Continuation of the Rebound Trend

With the improved control of the COVID-19 pandemic and the gradual recovery of the economy, the private equity (PE) industry in the People’s Republic of China (China or the PRC, which, for the purpose of this chapter only, excludes Hong Kong SAR, Macau SAR and Taiwan) in the first quarter of 2021 continued the rebound trend started in the second half of 2020. It was reported that both the number and the total value of PE investment transactions in the first quarter of 2021 saw a substantial increase of approximately 33% and 90%, respectively, on a year-on-year basis. Beijing, Shanghai and Shenzhen continued to lead in the number and value of PE investments. The number of PE-backed exit transactions in the first quarter of 2021 also increased by approximately 30% year on year. IPOs and share transfers ranked as the most popular exit routes for PE investors. In particular, boosted by the registration-based IPO process of Sci-Tech Innovation Board (STAR Board) and China's Nasdaq-style board of growth enterprises (ChiNext Board), PE exits by way of IPO constituted approximately 80% of all exit transactions.

Effect of New Legislation

There were around 247 IPO exits in the A-share market in total in the first half of 2021. Both the number of IPO exit cases and the total funds raised in the A-share market saw a substantial increase of approximately 110% and 50%, respectively, on a year-on-year basis. With respect to Chinese companies listed overseas, it was reported that both the number of US-listed Chinese companies and the total amount of funds raised in the first half of 2021 saw a significant increase of approximately 120% and 370%, respectively, on a year-on-year basis. However, it is noteworthy that in July 2021, the Cyberspace Administration of China launched a cybersecurity review on several Chinese companies recently listed in the US (ie, Didi, Full Truck Alliance and Boss Zhipin), and also proposed an amendment to the Measures for Cybersecurity Review, which would require companies that control data of more than one million individual users to make a filing for internet security review before seeking IPOs abroad (whether “abroad” includes Hong Kong for the purpose of this amendment remains to be clarified by Chinese regulators). It was also reported that the China Securities Regulatory Commission (CSRC) is formulating new rules according to which all companies registered overseas with red-chip ownership structures or variable interest entity (VIE) structures effectively involving PRC operations may need to obtain the CSRC’s sign-off before they seek IPOs on any overseas securities market. Affected by the aforesaid legislative developments in China, together with the implementation of the Holding Foreign Companies Accountable Act by the US Securities and Exchange Commission, it is reported that many Chinese companies with red-chip ownership structures or VIE structures have shelved or delayed their US listing plans and are considering seeking IPOs on, or turning to, the Hong Kong or China securities markets, which, in the long run, may affect exit channels and opportunities for foreign PE/venture capital (VC) investors.

In the first quarter of 2021, information technology, healthcare and life sciences, the internet, and semi-conductor and electronic equipment continued to be the most popular industries by both number and value of PE transactions in China. The IT industry attracted the most PE investment capital. The healthcare and life sciences sector led in the number of PE transactions due to the COVID-19 pandemic and relevant policies in response to the pandemic.

Fundraising

In terms of fundraising, a series of new regulations and policies were promulgated from the second half of 2020 to the first half of 2021, which had the effect of broadening the fundraising channels for PE/VC funds. Restrictions on investments with funds from the Qualified Foreign Institutional Investor (QFII) and Renminbi Qualified Foreign Institutional Investor (RQFII), insurance institutions, and asset management products issued by institutions regulated by financial regulatory authorities and co-operation between PE/VC funds and banks and their wealth management subsidiaries, have generally been lifted. Removal of the total investment quotas of QFII and RQFII has, to some extent, provided an effective channel for offshore funds to participate in private investment in the A-share market.

New Administration Scheme for Foreign Investments

Investment-wise, the Foreign Investment Law which took effect in January 2020 has officially established a new administration scheme for foreign investments based on “national treatment” subject to a “negative list”, and has replaced the prior approval by, or filing with, the Ministry of Commerce or its local counterparts (MOFCOM) with an ex-post information reporting system. For investments not included on the negative list, a mostly equal regulatory regime is applicable to transactions by foreign investors and domestic ones. Foreign investments that do fall within the negative list will be subject to approval by the competent regulatory authorities for particular industries (if applicable) and the State Administration for Market Regulation or its local counterparts (SAMR). The new administration scheme has significantly simplified government procedures for foreign investments and enhanced the competitiveness of foreign PE funds. Furthermore, following the Chinese government’s efforts to shorten the negative list in 2020, it is reported that MOFCOM and the National Development and Reform Commission (NDRC) are formulating the 2021 negative list with the aim of further opening up the services sector for foreign investments.

Reform of the Capital Market

Following the launch of STAR Board and the Chinese Deposit Receipts (CDR) scheme in the first half of 2019, China has further accelerated the reform of its capital market. The registration-based IPO system launched from STAR Board has been implemented on ChiNext Board and is expected to expand across the whole capital market. The new rules on refinancing by listed companies issued by the CSRC in February 2020 has allowed qualified strategic investors to enjoy a higher price discount (ie, 20% as opposed to the previous 10%) and a shortened 18-month lock-up period in private placement financing of listed companies, though under current practice, it is still hard for PE investors to be recognised as qualified strategic investors to enjoy such preferential treatment. The Qualified Foreign Limited Partner (QFLP) pilot policies in certain regions such as Shanghai and Shenzhen have also been reformed to allow offshore investors to participate in private placement financing of listed companies through investing in PRC-formed PE funds. Furthermore, the CSRC also clarified rules for issuing shares or CDR on the A-share market by offshore companies with red-chip ownership structures or VIE structures, and allowed shares with different voting rights or pre-IPO employee stock ownership plans (ESOPs) to be listed on the STAR Board and ChiNext Board under certain circumstances. It is believed that all these legal developments in the capital market will help to enhance the competitiveness of the A-share market and provide more investment opportunities and more flexible exit channels for PE investors.

