China Changes Offshore Investment Rules, Venture Capital Cools

Global venture capital funds slowed offshore investment into Chinese companies in the first quarter after the country’s foreign exchange regulator issued rules that may hinder international share sales and capital raising by China businesses.

Chinese residents must for the first time get approval from the State Administration of Foreign Exchange before starting or investing in an offshore company, according to notices from the regulator dated Jan. 24 and April 8. Venture capital into China slowed by one-third to $552.6 million in the first quarter from a year earlier, according to the Asian Venture Capital Journal.

Warburg Pincus LLC, Newbridge Capital LLC, the Carlyle Group and other private equity and venture capital firms have used international holding companies to exit their China investments through initial public offerings and stake sales. The new rules are designed to stop companies setting up overseas to strip state- owned assets and avoid paying domestic taxes.

“It’s a big headache,” said Andrew Qian, managing director for New Access Capital Co., a Shanghai-based corporate financial advisory that has postponed several deals this year, including a $3 million investment by a U.S. venture capital fund in a Shanghai-based industrial gas supplier. “Every private equity fund is scrambling to figure out what the measures mean and how to comply with them.”

The changes led to the Beijing-based China Venture Capital Association to send a letter on April 30 to the regulator, calling for consultation and a revision of the rules.

Detrimental

“SAFE has valid concerns about people transferring assets offshore,” said Chang Sun, chairman of the association and a Hong Kong-based managing director of Warburg Pincus in Asia. “The rules as currently published are impractical, hard to implement, and detrimental to foreign investment in China.”

The number of announced private equity deals in China in the first quarter was 19, compared with 31 during the same period last year, according to the Asian Venture Capital Journal, that provides industry data.

The regulations will track cross-border capital flows and control the transfer of Chinese assets from domestic to offshore companies, including those in the Cayman Islands and British Virgin Islands, where many of the Chinese companies listed in Hong Kong and the United States have headquarters.

China Techfaith Wireless Communication Technology Ltd., which raised $142 million in a Nasdaq listing last week, included a clause in its sale documents advising investors about possible risks related to the new rules by the foreign exchange regulator. The company said it cannot predict how the notices will “affect our business operations or future strategy.”

Dampening

The number of Chinese companies listed on Nasdaq is expected to double to 40 by the end of this year, Stuart Patterson, Asia Pacific senior managing director of Nasdaq Stock Market Inc., said last month.

“There is definitely a dampening affect on the number of deals getting done,” said Sun of the venture capital association, a trade group of 100 members with $1.3 billion invested in Chinese companies. “A number of pre-IPO deals have been affected.”

Chinese entrepreneurs and international venture capital funds have reorganized their businesses offshore because the local regulations do not recognize different classes of shares and restrict the sale and public trading of equity held by founding stockholders, according to Barbara Mok, a partner with Jones Day in Hong Kong.

Typically, an offshore reorganization involves Chinese entrepreneurs swapping equity between a local business and an offshore holding company, Mok said. That allows them to issue additional shares in offshore jurisdictions to international investors.

Less Flexible

“Chinese joint stock companies have more restrictions and less flexibility compared to companies registered under the British common law system,” Mok said.

Semiconductor Manufacturing International Corp., a Shanghai- based chip producer incorporated in the Cayman Islands, raised $1.8 billion through an initial public offering last year on the Hong Kong stock exchange.

The top five Chinese companies listed on the Nasdaq last year, including Shanda Interactive Entertainment Ltd. — which operates China’s most popular online game Legend of Mir II — raised about $547 million.

Foreign investors must now register and obtain foreign exchange approval before taking equity in a Chinese domestic enterprise prior to an offshore restructuring, according to the regulations.

Supervision

The government is strengthening its supervision of cross- border money flows in order to address fraud and tax evasion, said Xiaohu Ma, a Hong Kong-based partner with U.S. law firm Morrison & Foerster LLP.

“Offshore restructuring has allowed privatized Chinese state-owned enterprises to trade domestic assets inexpensively to offshore companies,” said Ma. “It also permitted Chinese citizens to avoid capital gains taxes by selling shares in the offshore company, rather than domestically.”

The new rules also require Chinese residents who restructure their companies prior to the January 24 notice to register their deals. That may create problems for international venture capital investors now preparing initial public offers or making additional private equity deployments, says David Lin, a lawyer with O’Melveny & Myers LLP in Hong Kong.

“People are nervous,” said Lin. “The law, itself, is retroactive and could reach transactions in the past.”

Companies completing their offshore reorganization prior to January 24 and which are contemplating initial public offerings overseas have increased risk as a result of the new rules, Lin said.

“If any of the Chinese resident shareholders failed to fulfill their SAFE obligations, for example, then there may be serious ramifications,” Lin said. “That includes a prohibition on distribution of profits to overseas foreign shareholders.”


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