Onshore IPOs and China VIEs: Replacement capital?

The price tag attached to Focus Media's reverse merger in Shenzhen is RMB45.7 billion ($7.37 billion), more than twice what a consortium of PE investors and management paid to privatize the then-NASDAQ listed business in a deal completed two years ago. These backers might be anticipating a far higher valuation when they eventually make their exit.

Assuming Focus Media completes the merger with Jiangsu Hongda New Material it will take its place on a bourse that has been trading at an all-time high. The Shenzhen Composite Index has gained nearly 100% in the last six months; the average price-to-earnings (P/E) ratio is 38, compared to 23 for the NASDAQ 100 Index.

The RMB45.7 billion figure is the product of a series of transactions through which ownership of Focus Media was restructured. But one previous complication has been removed. The variable interest entities (VIEs) used to separate offshore investors from assets to which they could not have direct exposure - put in place ahead of Focus Media's 2005 IPO - no longer apply due to a relaxation of foreign investment restrictions in the advertising industry. This means The Carlyle Group, FountainVest Partners, CITIC Capital Partners and Primavera Capital can hold stakes in the listed entity.

It is a regulatory nuance, but a significant one. With China's capital markets in overdrive, local entrepreneurs are now targeting IPOs or reverse mergers on domestic bourses. Not only has there been a surge in take-private bids for US-listed Chinese companies, but unlisted start-ups are also reevaluating their options. Structures set up offshore to facilitate US IPOs are now being replaced by onshore vehicles.

Provided the industry in which a portfolio company operates is not barred to foreign investors, an offshore VC fund can switch their ownership to the onshore entity and look forward to the upside. These are predominantly technology companies, though, and many - but not all - hold internet content provider (ICP) licenses that are off limits to foreign players. An onshore listing can't come with a VIE attached, so in these instances VC firms must sell their positions.

Changing dynamics

The situation represents a potential dilemma for VC investors with US dollar-denominated funds, not only in terms of current portfolio companies but also their ability to secure future investments if entrepreneurs would prefer to get funding onshore and in renminbi. However, questioning the viability of these funds, or the VIE structures they often employ, is premature.

Onshore restructuring is certainly being addressed by investors and entrepreneurs, but as Ron Cao, managing director at Lightspeed China Partners, puts it: "These are real-time discussions over a complex set of issues." They are taking place against a backdrop of uncertainty. While the government has spoken of its desire to see technology companies list domestically, it has yet to put mechanisms in place. And it is unclear whether valuations will remain heady enough to overcome the risk factors.

"It is not just the P/E ratio," says Maurice Hoo, partner and head of the M&A and PE practice at Orrick. "There is currency strength and convertibility, the relative robustness of the US capital markets versus the Chinese capital markets, and the ability to control the timing because listing in China still comes with a high level of uncertainty. In 2008-2009, for example, various people looked at it but not everyone tried to do it."

He is referring to a period after the global financial crisis when the US markets were weak and it was unclear when demand for new listings would bounce back. For about 12 months, a China listing seemed much more appetizing.

Similarly, when a number of accounting scandals involving US-listed Chinese companies in 2011-2012 turned international investors cold on all mid-cap China stocks, there was a spate of privatizations. Founders and their PE backers concluded that the difference between these companies' depressed valuations in the US and what they might trade for back home made action economically justifiable.

The current phase is different in that US markets are not necessarily underperforming. Rather, since the beginning of this year China has outperformed, with the Shanghai A-share market, Chinext and the Shenzhen SME Board reaching record highs in June, alongside the Shenzhen main board. Listings on these bourses are not the only factor. The National Equities Exchange and Quotation (NEEQ), commonly known as the New Third Board, has also been transformed.

"If you asked me a year ago I would have said the New Third Board wasn't an option because there was little fundraising," says J.P. Gan, managing partner at Qiming Venture Partners. "But recently there have been a number of cases in which companies have raised billions of renminbi, which is real money by any measure. Increasingly, we are seeing NEEQ as a viable fundraising platform - as long as you can raise money at a high valuation."

This market, which started as a pilot program enabling high-tech focused small and medium-sized enterprises (SMEs) to raise capital, is an antidote to the long waiting times and strict requirements of the other boards. With participation limited to qualified investors, companies do not have to show two years of profitability to list. Start-ups that had assumed liquidity was years away now have a fast track.

"I have a company that was in the middle of a Taiwan IPO and decided to scrap it and go for the New Third Board," says James Lu, a partner at Cooley. "The record for listing a domestic company is one month but typically it's a three-month process. No wonder everyone is saying, ‘Let's do it now.'"

Taking action

The restructuring process itself is not overly complex, especially if the target has not yet listed. VC firms invest in an offshore vehicle, which holds onshore assets through a wholly foreign-owned enterprise (WFOE). If there are restricted assets, they are placed in a parallel structure owned by one or more Chinese nationals, usually the company founder. The VIE secures the WFOE's interest in the parallel structure.