Validity of VAM Arrangements

From a practical perspective, such previously controversial investment terms in PE investment as the valuation adjustment mechanism (VAM) and redemption arrangement have received more support from competent PRC courts and administrative agencies. The CSRC has started to allow IPO applicants to keep VAM clauses between investors and the founding shareholders under certain circumstances, instead of asking the parties to cancel all such clauses before an IPO application. In addition, the Summary of the National Court’s Work Conference on Civil and Commercial Trial released by the Supreme People’s Court in November 2019 (which sets out court trial guidance on typical cases) generally confirmed the validity of VAM agreements between a target company and its investors, but the enforceability of such VAM arrangements or redemption arrangements with target companies is still subject to deal-specific dynamics and should be determined on a case-by-case basis.

More Flexibility for Foreign PE Investors

Finally, China has continued to push forward and streamline reforms on foreign exchange control and administration systems. In October 2019, the State Administration of Foreign Exchange (SAFE) lifted restrictions on non-investment types of foreign-invested enterprises (FIEs) using capital account funds to make onshore equity investments, as long as the investment project is true and complies with the negative list for foreign investments and other relevant rules. To some extent, this may provide more structural and fund-flow flexibility to foreign PE investors.

Formation and Operation of PE Funds

In China, a PE fund may be established in the form of a limited partnership, a company or contractual arrangements, among which, limited partnership is the most popular form in terms of both the number and scale. PE funds formed under Chinese laws are generally administered by a self-regulatory industrial association, namely, the Asset Management Association of China (AMAC), which is in charge of the registration and filing of fund managers and the funds under their management. Depending on the organisational form, PE funds should comply with such applicable PRC laws and regulations as the Partnership Enterprise Law, the Company Law, the Trust Law and/or the Civil Code, which govern, among other matters, the formation, governance structure, operation, liquidation and distribution of PE funds. PE fundraising and investment activities are also subject to the various rules and regulations released by the CSRC and the AMAC. The AMAC has also introduced various restrictions on the business activities of PE funds in China. For example, PE funds are generally not allowed to engage in regular or operational private lending, debt investments in a disguised form of equity investment (except for bridge loans for one year provided to target companies to facilitate equity investment), or secondary market investments without explicit permission to do so under the applicable rules. In addition, RMB PE funds are required to have an operating term of no less than five years (actually, seven years or longer is encouraged).

Foreign investors may invest in PRC-formed PE funds (“Funds with Foreign Investments”) in the following ways:

• through their directly or indirectly controlled FIEs acting as general partner, limited partner and/or fund manager of PRC-formed PE funds with available onshore RMB funds; or
• through the QFLP scheme which allows foreign institutional investors to convert their foreign currencies into RMB funds for investment in PRC-formed PE funds.

In addition to the requirements applicable to RMB PE funds, Funds with Foreign Investments must also comply with relevant foreign investment restrictions, such as the negative list and foreign exchange controls.

Antitrust Filing/Merger Control

The Antitrust Bureau of the SAMR is the government agency in charge of the antitrust review of business concentrations or merger control under the PRC antitrust law regime, which generally includes the Anti-Monopoly Law, the Interim Provisions on the Examination of Business Concentrations, and the Rules on Filing Thresholds for Business Concentrations, among others. A PE-backed transaction will be subject to merger control review (AML filing) if it involves the acquisition of control over the target company, and if the revenue of the parties involved meets the relevant thresholds.

It is noteworthy that the Chinese government has stepped up antitrust law legislation and enforcement since 2020. The SAMR published the Draft Amendments to the Anti-Monopoly Law for public comment in early 2020, according to which, companies that fail to comply with AML filing obligations would be subject to a fine of up to 10% of their total revenue in the previous year, instead of the current maximum of RMB500,000. The aforesaid draft amendments have been included in the State Council’s legislative plan of 2021 and can therefore be expected to be issued in the near future. The Interim Provisions on the Examination of Business Concentrations issued at the end of 2020 enumerated the factors that should be considered in determining “control”, and the Antitrust Bureau also provided a quite broad interpretation of "control" in the relevant Q&A session. The Antitrust Guidelines on E-Platform Economy issued in early 2021 specified the principles of antitrust enforcement against internet platforms. It is noteworthy that since the end of 2020, the Antitrust Bureau has intensively launched investigations and imposed penalties on M&A transactions involving internet platforms, including a few cases in which minority equity investments were recognised as acquiring control of target companies, as well as cases involving VIE structures that were previously in a grey area in antitrust regulatory practice (eg, Alibaba Group's acquisition of Yintai Commercial, and China Reading Group's acquisition of Xinli Media). The above-mentioned legislative and enforcement developments reflect a trend of tightening antitrust regulation and supervision, and remind PE investors to pay more attention to the antitrust risks associated with their investments.

