Looking for the exit

3. Why is there such a huge backlog of companies waiting for IPOs? How long has the moratorium been in place? What effect has this had on PE and when do you expect IPOs to be allowed again?

The main reasons for the backlog in the stock market are, on the one hand, the relatively strong desire on the part of enterprises to list due to the limited financing channels available to them in China; and, on the other hand, the damping down of the IPO rhythm by regulators due to poor sentiment in the stock market and the recently exposed scandals involving listed companies that have fiddled their finances, or whose performance has done a 180° turn after listing, as well as the regulators' extensive verifications of companies intending to list. These factors have resulted in a difficult situation where a large number of enterprises have poured into the IPO channel without, however, being able to offer shares.

Since the listing of Zhejiang Shibao Company Limited on November 2 2012, it has been more than eight months since the last IPO on the A-share market.

The limited channels and means presently available to PE investors to exit from their investments, the moratorium on IPOs and the continuously increasing number of enterprises lining up to apply points to longer waiting periods for PE divestment and greater uncertainty as to whether divestment can be achieved through an IPO. Developments such as the replacement of the CSRC chairman and the reform of the new share offer mechanism make it difficult to predict exactly when IPOs will restart. However, with the completion of the first round of financial verifications by the CSRC, we believe that the signals for the restarting of IPOs are getting stronger.

4. IPOs are the main exit route for PE investors in China. As there is a moratorium on IPOs, what other exit routes are there?

Given that it is becoming more difficult for PE to exit via an A-share IPO, and that returns have declined, M&A will become the future substitute option for PE divestment. Furthermore, in September 2012, the curtain was formally raised on expansion of what is called the “new third board”, making an exit through the “new third board” another substitute option for quite a few PE investors; the principal means of exit for PE on the “new third board” at present are equity transfers and re-directed IPOs effected through the “new third board” to realise an exit by listing on a different board. Additionally, listing in Hong Kong, Taiwan or the US or a buyback by the investee company or a major shareholder are other substitute exit routes available to PE investors.

5. What is your outlook on the rise of domestic Rmb funds?

Compared to US dollar funds with foreign investment structures, Rmb funds have the following advantages when invested in in China: (1) the scope of the industries of the available investment projects is much wider; and (2) under the current foreign exchange control environment operating in China, the investment and exit mechanisms for Rmb funds are much more flexible. However, Rmb funds also suffer from weaknesses such as a comparatively short history, insufficient experience and insufficiently sound incentive mechanisms.

We believe that, in the next few years, with the legally compliant development of the PE industry, Rmb funds will maintain their growth trends in terms of the number established and the amount of offer proceeds, and will become more and more competitive. Additionally, with the state's gradual relaxation of its policy of controlling the establishment of equity enterprises in China by foreign investors, Rmb funds and US dollar funds, while competing, will have more opportunities to cooperate and achieve win-win situations.

6. CSRC chairman Guo Shuqing stepped down earlier this year after only 18 months in his role. Guo was known as a reformer in the market. What were some of his achievements and what is still left to be done?

During his time as chairman of the CSRC, Guo Shuqing carried out a number of reforms, the principal ones being the new policy setting minimum dividends for listed companies, the introduction of long-term money, such as RQFII, the establishment of the A-share delisting system, the crack down on insider trading, the disclosure of the IPO review procedure and the financial verifications which commenced at the end of 2012. These measures raised the quality of listed companies and cleaned up the capital market environment, but some of the reform measures still require further testing or implementation – for example: how to attract stable long-term funds and establish complementary rules, how to genuinely implement the A-share delisting system, how to change the public's impression of China's stock markets as what are known as appropriation markets and change speculation to investment. These are all problems that the new chairman, Xiao Gang, will have to face. Among these, perhaps the most pressing problem is how to smoothly restart IPOs and effectively clear the IPO backlog.

7. What new opportunities are available for foreign investments in renminbi funds and for offshore investment of China funds?

For foreign investors, the ways to enter the domestic fund sector at present are foreign-invested venture capital enterprises, equity joint venture funds and region-specific QFLP. The state is currently improving the rules and regulations that govern investment in domestic funds by foreign investors so as to further guide and encourage investment in domestic funds by foreign investors.

