and its majority shareholders to facilitate a more conventional exit. These other mechanisms generally involve requiring the portfolio company or the non-investor shareholders to repurchase the sponsor's equity or to make some other payment to the sponsor that enables it to recoup some or all of its invested capital. Some mechanisms may also involve adjusting the sponsor's ownership percentage in the portfolio company in a way that increases its return on investment or incentivises the other parties to facilitate the sponsor's exit.

These mechanisms can take various forms, including cash or stock earn-outs, puts or redemption rights, and may be tied to the company's performance, a fixed time horizon or other triggers depending on the concerns of the parties when negotiating the investment. However, the validity or enforceability of a number of these mechanisms under Chinese law is in doubt insofar as they are sought to be enforced against the portfolio company. One of the more popular mechanisms that sponsors often seek to obtain when investing in onshore Chinese portfolio companies, the so-called valuation adjustment mechanism (VAM), was the subject of a recent case, Haifu v Shiheng, Wisdom Asia and Lu Bo (2012), in which the Supreme People's Court, while affirming the validity of VAM-type agreements that are solely between shareholders, held that an agreement requiring a Chinese domestic portfolio company to pay a cash earn-out or other distribution to shareholders on a non-pro rata basis would violate Chinese law.

|

Redefining the market

In light of the continuing concerns as to the reliability of the Chinese IPO market as a viable path to liquidity, private equity sponsors are likely to focus much more on ways to facilitate non-IPO exits – both when structuring new investments and through taking advantage of opportunities to renegotiate or restructure the terms of existing investments.

One possible consequence of this increased focus is that portfolio companies that are plausible candidates for an eventual trade sale exit may be in much greater demand and may command higher valuations and better terms from sponsors.

Additionally, private equity sponsors and regulators may place new emphasis on figuring out ways to make the buyout model work in China. The success of this model in many of the recent going-private transactions involving US-listed Chinese businesses, and in particular the growing willingness and ability of domestic and international banks to provide senior financing for these transactions, offers some hope for further development in this area. However, the success of the buyout model and its acquisition financing in these deals may depend to a great extent on factors that are somewhat unique to these transactions, and it remains unclear whether this can be successfully extended in China much beyond the US going-private context.

Sponsors may also focus to a much greater degree on identifying and capitalising on unconventional M&A-related exit opportunities that avoid the impasse over ceding control and other traditional obstacles posed by a trade sale. These could include outbound M&A acquisitions by the portfolio company in which the majority shareholder retains control but which are structured in a creative manner to facilitate a direct or indirect exit by the private equity sponsor. Likewise, inbound M&A transactions, for example a joint venture or other combination with a foreign strategic partner, might be structured to meet the majority shareholder's control and other objectives but also open up creative paths to liquidity for the private equity sponsor. Experienced, sophisticated and international private equity firms with extensive overseas networks may be better positioned than their competitors to conceive of and execute these kinds of unorthodox exits.

Lastly, private equity investors may begin to have an increased appetite for negotiating and building in economic and other incentives in their deals to motivate controlling shareholders to cooperate in and facilitate a secondary sale, leveraged recapitalisation or other non-IPO exit. The benefits of these incentives will have to be carefully weighed against the costs to an exiting sponsor and be structured in ways that align the interests of the exiting sponsor and the controlling shareholder as much as possible.

Mark Lehmkuhler and Steven Sha, Davis Polk, Hong Kong