Restrictions on Foreign Investments

As mentioned in 2.1 Impact on Funds and Transactions, investments made by foreign PE funds and Funds with Foreign Investments in China are subject to restrictions or prohibitions under the negative list. The negative list has divided business sectors into two different categories: restricted and prohibited. Foreign PE funds may still make investments in the restricted sectors after satisfying certain requirements (eg, foreign-invested medical institutions are only allowed to be formed as Sino-foreign joint ventures rather than wholly foreign-owned enterprises) and after gaining prior approval from or being reviewed by the regulatory authorities in charge of particular industries (if applicable) or the SAMR. No foreign investor is allowed to hold equity interests directly or indirectly in any target company engaging in any prohibited sector (eg, online publishing, online audio-visual programme services and genetic diagnosis and treatment). To avoid the restrictions under the negative list, foreign investors may, in practice, realise an M&A transaction through a VIE structure (which has been widely adopted in the TMT industry), as opposed to direct or indirect ownership structures.

National Security Review

The Chinese government established a national security review mechanism on foreign M&A transactions in 2011, according to which, an M&A transaction in which foreign investors collectively take control of a PRC-formed company engaging in sensitive sectors will be subject to a PRC national security review led by MOFCOM and the NDRC. The national security review scheme was further confirmed by the Foreign Investment Law, which came into effect in January 2020. Furthermore, the Rules on Security Review of Foreign Investment, which came into effect in January 2021 have systematically specified the type of foreign investments and sensitive industries generally subject to a security review, the authorities in charge of the review, as well as the scope and procedure of the security review. However, except for a few industries expressly specified in the relevant rules, the Chinese government has not yet released detailed guidance on the list of “sensitive industries” that are subject to security review.

In practice, a foreign PE investor may need to consult with the competent regulatory authorities if it plans to perform a transaction involving a change of control, on a case-by-case basis. The most recent publicised case in connection with a national security review of foreign investments was Yonghui Superstores’ acquisition of Zhongbai Holdings Group in 2019.

Foreign Exchange Controls

Even though significant efforts have been made to streamline foreign exchange procedures, transactions by foreign investors are still subject to various foreign exchange controls and restrictions, including (without limitation) restrictions on the usage of the funds available in target companies’ capital accounts (which are generally not allowed to be used for external loans, nor to build or purchase real properties that are not for self-use), and those on cross-border loans and guarantees between PRC target companies and their foreign shareholders.

Other Rules and Regulations

Various other PRC laws and regulations may be applicable to PE-backed transactions. Special qualifications for investors, and approval, registration and/or filing procedures, as well as specific information disclosure requirements, may be applied, depending on the various aspects of the target company, such as its business sector, whether it is a public company, and whether it involves a special ownership structure (such as a PRC state-owned enterprise).

The scope and level of legal due diligence in an M&A transaction is generally flexible, and is highly dependent on such factors as the target company’s development stage, the corporate structure, whether an auction process is involved, the bargaining power of the relevant parties, and other dynamics of the transaction. In general, the higher the transaction value or equity stake involved, the more detailed the legal due diligence would be. For listed companies, special rules should be carefully reviewed and evaluated to ensure compliance, particularly those governing insider information and disclosure.

Routine Due Diligence

A routine PRC due diligence exercise generally focuses on customary issues, such as incorporation and the history of the target company, the shareholder structure, operational licences and permits, material assets, material contracts, labour and employment, environmental protection, production safety, disputes, penalties and legal proceedings. Depending on the industry characteristics of the target company, some PE investors may request to conduct separate due diligence on specific aspects such as Foreign Corrupt Practices Act investigations, environmental health and safety assessments, and patent stability assessments.

Regulations in Emerging Industries

It is noteworthy that the Chinese government has continuously strengthened regulations on such emerging industries as big data, cloud computing, streaming media, biotech and the internet, with a focus on tackling "hot" issues involved (eg, unfair competition from internet giants, personal information protection, data privacy and cybersecurity). These hot issues have gradually become the focus of legal due diligence in M&A transactions involving such emerging industries.

In most M&A transactions in China, the buyers generally tend to engage their own counsel to conduct independent due diligence on the target companies. However, when the exit is conducted through a bidding process and/or when the seller only holds a minority interest in the target company and the target company or controlling shareholder is less willing to co-operate with a third party’s due diligence, the seller would strongly prefer a vendor due diligence report in order to control costs and the timetable of its exits. The buyer and its advisers are generally less willing to provide full credence to the vendor due diligence report and will be more careful in dealing with the representations and warranties from the seller side. For example, they may request the incorporation of the vendor due diligence report as part of the seller’s representations and warranties.

Acquisitions by PE investors are typically carried out through either a private sale agreement or an auction process. Judicial auctions are not commonly seen in China. The auction process is less likely to be adopted if the target company is a public company, as there is a higher possibility of information leakage, which will affect the transaction price. If the target company is a public company, transactions are often completed through private placements, block trading or tender offers, in addition to private agreements.

In a privately negotiated transaction, the parties usually set out the key commercial terms in the term sheet (which is usually non-binding); they may open new issues or reopen the terms addressed in the term sheet based on the investors’ due diligence findings and other deal dynamics during the documentation process. In an auction sale, the investors tend to focus on more essential terms in their offers, in an effort to secure the transaction. If the target company is a public company, there is generally less flexibility in the transaction structure and terms, due to the more stringent rules governing insider information and shareholders' rights, among other matters.

The structure of the PE-backed buyer will be determined by various factors, including the structure of the transaction as a whole, tax efficiency, liability segregation, information disclosure, and efficiency of management. In general, China has a less flexible regulatory regime for the incorporation, organisation and governance of relevant legal entities. A PE fund in China is normally formed as a flow-through limited liability partnership under PRC laws, and an additional structure would generally increase management costs and other potential tax burdens. Such a fund therefore more often participates directly in an acquisition, as a direct buyer. Foreign PE investors usually prefer to establish an SPV for an acquisition (most commonly in tax havens such as the British Virgin Islands or Mauritius), and are less likely to be directly involved in the acquisition documentation.

