Equity controls in China

With a market share of 40%, China has positioned itself among the most influential players in Venture Capital worldwide, second only to Silicon Valley’s 44% market share (The Diplomat). Its position as an important global player is emphasized by the fact that by October 2019 China alone had produced around 45% of all the unicorns – privately held start-up companies with a valuation of over $1bn – around the globe (Blue Future Partners).

VC targets

According to a 2018 analysis carried out by Blue Future partners, nearly half of Chinese capital is invested in Internet and IT. The runners-up are Biotech and Healthcare alongside Automotive and Machinery Manufacturing with each making up a 10% share. The following prevalent divisions are Semiconductor & Electronic Equipment (8%), Telecom (5%), Entertainment & Media (4%), Education (3%), retail (3%) and the rest (8%).

Covid-19 and the evolution of Chinese VC

The most evident impact of Covid-19 has been the steep reduction in number of deals translating to a fall of almost 50%. In particular, in 2020 there have been only 4,000 deals in Chinese VCs compared to the 7,659 deals in the previous year. However, projections for 2021 are hopeful given the rebounding of the deal paces in the second half of 2020 and given that China has shifted its investment focus towards a different country.
The reason for this shift of focus lies in the tension between China and India over the border clashes in the Himalayas and has resulted in China losing a major market. Precisely, at the start of 2020 alone, China had financed 90 Indian start-ups with an overall value of $4bn while also having funded 18 of India’s 30 unicorns. However, even since the ban on Chinese investments in India, Chinese VCs have looked towards Indonesia. The reason for this lies in the fact that not only does Indonesia detain the highest number of billion-dollar start-ups in Southeast Asia, but it also has experienced a 55% increase in digital economy in the first half of 2020.

PE in China

Private equity in China has become the third largest global market and the most popular investment destination in Asia, accounting for two thirds of all investment funds. Nevertheless, it seems that the Chinese PE market has yet to reach its peak. In 2019, PE in China comprised only 0.5% of GDP, which when compared to the United States’ and United Kingdom’s level of 2.2% and 2.6%, respectively, is still a really limited share.
Regardless of its limited share, the People’s Republic of China remains an appealing investment destination and has experienced major growth in the decade going from 2009 to 2019. Specifically, not only has this decade seen a 29% compound annual rate of growth for fundraising, but the average deal size has shot up from $36m to $75m. Additionally, the number of deals over $500m shifted from 1% in 2019 to a staggering 40% in 2019.

Advantages of PE in China

Private equity funds in China mainly derive the benefit of high returns – having on average, a higher Return on Investment (ROI) than western countries – and the benefit presented by the ability to expand its business in the large Chinese economy. In recent years, as the country transitions to a market economy, PE has also experienced an increase in investment opportunities driven by the growing number of companies which have met the criteria necessary to be funded by PE firms. All of these factors have, cumulatively, pushed PE firms away from Limited Partnerships (LPs) to General Partnerships (GPs).

Obstacles for PE in China

The obstacles connected to investing in China concern the issues related to the highly regulated market and issues pertaining to selection stages. The latter is characterized by the fact that in recent years – because of the high returns on Chinese investments – competition has increased, consequently triggering scarcity of good deals and the skyrocketing of valuations. All of these factors combined have contributed to an increase in investment risk over time.
With regards to regulations in China, foreign PE funds face the obstacle of having to understand and meet stricter due diligence procedures and legal concerns instigated by the lack of a strong legal ecosystem. In addition, the lack of audited financial statements in many small private Chinese companies poses a threat to proper valuations. However, the most concerning factor is currency risk. This has been progressively problematic since 2006, when the Renminbi (RMB) switched to a floating system of exchange rate management, which led to a higher volatility and an increased difficulty in the valuation of target companies. This system also entails that the government can devalue or appreciate the currency without warning and thus causing another factor of uncertainty for investors.

How PE firms enter the Chinese regulated market

The main distinction in strategies adopted by PE firms when accessing the Chinese market lies in whether the PE firm is an on-shore or off-shore fund.
In the on-shore model, the PE firm invests using a Special Purpose Vehicle (SPV) directly in an on-shore domestic Chinese enterprise, and as a result it becomes a shareholder in the target company.
On the other hand, however, in the off-shore model an SPV targets the off-shore holding company of the Chinese target company by acquiring a stake in it or assuming full ownership . Often this process occurs through an 100% owned intermediary company located in Honk Kong which in turn owns 100% of a subsidiary company located in the People’s Republic of China (PRC). The latter, or rather the PRC subsidiary, is also referred to as a WFOE (wholly foreign enterprise).
Nonetheless, not always is the target company structured as being owned by a foreign holding company, but since the off-shore model is more advantageous for PE firms, target companies are usually required to restructure into an off-shore structure themselves. The reason for this model being more advantageous arises from the fact that the most common exit strategy consists of an IPO listed on a stock market outside the PRC.

Subsidiaries or Foreign Invested Enterprises

Foreign investors looking to deal directly with China are faced with the different problems and regulations limiting their involvement in the Chinese economy. In fact, even if foreign investors have a resident representative office in China, that alone doesn’t enable them to do business directly without an approved business license. The solution to this set of problems lies in establishing Subsidiaries, which are often referred to as FIEs (Foreign Invested Enterprises).

Characteristics of subsidiaries

Subsidiaries in China are entities where at least one of the shareholders is a foreign entity or a foreign investor incorporated or with citizenship outside China. The foreign investor must have at least 25% equity shares and his country of origin does not impact the approval procedure or treatment of the FIE. Needless to say, the country of origin will have tax implications depending on the country’s taxation agreement with China.
Another important factor when setting up a subsidiary is the relationship with local authorities as this can determine the ease with which the business can be set up. Regarding the costs of setting up an FIE, there are three key elements. The first two are the registration fee and the announcement fee, which overall are typically less than $8,000. The last key element is the “registered capital”, which is a requirement by the Chinese authorities for investors to put real money into the subsidiary and to contribute at least with 15% of registered capital within 90 days of the issuance of the business license.
The most important restriction regarding FIEs, however, has to do with Foreign Exchange and the fact that foreign currency cannot circulate in China. In particular, a subsidiary’s revenue in foreign exchange must be converted into RMB – Chinese lawful currency called “Renminbi”. Despite this, lawful payments outside of China are permitted to be converted into foreign currency.

Is investing in Chinese VC or PE feasible?

For a foreign fund the Chinese market presents a great opportunity for capital allocation in both Private Equity and Venture Capital alike given the high return on investment in the latter and China’s high market share in the former. However, it is essential to analyse and evaluate the many obstacles presented by regulation in the People’s Republic of China and use this as a base to decide whether to invest. This decision will mainly be based on economic capacity and size of the foreign fund looking to approach the Chinese market. Therefore, it is advisable to invest in such a large and growing market such as China only if the foreign fund can bear the costs associated with complying with Chinese regulation.

Author: Jakob Jones

Editor: Tiago Guardão

References:

https://assets.fenwick.com/legacy/FenwickDocuments/Establishing_Subsidiary_in_China.pdf (Silicon Valley law firm)

https://www.mckinsey.com/industries/private-equity-and-principal-investors/our-insights/in-search-of-alpha-updating-the-playbook-for-private-equity-in-china (McKinsey report)

https://corporatefinanceinstitute.com/resources/careers/jobs/private-equity-in-china/ (Corporate Finance Institute)

https://thediplomat.com/2021/01/the-global-reach-of-chinas-venture-capital/ (The Diplomat)

bfp.vc/venture-capital-in-china-landscape-overview/ (Blue Future Partners)