Trends, Challenges, and Opportunities: China's PE/VC Sector in 2019

…China has continued, even in the current geopolitical environment, to open new sectors of its economy to non-Chinese investments

China's new PRC Foreign Investment Law (Foreign Investment Law) (中华人民共和国外商投资法) will officially take effect on Jan. 1, 2020.  The new Foreign Investment Law introduces the concept of a "negative list", stating that non-Chinese investment is deemed permitted except as otherwise specified in a "negative list".  This differs from prior requirements that categorized non-Chinese investments into four categories (encouraged, permitted, restricted, prohibited), with different requirements in each category.

As an aside, China has continued, even in the current geopolitical environment, to open new sectors of its economy to non-Chinese investments.  For example, recent openings include e-commerce (own products), logistics, cinemas, tourism, ratings agencies and financial services (a gradual phase-in).

…Chinese companies with VIE Structures can continue, as before, to list on U.S. exchanges and the Stock Exchange of Hong Kong, whether or not they are "controlled" by PRC persons

Equally important is what the new Foreign Investment Law and its implementing regulations (中华人民共和国外商投资法实施条例) omit.  A prior draft stated that variable interest entity structures (VIE Structures), a workaround structure that permits non-Chinese investors to invest in sectors limiting non-Chinese investments in different ways, would only be allowed if they were actually "controlled" by PRC persons.  The prior draft resulted in uncertainty, as many Chinese technology companies with VIE Structures are not controlled by PRC persons (e.g. due to multiple rounds of financing that diluted the holdings of PRC persons to under 50%).  However, the new Foreign Investment Law sidestepped the issue altogether, which effectively preserves the status quo, where the VIE Structure is not officially recognized but also not officially prohibited.  As a result, Chinese companies with VIE Structures can continue, as before, to list on U.S. exchanges and the Stock Exchange of Hong Kong, whether or not they are "controlled" by PRC persons.

Domestic Equity Investments Open to All Non-Chinese Enterprises

On Oct. 23, 2019, the State Administration of Foreign Exchange issued the Circular on Further Promoting Convenience in Cross-Border Trade and Investment (关于进一步促进跨境贸易投资便利化的通知), which permits non-investment non-Chinese enterprises to engage in equity investments in China.  Previously, non-Chinese enterprises could only engage in equity investments in China if "investments" were permitted by its scope of business.  In practice, this meant that only investment funds that cleared several regulatory hurdles could engage in equity investments in China.  Now, the sector is effectively open to all non-Chinese enterprises, paving the way for increased activity in the Rmb denominated PE/VC space in China.

Leveling the playing field in the IP technology transfer space may have the effect of compelling Chinese start-ups to innovate in order to compete

IP Regulations

On March 2, 2019, the State Council promulgated the PRC Regulations for the Administration of Technology Import and Export (中华人民共和国技术进出口管理条例) and the Implementing Regulations for the PRC Sino-foreign Equity Joint Venture Law (中华人民共和国中外合资经营企业法实施条例).  These new regulations removed prior restrictions and conditions on technology transfers that only applied to non-Chinese entities and not Chinese parties, such as limitation on the terms of transfer, payment of fees for invalid or expired patents, use restrictions, negative covenants, compulsory transfer of improved technology, third party liability, and the term.  The practical effect of such actions is to provide non-Chinese entities with the right to enter into technology arrangements with Chinese parties (such as the sale or license of technology) on the basis of freedom of contract, subject only to regulations that also apply equally to domestic entities.

Leveling the playing field in the IP technology transfer space may have the effect of compelling Chinese start-ups to innovate in order to compete.  Non-Chinese licensors may also be more willing to license IP to Chinese counterparties now that such licensors may do so on terms largely in line with international standards.  The ripple effect of these regulations may impact certain sectors of the PE/VC market, such as Chinese start-ups in the hardware, AI, and life sciences space that rely on IP licensing.

2019 Trends

Types of Investment and Financing Channels

Based on the regulatory breakthroughs discussed above, the geopolitical tensions described below, and our own internal data, we are seeing a shift towards more JV investments (the first structure below).  Due to more sectors being open to foreign investment, such as health care and life sciences, joint venture investments are now feasible for non-Chinese investors and allow the issuer to maintain the ability to freely list in mainland China and Hong Kong.