To take this apart, shares in the offshore entity are cancelled and the WFOE converts to a new structure, perhaps beneath the entity that holds the VIE. If foreign participation is still permitted in a minority capacity the company could become a Sino-foreign joint venture; if not, the investors are cashed out.

There are, however, several issues that could complicate these transactions. First, selling or transferring shares in the offshore entity incurs capital gains tax. Then there may also be a levy arising from changes in the ownership of the WFOE and VIE entities, particularly if the latter takes ownership of the former. Furthermore, the valuations at which these transactions happen may result in larger future tax liabilities.

"Let's give the VIE a nominal valuation of $100. If you spend $90 cashing out the foreign investors and then you invest $10 into the onshore company to get $100 worth of value, the cost base of the onshore company's shares is only $10. If you subsequently sell the company for $100, you are crystallizing a $90 gain in China, which is taxable," says Christopher Xing, a partner at KPMG. "It's a very difficult issue to resolve because there is no cross-recognition cost base under Chinese tax law."

Second, these transactions require financial support. In the case of a privatization or the onshore restructuring of a company operating in a restricted industry - which means the foreign investors have to be taken out - a founder needs capital to buy the shares.

If a company is valued at $1 billion, it would cost around RMB1.2 billion to redeem a shareholder with a 20% stake. Even at half this valuation, few VC firms have renminbi vehicles capable of addressing transactions of this size. Capital flooded into US dollar VC funds last year, with GGV and Qiming raising $620 million and $500 million, respectively. On the renminbi side they are smaller. GGV has raised two local currency funds of RMB600 million and RMB1 billion through an affiliate, while Qiming also has a RMB1 billion vehicle.

It is generally accepted that there will be a spike in renminbi fundraising as investors rush to capitalize on the restructuring opportunity. Sequoia Capital is understood to have teamed up with local brokerage Huatai Securities to raise a RMB10 billion fund and China Renaissance has a similar arrangement with CITIC Securities. Plenty of newcomers to the space are also working with investors on potential deals.

"It would be foolish not to take advantage of this - everybody is doing it," says one of these GPs. He is talking to VC firms that might have to exit positions and estimates that if one can be sourced from each of the top 20 players in China, the restructuring and re-listing process would keep his team busy for two years. "Some might fail; some might have issues during the process. If we complete 10 I would be happy," he adds.

Conflicts of interest

Industry sources say there are GPs restructuring large swathes of their portfolios with a view to transferring investments from US dollar funds to renminbi funds they also manage. However, it is doubtful whether the trend will catch on among the more established US dollar managers that have sophisticated international LPs. This is where third parties hope to come in.

When VC firms started setting up renminbi funds alongside their US dollar vehicles several years ago, there was some disquiet among foreign LPs who were concerned that the local currency funds - in which they were not able to participate - would get preferential treatment in terms of investment allocation. This has arguably held back some firms' renminbi ambitions.

Transferring assets from one fund to another, therefore, is fraught with potential fiduciary conflicts. How does a GP ensure alignment of interest when it has two funds, with completely different sets of LPs, on either side of a transaction? For many, the answer is to proceed with caution.

"Our renminbi fund, which is run by a separate team, would not provide all the restructuring capital, so we could participate but we would not drive a transaction," says Jixun Foo, managing partner at GGV. "And if it is our own portfolio we would definitely not want to be negotiating with ourselves. We need to be clear where we stand - we are either seller or buyer, we can't be both."

As a result, the drivers of these transactions may well be new pools of capital. Partnerships between GPs and brokerages such as Huatai and CITIC Securities are likely to be an enduring theme: the former provide deal flow and transaction expertise, while the latter have plenty of high net worth individuals in their client bases that want access to the private market alpha associated with technology stocks.

Though negotiations are challenging when one group of investors is replacing another, the outcomes are tolerable as long as China's public markets continue to imply that companies can achieve a substantial valuation premium to what is paid to the exiting investors. "Imagine a company is trying to get on NASDAQ at 30x and then all of a sudden there is talk of this mystical 100x on China exchanges," notes Rocky Lee, Asia managing partner at Cadwalader. "There is nothing wrong with a US dollar fund getting 30x return and exiting, provided the companies actually have the ability to cash them out."

There are ways around temporary cash shortfalls. For example, should a company avoid waiting for an IPO by arranging a reverse merger into a listed entity, it can raise capital by issuing shares and use that to redeem investors through a combination of cash and shares. This is of course contingent on the company meeting listing requirements - notably the profitability criteria - and not being in an industry where foreign ownership is prohibited.

James Lu, a partner at Cooley, has also seen agreements whereby the buyer settles a portion of the transaction up front in cash and then makes an additional payment if the company reaches a certain valuation on listing.

Echo chamber

Beyond this, the debate descends into a series of ifs and buts. Earlier this month Premier Li Keqiang said the government would promote start-ups with "special ownership structures" to list onshore. In the absence of further detail, rumor is occupying the policy vacuum.

