China downside protection: Parachute play

Searching for an analogy that captures the deterioration in relations between entrepreneur and investor, Johannes Schoeter eventually settles upon two pandas paired together at a zoo with a view to procreation. No matter what is tried, the male shows no interest whatsoever in the female.

China New Enterprise Investment (CNEI), the PE firm of which Schoeter is founding partner, should have been on course for a 5x return. It held a stake in a Chinese business with strong fundamentals, an impressive product portfolio, and a long-standing and recognizable brand name. There was every reason to foresee sustained growth and ultimately an IPO exit.

The problem was the founder and majority shareholder. Not long after CNEI's investment, he became distracted by real estate opportunities, to the detriment of the main business. Various efforts were made to reengage the founder but to no avail. Eventually it was agreed that CNEI would install a new CEO but the founder, in full procrastination mode, vetoed every candidate.

With CNEI applying pressure, the founder decided he'd had enough. "We were already quite exhausted from all our efforts when he came to us and asked to buy back our shares on the strength of our put option," Schoeter recalls. "We said, ‘You can buy them back but at a different price from the put option because we aren't putting to you, we are selling to you.' In the end he agreed. The put option would have given us about 1.7x but we received 2.2x."

The situation was unusual - a PE firm would typically take the initiative and tell the founder that it wanted to exercise a put option in order to exit an investment - yet it is still instructive.

While a put option is usually a highly structured piece of downside protection, its true merit is in providing leverage, not necessarily facilitating execution to the letter of the law. The threat of redeeming a position, and taking the assets held as security or finding a way to turn the screw on the founder, is part of a broader negotiation. And success rests on understanding the business and its majority owner, so the process - if there is no way of making it amicable and mutually beneficial - is at least smooth.

"Put options are not foolproof but only in extreme cases would a founder not feel pressured by the presence of these rights, so they are useful in terms of having both carrot and stick," says Bonnie Lo, partner at NewQuest Capital Partners. "If an investment goes south for whatever reason there is a way to bring everyone to the negotiating table. You might not get 100% of what the put option says, but the success rate for getting founders to buy back shares is reasonably good."

Devil in the detail

Downside protection for minority investments in China comes into effect if a portfolio company fails to meet certain performance targets or if an IPO doesn't happen within an agreed timeframe. A PE firm might seek to redeem its investment according to a formula based on interest or IRR or trigger a ratchet mechanism that increases its holding in the portfolio company.

Many investments are made in the form of subscriptions to convertible bonds or preference shares that give the private equity firm a priority claim in the event of a default. It is common for the founder to pledge his own shares in the company as security for an investment. Unsigned letters of resignation from the founder's representative board members and share transfer agreements are held in escrow and released to the investor if there is a desire to claim the security and assume control of the company

In some cases, the founder might also offer a personal guarantee comprising onshore or offshore assets.

Before the global financial crisis and more recent cooling of China's domestic IPO market plenty of investors rushed in looking to flip companies into public listings. The strategy was short term and largely passive, and some paid the price for not paying enough attention to portfolio companies or the downside protection in the deals. The general view is that PE firms are now better prepared and better advised.

"In the old days, investors would come in and get a board seat and information rights," says Michael Chin, a Shanghai-based partner at Hogan Lovells. "Now they appear to be getting a lot more involved. We had a wave of PE firms that were sitting on too many portfolio companies and there were instances in which companies had gone too far down hill to turn things around because of insufficient monitoring."

All investors want an element of downside protection, but what they get is highly negotiated - maybe there is no put option at all. It is one of many variables within a deal. The decision whether or not to invest is based on the GP taking a step back, evaluating the entire situation and asking if he feels comfortable with the situation. In the absence of a put, being comfortable with the founder is also paramount.

"It comes down to a judgment call on his personality, his quality as an entrepreneur and the quality of the business," says CNEI's Schoeter. "If I were an entrepreneur negotiating with a capital provider, I would say, ‘Why would I do this? We are partners, we both succeed or fail.' It is not 100% correct because he is running the show. But it is natural for an entrepreneur, almost as a reflex, to give this response."

Indeed, not getting this response might in itself be a red flag. William Shen, senior partner at Headland Capital Partners, treats the negotiations as an additional opportunity to get a measure of the founder. If he rolls over on every point he might not be taking the prospect of redemption seriously or he has no intention of honoring it.