In general, China has a fairly stringent financing system that involves expensive financing costs and high qualification requirements, especially for a private (as opposed to state-owned) borrower. As such, it is not common for PE investors to use leveraged bank loans to complete a transaction in China. Furthermore, sellers in China are generally reluctant to accept a closing condition regarding the obtainment of financing or equity commitment letters from the investors.

As the PE industry is relatively young in China, the majority of PE funds lack adequate experience in post-closing management, and their value added to the target companies is not yet apparent. Furthermore, following a transaction involving a change of control, the target company is normally required to operate for three more years before its IPO, and the controlling shareholder is generally required to be locked up for three years after an IPO (as opposed to one year for minority shareholders). As such, most PE investors (except for some industrial funds or government-backed M&A funds) tend to take a minority stake in a transaction in China. With the development and materiality of the PE industry in China, however, PE funds are becoming more willing to hold a majority stake in China.

Many M&A transactions in China involve a consortium of PE investors, which is particularly driven by the shortage of quality target companies and soaring valuations for a limited number of unicorn enterprises in recent years. Depending on the deal-specific dynamics of the transaction, a buyer consortium led by PE funds may include their major limited partners, other affiliates, existing investors of the target company and unrelated third-party co-investors.

Completion accounts, fixed price and estimated valuation with performance-based adjustments are more typically used to price PE transactions involving a non-public company in China. For a transaction involving a public company, the purchase price is generally determined based on the trading price of the company’s shares on the securities market, subject to certain statutory restrictions.

When there are greater uncertainties for the post-closing performance of a target company, the transaction parties may adopt a more flexible consideration mechanism, such as performance-based VAMs, earn-outs and/or deferred payment. These kinds of flexibilities are not uncommon in China’s PE transactions (but are rarely seen in public target companies).

Each of these consideration mechanisms reflects, to some extent, the risk allocations between the seller and the buyer in a transaction. On the one hand, a PE seller generally prefers a fixed price, in order to avoid uncertainties and limit the period from signing to closing as much as possible. On the other hand, a PE buyer would generally like to adopt completion accounts, price with VAMs, earn-outs and/or deferred considerations as protections against future uncertainties.

In general, a PE seller and a corporate seller do not disagree too much in terms of consideration mechanisms, while a corporate buyer (compared to a PE buyer) is more likely to offer a higher price and better consideration in favour of the seller, given the potential strategic advantages and synergies with the target company.

The locked-box consideration structure is not commonly seen in the PRC PE investment market. The relevant discussions and practices with respect to leakage during the period from the pricing date to the closing date are very limited.

In order to determine the relevant accounts in a timely manner in the case of the completion accounts mechanism, and to avoid disputes, the parties usually specify the composition of pricing-related items and the specific process to follow in order to determine the value of such items in the transaction documents. For example, the transaction documents typically provide the following, among others:

• that an auditor be appointed if the parties cannot agree on the completion accounts;
• the mechanism for determining such an auditor; and
• the buyer’s right to conduct an independent audit.

The closing conditions of PE transactions vary significantly, depending on the deal-specific dynamics. In general, basic closing conditions for PE investments commonly include power and authorisation to execute and perform the transaction, complete legal title of the subject shares, the obtainment of internal and external approvals or consents, true and complete representations and warranties upon signing and closing, no material adverse changes from signing to completion, etc. Financing of the closing funds is not commonly seen as a closing condition in China.

PE investors may require additional closing conditions, based on their due diligence review and other deal-specific concerns. For example, they may request the completion of a certain restructure, the transfer of significant intellectual properties, and the rectification of certain non-compliant activities, as may be applicable. For acquisitions by foreign investors, the closing conditions of buyers often include the successful opening of certain special purpose foreign exchange accounts by the PRC sellers.

Whether third-party consent will be required as a closing condition mainly depends on the target company’s contractual obligation in this respect and whether failure to obtain this will have a material adverse impact on the target company. In practice, commercial banks or certain major customers of a target company may require prior consents in the case of a material change in the target company (such as a change of control); otherwise, the banks may accelerate the repayment of loans and the customers may terminate their contracts with the target company early, or cancel the target company’s vendor qualifications, which may materially affect the target company.

“Hell or high water” undertakings are relatively rare in China. Instead, if the parties reasonably believe that a certain regulatory condition (such as government approval for merger control, a national security review or foreign investment in restricted sectors, registration by the SAMR or the opening of certain special purpose foreign exchange accounts, etc) is necessary prior to the closing, they would usually accept such a requirement as a closing condition. If such a requirement cannot be fulfilled prior to the agreed longstop date, the non-breaching party will generally be allowed to terminate the purchase agreement without liability, usually without a break fee. To avoid abuse, the purchase agreement is usually specific to the regulatory condition, and will typically oblige the relevant party(ies) to make an effort to fulfil the regulatory condition as soon as practically possible.

In conditional transactions with a PE-backed buyer in China, it is not common to see break fees in favour of the sellers. In limited situations where break fees do apply, a PE investor is more likely to ask for reverse break fees, subject to a deal-by-deal negotiation. In a PRC law-governed transaction, break fees are often treated as liquidated damages in nature, which in principle should not exceed 30% of the non-breaching parties’ actual losses, according to prevailing judicial practice. Therefore, if the break fee is set too high in a transaction, the breaching party is likely to request that the courts reduce it to a reasonable amount.