Some industry participants predict the creation of a new board on which companies that are already listed overseas can issue Chinese Depository Receipts, enabling local investors to own stock despite the presence of offshore structures and VIEs. This would certainly be quicker than privatizing businesses and re-listing them domestically.

Meanwhile, GGV's Foo is among those who believe that the planned transition from an approvals-based system for IPOs to a disclosure-based model will, ultimately, result in the relaxation of the requirement that companies have been profitable for at least two years. This would open up other markets to start-ups that are currently confined to the New Third Board.

Even on VIEs, there is hope of reform. The Ministry of Industry and Information Technology (MIIT) recently announced that foreign investors would be able to fully own and operate e-commerce companies. Coming a few months after the publication of the draft Foreign Investment Law - which proposes that VIEs only be permitted if the associated operating company is controlled by Chinese nationals - it is reassuring. The move may even point to a more flexible attitude towards foreign ownership of ICP licenses in certain areas.

"They will probably limit foreign ownership of ICP licenses to pure transaction-based companies such as e-commerce, which has nothing to do with more sensitive areas like content and video-sharing," says Qiming's Gan. "It makes sense because China has already opened up to foreign investment in offline retail."

It is important to note that, even where industry participants see movement, they are reluctant to offer opinions as to when reforms might come to fruition. Indeed, there is no real consensus as to what constitutes "short term" in a China regulatory context. Sentiment is therefore divided between those who see the government's words of support as an irrevocable catalyst and those who are more wary.

Cadwaladar's Lee, for his part, is skeptical about change full stop. His takeaway from meetings with regulators is that they think the market is too hot, would like to see a reduction in the irrational exuberance, and generally do not favor a surge in new listings by companies that have little substance. He also sees little likelihood of new development on VIEs.

The broader question is what this means for US dollar investors. Any one of the reforms listed above might facilitate their participation in domestic capital markets - by effectively blurring the line between onshore and offshore - but right now the momentum is with renminbi funds. If a company is in a restricted industry, is there any point setting up an offshore structure that might just end up being unwound?

"There appears to have been a slowdown in US dollar fundraising recently, while on the renminbi side it is growing exponentially," says Cooley's Lu. "The New Third Board craze has put US dollar funds in a difficult position. A lot of smaller companies only agreed to VIE structures to get access to funding. Now that the government is opening up the capital markets for smaller companies, they may not need to do this any longer."

Here to stay?

It remains to be seen whether the current dynamic is sustainable. There are still plenty of investments offshore VC investors can make that do not fall in restricted areas, including the fast-growing hardware space. Start-ups may also seek out US dollar funding from brand-name VC firms because of the credibility it brings. They can achieve scale with the support of a Sequoia or a SAIF Partners and an onshore restructuring might make sense at a later date.

Then there are companies that have already gained traction with substantial amounts of offshore VC backing. Opinion is divided as to whether the likes of Didi Dache and Kuaidi Dache, the recently-merged taxi-booking platforms that have between them raised in excess of $1 billion, will pursue a domestic listing. "You are going to be surprised at the number of companies that are going to at least attempt to do this in the next six months, and the size of those companies," says Marcia Ellis, a partner with Morrison & Foerster.

She is referring not only to the New Third Board but also A-share market IPOs and reverse mergers, with latter expected to feature prominently as companies look to jump the queue for listings. If companies of size do not meet the current profitability requirement, others question whether the New Third Board could really accommodate them. Another option is to list overseas in anticipation of the government creating a mechanism for companies to sell shares back home, which is likely what most of the well-established US-traded China technology stocks are waiting for.

Finally, there remains the issue of valuations. After peaking on June 12, the Shanghai Composite Index dropped 13.3% last week - the worst five-day performance since 2008 - and other bourses saw similar declines. The New Third Board did not suffer so greatly, losing 2.17%, but a prolonged deterioration in the main markets would not help matters.

These movements may or may not represent the first salvos in a rebalancing, but China's public markets have been volatile in the past and will likely be so again. Venture capital investors managing predominantly US dollar funds are taking a longer-term view.

"If you ask me where the market is today, there is a natural arbitrage opportunity on the renminbi side - the sky-high valuations on domestic stock exchanges are attracting a lot of entrepreneurs and the government is encouraging offshore-structured technology companies to relocate onshore," says GGV's Foo. "However, as more companies list domestically and the liquidity gets soaked up and monetary policy changes, you will see valuations come back down. It will reach equilibrium."

Those with existing portfolios are also enthused by the growing array of exit options presented by these developments, even though onshore restructurings may force the sale of certain positions. Public markets in the US and China are now viable liquidity channels and there is more activity on the M&A front, particularly from listed Chinese companies that want to tap the technology space.

"I have never seen a market so vibrant in my 15-year career and we have never been so busy," adds Qiming's Gan. "We recently announced the sale of one of our portfolio companies, a mobile advertising platform called Domob. We considered a VIE restructuring but then an A-share company decided to acquire the business outright. The buyer is Blue Focus, which was in the first batch of Chinext listings."

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• Topics
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