Degrees of comfort

The amount of leverage a private equity firm has in a redemption situation is also influenced by the structure of the investment. There are two ways in, the most common being an investment in an offshore holding company, which operates on the mainland through a wholly foreign-owned enterprise (WFOE). This structure tends to be used where the objective is an offshore IPO.

The security held by the private equity firm tends to be pledged shares in the offshore vehicle. In order to take action against a founder or company that refuses to redeem a position, it is necessary to secure a favorable ruling from a judge or arbitrator in the offshore jurisdiction of incorporation and then go to a Chinese court and make the application once again.

Even if the protection extends down another layer and there is a pledge of shares in the WFOE, enforcement is a challenge. Investors that register WFOE share securities with the State Administration of Foreign Exchange (SAFE) up front should be able enact the pledge when necessary. But there are still obstacles.

"When it comes to enforcement, although you have the legal right, when you register the transfer of equity interests in a Chinese company, the transfer of shares, the State Administration for Industry & Commerce (SAIC) would then query whether or not you could do that," says Howard Lam, a partner at Latham & Watkins. "And then the existing management in the WFOE might resist that and their cooperation is needed to file the necessary forms with the SAIC to complete the transfer of the shares."

Headland's Shen adds that a Chinese entrepreneur might just take a ruling by a Hong Kong arbitrator more seriously than a notice issued by a Chinese court. "It could drag on for a long time and the costs could be high," he says.

As such, Headland is generally more comfortable with the second approach, investing through a Sino-foreign joint venture. This route precludes a listing in Hong Kong or the US because there is no offshore restructuring, but it became popular with the rise of the A-share market as a public market exit option.

The private equity firm invests directly into the onshore entity, and in the event of a dispute, it can opt for for a court process or arbitration. There is no two-step process of getting mainland endorsement of an offshore ruling. Clarifying where the case is heard is important, with most investors happy to go through Beijing and Shanghai. Other locations could be deal breakers.

"We have turned down deals for the sole reason that the entrepreneur insisted on having dispute resolution in his local area," says CNEI's Schoeter. "In smaller cities, most of the entrepreneurs have connections with the local government in one way or another. They could just call the mayor or local party secretary and ask them to tell the judge not to accept the case."

A potential problem raised by Steven Tran, a Hong Kong-based partner at Hogan Lovells, is that put options can be difficult to enforce onshore. Chinese courts do not recognize specific performance - through which an individual can be compelled to comply with an obligation - in the same way as Common Law jurisdictions. An investor cannot simply go to a local court and seek a ruling against a founder by saying he gave a guarantee and has breached his obligation to pay us money.

Trigger happy?

A reluctance to pursue an action through the Chinese courts is one reason why some investors hold off on redemptions when perhaps they should act. Several industry participants say they have seen GPs accept an entrepreneur's argument for why next year will be different and then de-focus on the investment in favor of better-performing assets. They are also motivated by a desire to preserve relationships.

"They want to show they are investors that work alongside companies to solve issues rather than investors that pull the trigger at the first sign of a dispute," adds Tran. "When there is a dispute, PE investors will usually try and deal with it amicably from a commercial and a relationship perspective, and keep the dispute out of the public domain."

First of all, investor agreements can be used to make things happen without resorting to enforcement. For example, there may be clauses that prevent a company from taking certain actions - such as incurring a large amount of debt or making disposals and acquisitions - without the PE investor's approval, which offers additional leverage. Documentation allowing a change of board control at the offshore level can also be effective when used in tandem with proactive onshore tactics.

When NewQuest spun out from Bank of America Merrill Lynch, the portfolio the firm brought with it included a Chinese company where there seemed little chance of a return. But NewQuest held pre-signed letters of resignation for the founder's board representatives and share transfer documents. The founder came to the table and the PE firm negotiated a $50 million buyback - acceptable, given the circumstances.

"Everything we did was focused on the offshore part but we also sent in people to take charge of the company's chops. We also had someone dedicated to understanding the cash flow situation," Lo explains. "There were pressures we could exert."

In short, information is power - but it must be used wisely. Protection measures enshrined in the investor agreement must be underpinned by a thorough understanding of whether the company or entrepreneur has both the incentive and means to honor a redemption order.