Termination of an acquisition by a PE seller or buyer normally occurs prior to the completion of the proposed transaction or the receipt of necessary government approvals (if applicable), and is typically triggered by circumstances such as the occurrence of material adverse events, the discovery of undisclosed material negative matters, significant policy changes, and failure to satisfy closing conditions before the longstop date, among others.

PE buyers tend to require a comprehensive and detailed list of warranties and specific information disclosures from the sellers in the transaction documents. In addition to the indemnifications provided by sellers for their warranties and certain covenants, PE investors usually try to minimise their investment risks by building in price adjustment mechanisms, deferred payments, escrow arrangements, and preferential and flexible exit mechanisms in the transaction documents (such as anti-dilution rights, tag rights, drag rights, put option and redemption rights, and liquidation preference), among others. In exit transactions, PE sellers usually seek clean exits by limiting the scope of their warranties and liabilities as much as possible.

As for the limitations on liabilities, sellers usually wish to set de minimis, basket, caps and time limits to the claims for their indemnification liabilities. PE sellers rarely accept strict payment conditions, payment by instalments and escrow accounts for indemnities on exit.

As mentioned in 6.8 Allocation of Risk, a PE seller seeks to minimise the scope of their warranties and subsequent indemnifications for the sake of a clean exit. A PE investor holding only a minority stake in a target company (which is common in China) may only accept fundamental warranties concerning its due authorisation and shares to be sold. Such an investor is less likely to agree to warranties on the operational aspects of the target company, and, in terms of the financial and other material assets of the target company, a PE seller’s warranties are normally limited to its knowledge as a minority shareholder. If a PE seller is a majority shareholder, its warranties would then be more comprehensive and would regularly be subject to the management’s knowledge, as the target company is normally operated by the management. Furthermore, a PE seller would push for all due diligence data as disclosures, subject to negotiations with the buyer. Since the management is normally not a party to the transaction, it rarely issues warranties directly to buyers. Whether the buyer is PE-backed or not does not generally make a difference to warranties offered by a PE seller.

The seller’s liabilities for warranties are typically subject to de minimis, basket, caps and time limits, among others. The amount set for the relevant de minimis, basket and caps varies from deal to deal, depending on the transaction value, the asset value of the target company and, of course, the bargaining powers of the parties. Time limits or survival periods for indemnifications vary for different warranties – normally up to five years (occasionally longer) for fundamental warranties, two to three years for other warranties, and applicable statutory limitations for some specially negotiated items. In addition, except for the specially negotiated items, the seller’s indemnifications are generally not applicable to issues that have been disclosed or that have otherwise become obvious to the buyers prior to the signing.

To increase the enforceability of the seller’s indemnifications, in some transactions a buyer may withhold a portion of the purchase price in an escrow account until the lapse of a certain time period (eg, the expiry of the survival period). For matters with higher risks, the buyer may request the seller to eliminate such risks before closing, adopt instalment payments or even request a reduction of the purchase price against such risks. In some cross-border transactions, PE transactional parties may also seek to purchase warranty and indemnity insurances (W&I insurances) to minimise their potential risk exposures. Though still not common, an increasing number of China-related transactions are using W&I insurances, which are generally purchased through foreign insurance companies as they are not yet widely available from Chinese counterparts.

PE investors generally prefer to choose arbitration as the dispute resolution proceeding in PE transactions, especially in cross-border transactions, as arbitration is generally deemed to be more flexible and equitable, with more confidentiality in China. Arbitration institutions located in Beijing, Shanghai, Shenzhen, Hong Kong and Singapore are the more typical choices. In PE transactions, warranties, indemnities, earn-outs, redemptions and valuation adjustments are more frequently disputed.

Although legally feasible under PRC laws, public-to-private transactions are quite unusual in the current Chinese capital market, mainly for the following reasons:

• the current regulatory system allowing for de-listing is too general and lacks implementing rules;
• the time-consuming and stringent IPO review process makes public shell companies highly valuable;
• A-share listed companies feature more concentrated ownership structures; and
• the lack of a “squeeze-out” mechanism (see 7.6 Acquiring Less than 100%).

In practice, going-private precedents in the Chinese market so far have mainly been conducted by large-scale state-owned enterprises for internal restructuring and group-level listings. Going-private transactions that are more commonly seen in the US or UK markets predominated by PE investors, existing shareholders and/or management teams are still rare in China.

It is noteworthy that de-listing in the Chinese capital market has recently become more normalised and marketable, mainly due to such reasons as the implementation of the registration-based IPO system, the decrease in the value of public shell companies and the improvement of the de-listing rules. Though most companies were de-listed from the A-share market because of weak financial performance, it is expected that de-listing due to typical public-to-private transactions will emerge in the future.

According to the Administration Measures for Takeover of Listed Companies as amended in March 2020 and other applicable PRC laws, an investor of a listed company should comply with different levels of disclosure obligations, depending on the percentage of shares so acquired by it. In general, an investor’s disclosure obligation will be triggered if its shareholding in a listed company reaches or exceeds 5% of the company after the proposed acquisition, in which case, the investor should:

• file a written report within three days (notice period) to the CSRC and the stock exchange;
• notify the listed company; and
• make an announcement accordingly (initial disclosure).