As for offshore investment of China funds, we believe that, in addition to the existing QDII policies, opportunities exist in the following aspects: firstly, the state has made clear the catalogue for guiding investment in industry offshore; secondly, the state has simplified the overall examination and approval procedures for offshore investment in terms of the approval of offshore investment, foreign exchange control; additionally, China has an increasing number of outstanding financial intermediaries familiar with offshore markets that can effectively assist investors in rapidly understanding local culture and laws, mitigating information asymmetry and reducing investment times and costs, thereby giving investors more opportunities than were available to them before to understand the actual circumstances of the companies they are investing in so that they can make their investments more effectively and safely.

8. Are there any tax updates that PE firms or funds should be aware of?

The one relatively major change in taxation recently has been the expansion of the scope of the pilot projects for levying value-added tax instead of business tax. On July 31 2012, the State Administration of Taxation issued the Circular on the Launch of Pilot Projects for the Levy of Value-added Tax in Place of Business Tax in the Transport Industry and Certain Modern Service Industries in Eight Provinces and Municipalities including Beijing that expanded the scope of the pilot projects for levying value-added tax instead of business tax from Shanghai to eight other provinces and municipalities including Beijing and Guangdong. Pursuant to a decision taken at an executive meeting of the State Council in April 2013, the business tax to VAT pilot projects for the transport industry and certain modern service businesses will be further expanded, and beginning on August 1 2013, the pilot projects will be implemented nationwide and the scope of industries covered will be gradually expanded. The implementation of business tax to VAT will, on the whole, reduce the tax burden on enterprises.

9. What are some of the major issues or concerns foreign PE clients might have in doing deals in China?

Recent changes that need to be paid attention to include:

• Preferential policies for the registration of regional PE institutions: in addition to the QLFP policies in regions such as Shanghai and Beijing, regions approved by the State Council such as Qianhai in Shenzhen and Hengqin in Zhuhai have established special preferential policies in terms of taxation, etc. in respect of the registration of PE institutions.
• Validity of VIE structures: in 2012, the Shanghai Commission of the China International Economic and Trade Arbitration Commission rendered an award in a case finding that a VIE agreement was invalid on the grounds that it took “a lawful form hiding an illegal objective” and that it “violated mandatory provisions of state administrative regulations”; this has given rise to a general malaise among domestic and foreign investment institutions as to the legality and stability of VIE structures.
• Validity of valuation adjustment mechanisms: in a retrial judgment rendered at the beginning of 2013, the Supreme People's Court clarified the validity of valuation adjustment agreements, namely that valuation adjustment mechanisms between an investor and a company are invalid but that such mechanisms between an investor and a shareholder of the company are valid. Although China is not a case law country, the case has nonetheless triggered a great deal of debate and given domestic and foreign investment institutions a better understanding of the validity of valuation adjustment mechanisms.

10. The CSRC has taken an active role in clamping down on insider trading and accounting irregularities – how has this affected the PE market?

In the short term, the investment benefits of certain PE institutions will suffer and the investment costs and operating costs of certain PE institutions may increase as the clampdown may affect the IPO schedules of their investee enterprises or the acquisition transaction procedures. However, in the long term, only a healthy market environment can offer the PE industry better growth and more business opportunities; this process is also conducive to promoting the transition from a situation where only one exit route – an IPO – is available to PE in China to one where multiple routes, including M&A, restructuring and buyback are available.

Furthermore, this process will cause PE institutions to assist their investee enterprises, after the investment, in making their finances and internal controls compliant so as to liberate the enterprises' potential, thereby leveraging PE institutions' greater value. In the future, PE institutions will participate more than before in the strategic planning and management of their investee enterprises.

Author biography

Hu Yijin

Hu got his LLB from the Law Department of Nankai University in 2000 and LLM from the School of Law of Tsinghua University in 2003. He joined Jun He in 2005. Hu is a partner of Jun He Law Offices and currently practises at the Shenzhen office.

Since joining Jun He, Hu has represented more than ten companies in their successful IPOs, and issuances of shares and bonds. He has also helped many funds in their establishment and investment. Hu has provided legal services for many companies in their restructuring, M&A and employee incentive plans. He also serves as counsel to some listed companies in information disclosure matters and general corporate matters.

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寻找出路

君合律师事务所的胡义锦律师综合了私募股权的最新发展，并对IPO暂停的因由作出分析