First, it is important to look into an entrepreneur's net worth and whether he has other business interests. Second, understanding the company's debt situation can be useful. For example, there may be a lot of bank loans with cross-default clauses and refusing to redeem a PE investor's convertible bond could ultimately lead to banks foreclosing on the business. Would the founder want to risk losing everything for the sake of a $50 million settlement?

At the same time, a private equity investor must bear in mind what that $50 million means to the company. If immediate repayment would bankrupt the business then the entrepreneur is likely to resist honoring the put option regardless of the consequences. This understanding should stretch to the industry in which the company is operating. If the founder is fighting against an irrevocable industry downturn, there is no point waiting for a turnaround.

"You can put everything down on paper and he can agree it all, but you have to talk to the company and check up every day from the outset. Has the business changed? Is the entrepreneur taking money out of the business?" says Junlee Hsu, a partner at Headland.

Through this ongoing dialogue, a PE investor can make management aware that a redemption notice is likely to come and also provide advice as to how a company experiencing distress might generate the required funds.

A previous Headland portfolio company in Taiwan had a legal dispute with one of its largest distributors in the US. Distracted by the situation, management neglected the business and it suffered. Headland's put option wasn't due to come into effect for two years but ahead of the deadline it starting working with management on potential solutions. This resulted in the sale of one of the core assets that gave the company sufficient financial resources to redeem the GP.

"You need to think in their shoes," adds Hsu. "You are asking for the money back but how can they get it? Can they cut costs? If that's not enough, what about selling part of the business? Sometimes entrepreneurs procrastinate - these businesses are their babies so it is difficult for them to sell. However, it is better for everyone if there the company is still there rather than bankrupt. It takes time to change their thinking."

Liang Meng, managing partner at Ascendent Capital Partners, is also an advocate of the constructive approach, regarding as in tune with his firm's strategy of sourcing deals through building advisory relationships with companies.

"A lot of conversations run along the lines of us saying, ‘Let's develop this idea together and we will put in money to show we believe in the idea. If things go well, we get some equity upside. If things go really badly, just treat it as a loan and return the money plus some interest,'" he told AVCJ earlier this year.

Ascendent eschews downside protection that heavily penalizes a company, arguing that the entrepreneur might just respond by fudging the accounts. Rather, the private equity firm returns equity to the founder if growth exceeds projections and cash is returned ahead of schedule. For example, Ascendent might own 40% of a company with a 2x put option after four years and a preferred dividend stream that guarantees it covers its costs. If capital is returned earlier it may reduce its holding to 37.5%.

Same but different

The mechanisms that underpin downside protection will no doubt continue to evolve as risk perceptions and markets evolve. One clause that Headland is already trying to work into agreements is a drag-along right for a trade sale. It is a natural response to less vibrant IPO markets in China. If a company is performing sufficiently well that it doesn't trigger redemption clauses, but it can't go public at a particularly high valuation then a trade sale might be the best option for all concerned.

"Entrepreneurs are more open to it now than 3-5 years ago because the IPO market is much tougher," Shen says. "In the old days a China IPO story was worth 20x but now the market is more selective, there is no scarcity value for copy cats."

Beyond that, the negotiating dynamics will remain largely unchanged. A GP must make a judgment call on an entrepreneur's character and ability, and whether he will have the means and motivation to honor a redemption should the need occur. Strong documentation is required but also a grasp of a company's operations and what can be done to ensure an entrepreneur's interests are aligned with those of the investor.

Access to information is crucial and it should be crafted into a clear set of guidelines that are finalized before going anywhere near the negotiating table.

"Downside protection is very useful as a pressure point to negotiate a way out of a distress situation," says Lam of Latham & Watkins. "PE investors should identify the potential exit first and consider using enforcement steps to steer towards that exit. The offshore and onshore steps will need to be coordinated. Never go into enforcement when there is less certainty as to how local authorities and courts would behave. You need to have the deal pre-packaged before implementation."

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• Topics
• Investments
• Exits
• Expansion
• Greater China
• Restructuring
• China
• Exit
• Growth capital
• Distress
• NewQuest Capital Partners
• CNEI
• Headland Capital Partners
• Ascendent Capital