Navigating Private Equity in China

Published on May 22, 2010

Private equity is a relatively new concept to China, where until a few years ago, private ownership was not protected by the constitution, said Feng Xue, partner at Katten Muchin Rosenman LLP. “Arguably, there is still not a good translation – a Chinese word – for the phrase ‘private equity,’” Xue said during a talk presented by the student-led China Business and Economy Group at Gleacher Center on May 22.

The majority of the Chinese economy remains state-owned, including the large manufacturers, telecommunications industry, and steel companies, he said. Nonetheless, up to 60 percent of the work force is employed by companies bearing foreign investment, Xue said.

At one time, foreign investors required Chinese companies to establish offshore holding companies, which would acquire the assets of the Chinese companies through wholly owned subsidiaries in exchange for the equity in the holding companies, he said. However, since the adoption of its Circular 10 policy in 2005, the Chinese Ministry of Commerce has not approved any of these swaps, Xue said.

“For about two and a half years, foreign investors in PE were trying to figure out ways to get around this regulation,” he said. “Since 2008, people have come up with different ways to deal with Circular 10. Some of them work and some of them are questionable, but none of them have been litigated or sanctioned by the Chinese government. Part of the legal process of investing in China is that no one is going to issue opinions on the structures and there is always uncertainty.”

Acquisition in China is both a lawyer’s dream and nightmare, Xue said. “On the one hand, due diligence in China is so difficult that if you bill by the hour, you generate a lot of revenue,” he said. “On the other hand, it’s also very dangerous because China does not have a very good central finance system. It’s a very common, almost permitted practice for Chinese companies to underreport their taxes. The primary job of a CFO is to negotiate how much the company will pay to the taxing authority.”

Cross-guarantees for third parties are also very common in China, Xue said. “Those guarantees are not filed anywhere in China as a government record,” he said. “Two parties just sign a piece of paper and put it in a file. We have encountered a couple of transactions where after we closed the deal, a third party declared bankruptcy and tried to chase our client or our client’s portfolio for payment. No matter how hard you work, there is no way you can find the guarantee record unless people tell you.”

Key lessons Xue has learned in his 15 years of representing clients in China include:

  • Not everybody in China is rich. “Don’t underestimate the importance of reverse due diligence,” he said. “A no-name Chinese manufacturer signed a contract with GM to buy Hummer. That deal, not surprisingly, did not happen. The lawyer and investment banker for GM did not check to see if the money was there.”
  • Chinese investors are different from Japanese investors. “People talk big in China, but many times they are not very serious,” Xue said. “They may sign a letter of intent, but say later that it’s not binding. If they do acquire a U.S. company, they negotiate very hard and try to get a very reasonable price.”
  • Government approval is required for all offshore acquisitions by Chinese companies. “China has a lot of money sitting in the bank, but it belongs to the government,” he said. “The Chinese banks are allowed to help Chinese companies finance overseas acquisitions, but those are subject to case-by-case analysis.”
  • Local governments in China play a much larger role in business than those in the U.S. “We spend more time with the local Chinese officials than other government officials,” Xue said. “When Chinese investors come to the U.S., they feel disappointed if you don’t introduce them to the local government.”
  • Encourage Chinese investors to do business the American way. “They’re not used to using investment bankers, lawyers, or accountants,” he said. “They are very used to doing everything themselves. If they will use American professionals, they are serious. If they are not willing, you should be more cautious.”

As a Chinese citizen who has been away from home for eight years, Di Zou, a student in the Evening MBA Program who is president of the China Business and Economy Group, found Xue’s description of China fascinating. “I see a lot of good opportunities there,” Zou said. “I’m looking forward to going back, given the right opportunity. (Xue) gave many subjective opinions about what’s happening in China – there are pros and cons, of course – that raised our expectations.”

—Phil Rockrohr