Chinese courts threaten PE protection

Not all publicity is good publicity. Previously just one of China's many mid-cap private equity players, Suzhou Industrial Park Haifu Investment now finds itself in the spotlight for all the wrong reasons. The PE firm took its portfolio company Gansu Shiheng to court, seeking compensation after profit targets weren't met, only for a judge to rule the claim invalid.

It is the first time a Chinese court has expressed an opinion on the net profit guarantee that underpins many private equity and venture capital investment agreements. By refusing to enforce the clause, a key element of down-side protection is now under threat.

"The court case has significant implications," Gary Rieschel, founder of Qiming Venture Partners, tells AVCJ. "If entrepreneurs know that the letters they signed offering shares or cash to investors in the event of non-performance are invalid, then investors can no longer have protection in that regard and the discussions on price will become fallacious."

A net profit guarantee is a variety of the value adjustment mechanism (VAM) often used by private equity players to incentivize company founders to reach specific growth targets. In addition to revenue and net profit guarantees, VAMs include the timing or issue price of an IPO, as well as various operational milestones such as the realization of a strategic collaboration, a new product launch or a horizontal acquisition.

Root of the problem

The Haifu-Gansu Shiheng dispute dates back to 2007. The PE firm agreed to pay RMB20 million ($3.1 million) for a 3.85% stake in the northwest China-based non-ferrous metals manufacturer. A VAM was included in the contract: If Gansu Shiheng failed to achieve a net profit of RMB30 million in 2008, Haifu could claim compensation equivalent to its initial investment plus a multiple of the amount by which the company fell short of the target.

Based on the agreed calculation, had Gansu Shiheng made RMB10 million in 2008, it would have been obliged to return RMB13.3 million to Haifu. As it turned out, the company posted negligible income for the year, so the investor demanded virtually its entire principal.

When Gansu refused, Haifu sought legal recourse. However, both the First Instance Court and the Court of Appeal ruled the investment contract invalid, with the former declaring that any company issuing shares with preferential rights is in violation of Chinese Company Law. The case is now pending Supreme Court adjudication.

According to James Wang, a partner at Han Kun Law Offices, VAMs are increasingly popular in China, given that growth in the country's capital markets hasn't been matched by advances in investor protection and transparency. Foreign private equity funds, in particular, may rely heavily on VAMs to counterbalance the informational disadvantage that comes from limited experience dealing with local entrepreneurs.

In addition, a contractual agreement - whether it provides for monetary compensation, share adjustment or repurchase arrangements - may act as a short-term solution when private equity investors and entrepreneurs come up with different valuations for a business.

"I'd say 90% of the reasons for having these VAMs, or gambling agreements, are that sellers and buyers cannot settle on price and these terms can help them reach temporary agreements," says Frank Han, executive director of Bohai Industrial Investment Fund Management. "Without these terms, it's very hard for private equity players to close deals in China."

Although investors are trying to replicate international practices in China, the country's regulatory system suffers due to its inflexibility. A typical minority investment in a mature market, for example, might involve the issuance of preferred shares and ratchet clauses. Under Chinese law this isn't permitted.

"In China, investors would have to look for protection through a contractual arrangement with founders and other shareholders," Yingxi Fu-Tomlinson, a partner at legal firm Kaye Scholer, tells AVCJ. "However, from the enforcement perspective, a shareholder agreement and a statutorily provided structure are somewhat different species."

Debt for equity?

How, then, should private equity investors deal with Chinese entrepreneurs without the luxury of a VAM? One option is to structure the transaction as a loan rather than an equity sale. The debt instrument could then convert to equity if the portfolio company reaches the agreed development targets.

The Court of Appeal's ruling in the Haifu-Gansu case appears to advocate such an approach. Although the court held the net profit provision as invalid, it said that because Haifu has neither partici¬pated in Shiheng's operations nor assumed any risk, most of the capital it provided should be categorized as a loan. On these grounds, Haifu may recall its principal plus interest for a total consideration in excess of RMB18.8 million.

While a debt structure makes sense in terms of protection, private equity players are skeptical of such arrangement from a profitability angle. Loans are unlikely to generate the kind of returns PE investors require from a long-term illiquid commitment.

"The loan structure is a solution investors may look at, but how long is the loan outstanding and can the investor force conversion at the agreed price? All these questions will make the discussion more complicated," says Qiming'sRieschel. "What happens is that the PE firms risk becoming banks, with loans instead of equity and no board seat or influence on the company."

In the circumstances, all PE players can do is to hope entrepreneurs honor agreements. Reconciling with a CEO or founder is eminently preferable to seeing him in court, especially when recent case history suggests that the law doesn't stand on the side of the investor.

"I think these kinds of gambling agreements will continue because people in China cannot compromise on price anyway," says Bohai's Han. "But from now on, private equity investors should remind themselves to conduct better due diligence, as well as offering a more reasonable price in the first place in order to protect themselves."

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• Topics
• Regulation
• Greater China
• China
• regulation