Newly Proposed China Guidelines Could Stymie PE Market

Sarbanes-Oxley never looked so good. SOX has been called one of the most significant changes to affect federal securities laws in the United States since the New Deal.

But private equity professionals are just as worried about two new circulars proposed by China. If they are passed into regulation on Nov. 1 – as many believe they will be – then the draft circulars would establish potentially devastating guidelines for private equity firms doing business in China.

One of the new proposals – submitted by the State Administration for Foreign Exchange (SAFE) and the Ministry of Commerce (MOFCOM) – calls for every resident of China to seek approval by SAFE for his or her business plans. Included in the approval submissions is investment information on overseas holding companies. The regulation is also retroactive, seeking information on past investments.

The second circular, created by MOFCOM and the State Administration for Industry and Commerce (SAIC), affects the mergers and acquisitions of domestic Chinese companies by foreign investors. Under this proposal, M&A work in China would require PE firms to provide financial background information about the acquirer to Chinese authorities, and transactions would require approval at several stages by an “examination authority.”

The M&A document also calls for a listing of all “shareholders holding 5% or more of the equities issued by the overseas company” involved in the acquisition. Some critics of this proposed regulation suspect that the Chinese government could then assess taxes on every LP invested in a foreign fund that makes an acquisition of a China-based company.

The current model of Wholly Owned Foreign Subsidiaries, which conduct business in China, was created by U.S. attorneys in the late 1990s to allow VCs to exit their investments in Chinese domestic startups through the use of offshore holding companies. Such a structure has been used by virtually every firm that has listed a Chinese company on the Nasdaq stock market in the last 10 years.

Rocky Lee, a venture capital and private equity lawyer based in the Beijing office of the law firm Lovells, notes simply that the regulations could carry an adverse ripple effect for foreign venture investors in China, such as The Carlyle Group, among others.

Not everyone is negative about the new circulars. Stephen Toronto, managing partner of Morrison & Foerster’s legal practice in Beijing, says that most private equity professionals see the circulars as a positive development, giving the Chinese PE market some much needed standardization.

“But time will tell,” Toronto says. “We need to see the final regulation, not just the draft, before we can make any public comments.”