Following the initial disclosure, the investor should comply with similar disclosure obligations (subsequent disclosure) every time it, on an accumulative basis, acquires or disposes of 1% of shares of the company through concentrated bidding or block sale systems, or of 5% or more shares of the company through private agreement; the details of such subsequent disclosure may vary, depending on the investor’s post-completion shareholding in the company. In addition to these disclosure obligations, an investor with 5% or more shareholding in a listed company should generally suspend trading of the company’s shares for a certain period (typically including the notice period and three working days after the announcement date), every time the accumulated shareholding change in the company obtained through concentrated bidding or block sale systems reaches 5%. Violation of these disclosure obligations will subject the investor to prohibition from exercising voting rights over the shares so acquired in a 36-month period.

Under the PRC regulatory regime, if an investor intends to increase its shareholding in a listed company after acquiring 30% of its outstanding shares, a mandatory tender offer to all other shareholders to acquire all or part of the remaining shares of the company should be made. If an investor intends to indirectly acquire no less than 30% shareholding in a listed company (such as a takeover of the controlling shareholder of the company), a general offer for all remaining shares of the company should be made, except for in some statutorily exempted situations.

Moreover, the amended Administration Measures for Takeover of Listed Companies replaced the prior approval for such statutory exemptions with an “ex-post supervision” mechanism. Mandatory takeovers are less common in the PRC market than in other mainstream foreign markets and, when triggered, statutory exemptions are often applied.

Cash consideration is much more commonly used in PRC public takeovers, except for backdoor listing deals (including reverse mergers by absorption). The PRC laws provide various requirements and restrictions to allow other forms of consideration in a transaction involving a public company. Foreign buyers’ choices are further limited due to regulatory limitations on strategic foreign investment in listed companies, foreign exchange control and cross-border share swaps. In practice, foreign PE investors usually choose to pay with cash in PRC takeovers.

It is noteworthy that the draft Revised Rules for Strategic Foreign Investment in Listed Companies issued for public comment in June 2020 proposed to streamline regulatory requirements and simplify the approval/filing process for cross-border share swap with respect to strategic foreign investments in listed companies. The revised rules have been included in the 2021 legislation plan of MOFCOM and it is anticipated that share payments will see a rise in foreign investments in A-share listed companies once the revised rules are released, hopefully in the near future.

There are no statutory restrictions on the closing conditions of public takeovers under PRC laws. In practice, compared to those applicable to the acquisition of private companies, closing conditions in PE-backed takeovers commonly focus on matters that are necessary for the effectiveness of the transaction, including the following:

• obtaining the applicable government approvals, registrations and third-party consents;
• obtaining all necessary internal approvals and waivers;
• proper execution and delivery of the main transaction documents; and
• ensuring there is no material adverse change and no material breach as of the closing date.

As in other non-takeover PE transactions, the obtainment of financing as a condition is unusual in takeovers.

Deal and regulatory processes for public takeovers in the Chinese market are quite different from those in the mainstream foreign capital markets. In general, there is no explicit requirement for the board of directors (or other corporate authority) of the target public company either to consider other unsolicited offers or to “go-shop” after the relevant agreement is signed or an offer is made. Consequently, it is not common to see such deal security measures as break fees, match rights or force-the-vote provisions, which are more popular in US or UK takeover deals.

In a public takeover, if a bidder does not seek to obtain 100% ownership of the target company or to convert it into a private one, it will generally not be able to enjoy preferential shareholder rights that are disproportionate to its post-closing shareholding in the company, based on the “one share, one vote” principle provided in the Company Law.

Lack of a "Squeeze-Out" Mechanism

For public takeovers, instead of having a “squeeze-out” mechanism in favour of the bidder, the existing PRC regulatory regime provides a “sell-out” right to the minority shareholders of the target companies. Under the sell-out mechanism, the minority shareholders of a listed company are entitled (but not obliged) to sell all of their remaining shares in the company to the bidder, on the terms provided by the bidder in the tender offer, if the post-closing capitalisation of the company no longer satisfies the requirement for a listed company. The lack of any squeeze-out mechanism and detailed implementing rules governing the custody and exercise of shareholder rights over the de-listed shares held by minority shareholders is regarded as one of the major legal obstacles for going-private transactions in the PRC market.

Under PRC laws, if a shareholder holding at least 5% of the outstanding shares of a listed company (ie, a “major shareholder”) makes any formal commitment with respect to the sale of the public company’s shares, it must disclose such commitment in a timely manner, and the commitment should be clear, specific and enforceable. In practice, for the sake of a stable market and more flexibility, a major shareholder is less likely to enter into any formal legal document before the execution of definitive transaction documents. In exceptional situations where an auction process is involved, a major shareholder may choose to announce its intention to sell, in order to publicly solicit buyers, and would generally apply to suspend the trading of the company’s shares in order to freeze the transaction price if possible.

Hostile takeovers are not common in the PRC capital market, although no specific restriction in this connection is provided under PRC laws. This is mainly due to the fact that PRC-listed companies generally feature a capitalisation that is highly concentrated to one single shareholder, with the majority of the remaining shares being scattered among individual investors. In addition, the new CSRC rules that an investor with 5% or more shareholding in a listed company will be subject to a disclosure requirement with respect to every 1% change in its shareholding in the company would make it more costly and inefficient for a hostile takeover conducted through the centralised bidding system or the block trade approach. Typical takeover precedents mainly include the takeover of ST Shenghua by ZheMinTou TianHong in December 2017 (which is generally believed to be the first successful hostile takeover in the PRC market) and the takeover of ST Kondarl Group by Kingkey Group in November 2018. That said, there has been ongoing shareholding structure reform to reduce ownership concentration involving PRC-listed companies, and battles for control rights have also gradually increased in recent years. It is possible that hostile takeovers may rise in the Chinese market in the future.

