New China regs herald dry period

As investors from International Data Group and Accel Partners—who jointly announced last week a second fund target at China (see story, page 9)—investing in China from an offshore fund is likely to become increasingly difficult as a result of new regulations.

The regulations, referred to as the Implementation Rules, “will have a profound impact on how cross-border VC/PE transactions are done,” said Rocky Lee, head of the China venture capital and private equity practice at DLA Piper, in a statement.

Going forward, Lee and other lawyers say, closing deals will require more layers of government approval. For example, an offshore special purpose vehicle with Chinese residents as shareholders must obtain an approval letter from China’s Ministry of Commerce to establish an onshore subsidiary or engage in cross-border M&A. The government will also require, among other things, that partners provide three years of financial information about targeted companies and that they register option plans with China’s State Administration of Foreign Exchange.

Currently, enforcement of the Implementation Rules is not uniform, but Lee says he expects it will become consistent over time.

At the same time, Chinese regulators appear to be stepping up implementation of measures to encourage China-based companies to list on domestic exchanges. A law that took effect in September requires Chinese companies seeking to go public on overseas exchanges to first obtain approval from China’s Ministry of Commerce. As a result, companies seeking to launch stock offerings on foreign exchanges have been unable to move forward with IPOs as they await approval.

“We believe that the Implementation Rules, together with the government’s unwritten policy to encourage onshore listings, may herald another dry period for offshore investments in China and offshore listings of Chinese companies,” Lee says.

DLA Piper is advising companies and investors with transactions in process to close deals as soon as possible. For the long-term, venture capital and private equity funds committed to investing and acquiring Chinese enterprises may be forced to establish Renminbi-denominated funds and to consider exits on domestic markets, the firm says. (Renminbi is the official currency of China.)

So far, new regulations don’t appear to have put a damper on VC activity in China. VCs have continued pouring money into China during the second quarter, investing $420 million in 47 companies, according to Thomson Financial (publisher of PE Week). The investment pace slowed 22% from the $544 million invested from the first quarter, but was still higher than the $387 million invested during the second quarter of 2006.

Chinese Internet companies, in particular, have been sought after by U.S. investors, with social networking site 51.com, content delivery network ChinaCache, and matchmaking service love21cn.com each raising rounds of more than $10 million, according to Thomson Financial.

And new funds continue to come forth. IDG and Accel announced last week a second China fund targeted at $510 million. Kleiner Perkins Caufield & Byers closed on $360 million for its first China fund, while Infinity Venture Capital raised $155 million for a hybrid China/Israel fund, and Softbank Asia Infrastructure Fund closed on $1.1 billion for its third fund.

Sequoia Capital, meanwhile, is nearing the final close on two funds for China, including a targeted $225 million early stage fund and $450 million for a growth stage fund, according to recent regulatory filings.