We also encountered in our daily practice in 2019 a more relaxed policy towards overseas direct investment (ODI) approval.  An investment that requires ODI approval is one made by Rmb investors that invest in a Chinese target whose parent is incorporated outside of China, or a target outside of China.  Just a few years ago, ODI approval was considered a mere formality, but since 2016 China has issued a set of rules that have tightened the requirements for ODI approval.  However, unlike 2017 and 2018, in 2019 we saw a more relaxed approach for ODI approval, especially with respect to investments in Chinese targets whose parents are incorporated outside of China.  Whereas such ODI approvals previously depended on conditions that were sometimes outside the control of the parties, such as a bank's unofficial foreign exchange monthly quota, in 2019 we observed that these applications were generally approved as long as the underlying target company had substantive operations in China.

Below is a summary of the three main structures used by non-Chinese investors, along with a discussion about their rationale and purpose.

Exit Mechanisms

While M&A and secondary disposals remain exit mechanisms for PE/VC investors, a public offering outside of China, especially in the United States, may present future challenges.  China's new STAR Market, a part of the Shanghai Stock Exchange that permits pre-profit technology companies to list, may provide issuers with an alternative domestic financing option.  While offshore incorporated Chinese companies may theoretically list on the STAR Market, as of now the hurdles for such offshore incorporated Chinese companies are significantly higher than those of their domestically incorporated peers.

According to Dealogic, as of Oct. 31, 2019, 51 Chinese companies have listed in the United States since 2018.  On average, their stock prices are down 30% from their initial offering price.

According to the Wall Street Journal, as of Nov. 14, 2019, 30 Chinese companies in the technology and internet space have listed in Hong Kong since 2018.  On average, their stock prices are down 12% from their initial offering price.

More than 50 issuers have listed on the STAR Market since its inception in the middle of 2019.  As of Nov. 13, 2019, the stock prices of just six issuers is below their IPO price.  We also note that the initial roll-out of the STAR Market may lead regulators to introduce new rules to further refine the listing process, such as shortening lock-up periods, so they are in line with international standards, and allowing more issuers with VIE Structures to list.

The less than stellar returns of U.S.-listed Chinese issuers may lead non-Chinese based investors, especially those headquartered in the United States, to re-evaluate their investment exit strategies for their Chinese portfolio companies.

Impact of the US-China Trade War

The 2019 Annual Report of the U.S.-China Economic and Security Review Commission of the United States Congress released in November 2019 recommends that Chinese issuers with a VIE Structure be prohibited from listing on U.S. stock exchanges.  In addition, there is proposed legislation in the United States Congress that would prohibit Chinese issuers that cannot be audited by the Public Company Accounting Oversight Board from listing on U.S. exchanges, and mandate the de-listing of existing Chinese issuers from U.S. exchanges if such requirements are not met for three consecutive years starting in 2025.  Presently, the Public Company Accounting Oversight Board cannot access audited papers of Chinese issuers due to restrictions under Chinese law.  On Sept. 17, 2019, the U.S. Department of Treasury issued detailed proposed Committee on Foreign Investment in the United States (CFIUS) regulations that would require non-US VC transactions in "TID" industries (technology, infrastructure, data) meeting certain thresholds to file for CFIUS approval.  While there is a narrow exemption for investors from "excepted" countries, China presumably will not be one of them.  The final regulations are scheduled to take effect on Feb. 13, 2020.  Furthermore, we understand the United States also intends to expand items subject to export control, which may lead to more transactions being subject to CFIUS jurisdiction on account of underlying technology being classified as "critical technology", and more restrictions on the types of technology that may be licensed to Chinese parties.

…regulatory restrictions against Chinese investments in the United States may attract the money that otherwise would have been invested in the United States back to China

Against this backdrop, China has continually opened its markets as evidenced by the discussion above.  However, the developments in the United States may lead Chinese companies to think twice before listing in the United States.  Furthermore, regulatory restrictions against Chinese investments in the United States may attract the money that otherwise would have been invested in the United States back to China.

Outlook for 2020

…China will, for its own interests, continue to open its market to non-Chinese investors in 2020

We expect 2020 to be an interesting transition year in China's PE/VC market.

We believe that China will, for its own interests, continue to open its market to non-Chinese investors in 2020.  For example, in the financial services market, non-Chinese investors will be able to freely operate futures, fund management, and securities companies starting from Jan. 1, April 1, and Dec. 1, 2020, respectively.  Furthermore, now that non-investment non-Chinese enterprises may freely engage in domestic equity investment, there may be an increase in Rmb denominated investments in 2020.

We expect adjustments in the PE/VC market in 2020 in light of market and geopolitical conditions.  Namely, fund formations and amounts raised may decrease, non-Chinese investors may spread their risks across Asia instead of placing all or most of their resources in China, and government funds may increase their involvement in the sector.  On the other hand, reforms and developments within the Chinese market, such as the introduction of the STAR Market, may alter transaction structures (e.g. more Rmb denominated joint venture investments) and exit opportunities.