Share incentive plans or the like (eg, ESOPs) are one of the core commercial concerns in PE transactions in China. A private company may adopt such forms as stock options, restricted shares, phantom equity, etc. An option pool typically accounts for 10–15% of the total shares of a private company (on a fully diluted basis), among which, options reserved for the management team usually account for 50–70% of the total pool. For a PRC-listed company, the total shares under all valid ESOPs may be no more than 20% of the company’s total shares for a company listed on STAR Board or ChiNext Board, or 10% for a company listed on other A-share boards.

It is noteworthy that the CSRC has expanded the pilot rules and experience of keeping qualified pre-IPO ESOPs continuously valid after an IPO from STAR Board to Main Board and ChiNext Board. Under current practice, most of the qualified companies with pre-IPO ESOPs are listed on STAR Board (eg, National Silicon Industry Group, Junshi Biosciences and VeriSilicon).

As private companies in China usually have a relatively concentrated ownership structure and the founders normally retain absolute control over the companies, management participation in acquisitions of private companies remains uncommon in practice. Thus, currently available rules and regulations focus mainly on management participation in the reform or acquisition of state-owned companies and listed companies. Based on this, and subject to restrictions and requirements in respect of the management's fiduciary duties to the target companies and the fairness and openness of acquisition terms and processes, sweet equity and institutional strips are rarely seen in PE-backed MBO deals in the PRC market, compared to the US or UK. In China, the management of a target company typically participates in the proposed PE investment by teaming up with a PE investor to purchase shares of the target company at the same or similar price, assuming they have sufficient funds, or through exercising ESOPs adopted by the target company post-closing if the management does not have sufficient funds or is unwilling to co-invest with the PE investors.

Vesting/leaver provisions for manager shareholders are typically applicable to shares obtained under ESOPs, and the company or the controlling shareholder is generally entitled to acquire management shares upon the termination of management's employment. Leaver provisions are typically divided into “good leaver” provisions and “bad leaver” provisions. A “good leaver” usually refers to termination of management due to such reasons as retirement, disability, death, etc, while other circumstances are generally considered to result in a “bad leaver”. Generally, unexercised options/shares will be cancelled under both situations, while exercised shares held by a “good leaver” will commonly be redeemed by the company at the exercise cost or fair market value or net asset value, or will continue to be held by the “good leaver” until the occurrence of exit events, and exercised shares held by a “bad leaver” will be redeemed by the company at fair market value or exercise cost (whichever is lower), and the company is normally entitled to deduct from the redemption price an amount equal to damages (if any) caused by the “bad leaver” to the company.

Four years with a one-year cliff is a typical vesting schedule for options granted to a management team – ie, vesting will occur periodically over a four-year period after the first anniversary of the grant date. Additionally, vesting conditions of options granted to management teams often include the achievement of certain performance goals.

Manager shareholders are customarily requested to sign non-compete and confidentiality agreements before closing, and are subject to the obligations of non-compete, non-solicitation, confidentiality, non-disparagement, full-time commitment, etc. For key manager shareholders, continuous employment for a certain time period after the transaction may also be required.

Generally, protective measures available for a management team as minority shareholders are very limited. In circumstances where the management holds a significant stake in a target company and/or has significant influence over the company’s operation, the manager shareholders may ask for board seats or veto rights on material corporate actions of the target company.

To ensure a smooth exit, PE investors in an M&A transaction are reluctant to offer manager shareholders the right to control or restrict their exit. On the other hand, however, given that management’s co-operation and support on issues such as due diligence and the review or confirmation of relevant warranties, etc, appear to be necessary for a smooth exit, and given that the proposed buyer may request retention of the management, it is not uncommon in practice for the management to play an influential role in some aspects of the exit of previous PE investors.

As mentioned in 5.3 Funding Structure of Private Equity Transactions, PE investors in China more commonly seek a minority stake in target companies, and normally achieve a certain level of control over the target companies through the following arrangements.

• Director appointment – depending on the stake held by them in the target companies, PE investors normally request the right to appoint a certain number of directors or observers to the board, supervisors, and/or members of board committees. Where a PE shareholder has a relatively large stake, it may have a right to nominate senior managers to better protect its interests.
• Veto rights – if a PE shareholder does not control a target company, it will normally request veto rights over major corporate actions, including change of corporate capital/structure, charter documents, core business, board size and composition, annual budget, business plan, material investments, disposal of material assets, related party transactions, employee incentive plans, listing plans, etc. Under the trend of tightening antitrust regulation as mentioned in 3.1 Primary Regulators and Regulatory Issues, PE investors will need to pay more attention to compliance risks associated with their veto rights.
• Information and inspection rights – in addition to the general information rights enjoyed by all shareholders according to the Company Law, a PE investor often asks for additional rights, obliging the company to periodically provide financial statements and operation reports to the PE investor. Some PE shareholders may also ask for inspection rights to access and inspect the records and books of portfolio companies, either themselves or through a third-party auditor.

As discussed in 7.6 Acquiring Less than 100%, PRC public companies are generally subject to the “one share, one vote” principle in the Company Law, and PE shareholders of public companies are normally not able to enjoy preferential shareholder rights that are disproportionate to their shareholdings.

It is generally rare for a PE shareholder to be held liable for a portfolio company’s liabilities, unless this is pursuant to the doctrine of “piercing the corporate veil” – ie, if the PE shareholder abuses the portfolio company’s independent status to evade debts and seriously damages the rights and interests of the portfolio company’s creditors.

From a compliance perspective, a due diligence review prior to the transaction is not uncommon for PE investors. However, whether they decide to impose their internal compliance policies on a portfolio company will depend on a number of other factors, such as, the compliance risk level associated with the portfolio company’s industry, the sufficiency of the portfolio company’s existing compliance policies, the risk susceptibility of the PE investors, and non-compliance issues identified during the due diligence process. In practice, leading international PE funds and major domestic investment institutions are more likely to require portfolio companies (especially those engaged in industries with high compliance risks) to adopt and maintain relevant compliance policies after the transaction.

The typical holding period for PE transactions in the Chinese market ranges from five to eight years, subject to the specific dynamics of each deal. Common exit routes for PE investors include IPOs (including backdoor listings), trade sales, share transfers, repurchase by controlling shareholders or redemption by target companies. As of the first quarter of 2021, the most common exit routes appear to be IPOs (which have recently increased significantly due to continuous reforms in the Chinese capital market) and share transfers. Considering the market and regulatory uncertainties associated with the listing process, a PE investor pursuing an IPO exit normally considers other exit alternatives at the same time, such as a trade sale, repurchase by major shareholders or redemption by target companies.

Whether PE investors will reinvest upon exit mainly depends on the provisions of their constitutional documents and the deal-specific dynamics. In general, if PE investors exit within six months after the investments, they are likely to apply the proceeds received from the exits to investing in other projects.

Drag rights are one of the most typical arrangements in PE investments, though they are not a necessity. Whether to include drag rights in favour of the PE investors in a transaction mainly depends on the rounds of investments, the bargaining powers of the parties and other deal dynamics. For institutional investors (such as PE funds) that intend to include the trade sale as one of their exit alternatives, drag rights are of particular importance. In practice, it is not uncommon to see PE investors exit by exercising their drag rights. CVC’s acquisition of South Beauty in 2012 is a good example.

The conditions for exercising drag rights in PRC deals do not differ much from those in deals conducted in other jurisdictions, and normally include the following:

• shareholding ratio requirement – drag rights will not become exercisable unless and until approvals by shareholders with certain shareholding percentages are obtained (such as shareholders representing at least 50% of the voting rights), or the proposed shares for transfer reach a certain percentage of all issued shares of the target companies (such as more than 50% of shares);
• the valuation requirement – drag rights will not become exercisable unless and until the valuation of the target companies reaches a pre-agreed minimum amount; and
• the time requirement – drag rights will not become exercisable unless and until the target companies fail to complete a qualified IPO within an agreed time period.

In M&A transactions with multiple PE investors, the exercise of drag rights is usually a highly negotiated term, and is more commonly decided by a majority of the PE investors (or the PE investors holding a majority of the shares of such investors).

As mentioned in 8.5 Minority Protection for Manager Shareholders, PE investors are reluctant to grant influential rights to manager shareholders with respect to their exits. Thus, unless the manager shareholders have strong bargaining power, PE investors rarely agree on tag rights only in favour of the manager shareholders, although they usually ask for tag rights in the case of exit of other shareholders, particularly controlling shareholders, founder shareholders or important manager shareholders. For PE investors’ exits from portfolio companies with a relatively dispersed ownership structure or having undergone several rounds of equity financing, the triggering event for exercising tag rights in favour of other shareholders (if any) is normally set as a change of control or agreed trade sale event of the portfolio companies, while PE investors would try to relax the triggering threshold for tag rights in their favour. Exit rights enjoyed by institutional co-investors are generally consistent with those of the PE investors.

Lock-Up Arrangements

In China, in an exit by way of IPO, the lock-up periods applicable to PE investors are typically one year (for minority shareholders) or three years (for controlling shareholders) after the IPO. It is noteworthy that, for a company without an actual controller, the shareholders whose shares, ranking from high to low, collectively constitute 51% of all issued shares of the company prior to an IPO will be subject to a 36-month lock-up period from the IPO date (except for the shareholders who are qualified venture capital funds). However, any investor who acquires shares in a company within 12 months before the IPO application of such company will be subject to a 36-month lock-up period from the date of acquisition.

Other Restrictions

Transfer of pre-IPO shares

Besides these lock-up arrangements, a transfer of pre-IPO shares on the secondary market by a shareholder via a block trading or centralised bidding system is also subject to certain restrictions. For example, the share reduction plans must be publicised by the selling shareholder in advance, and the total shares sold every three months (restriction period) may be no more than 1–2% of the total issued shares of the listed company. It is noteworthy that, pursuant to new rules issued by the CSRC in March 2020, for a PE investor filed with the AMAC, the restriction period applicable to its sale of pre-IPO shares in certain qualified listed companies (such as hi-tech public enterprises) will be in inverse proportion to the time period of its pre-IPO shareholding (eg, the sale of pre-IPO shares by a PE investor with an over 60-month shareholding period will not be subject to any restriction period).

Independence of an IPO applicant

The independence of an IPO applicant (including independence in terms of assets, businesses, organisational forms, personnel and finance) and the fairness of its related party transactions are among the CSRC’s major concerns when reviewing and assessing its IPO application. An IPO applicant should disclose and make commitments in its prospectus that it has met the basic requirements in terms of company independence. Though the controlling shareholder of an IPO applicant is not obliged to enter into any “relationship agreement”, it may voluntarily provide a commitment letter on the independence of a company and the fairness of related party transactions, in an attempt to accelerate the IPO process.