The U.S. mainstream media continues to hype investing in China, but the story on the ground in Beijing is much different. Investments in Chinese companies by foreign (read U.S.) venture capital firms have virtually ground to a halt due to new government regulations.
Since 1999, VCs have set up offshore companies to allow them to exit from their Chinese investments by selling shares on U.S. stock exchanges. Those offshore holding companies, typically based in the Cayman Islands, are known as Wholly Owned Foreign Entities, or WOFEs (pronounced woof-ees). Most, if not all, of the Chinese companies listed on the Nasdaq and NYSE are WOFEs, such as VC success stories Ctrip.com, Shanda Interactive and Sina.com
Howling over WOFEs
The Chinese government is unhappy with WOFEs because the VCs and entrepreneurs who own shares in the offshore companies avoid paying taxes to China. The new regulations say that no onshore resident (a Chinese citizen or a resident foreigner) may establish, control or own shares in an offshore company, either directly or indirectly, without the Chinese government’s approval. Sounds simple enough, but private equity professionals here say that almost no one is getting regulatory approval for new PE- backed WOFEs. The government entity charged with granting such approval is called the State Administration for Foreign Exchange (SAFE).
In light of the confusion over the new regulations, private equity firms say they are using a variety of workarounds. They include joint-venture investments, bridge loans for portfolio companies and gentlemen’s agreements that allow PE firms and their portfolio companies to move forward on the basis of a handshake-in the hope that they will be able to convert their handshakes to legal agreements in six months, or whenever regulators have cleared up the situation.
The trouble started in January with SAFE’s issuance of “Circular No. 11.” China’s once- vigorous investment environment came to a virtual standstill because “SAFE offered no procedures, no guidelines,” Richard Xu, a private equity specialist at law firm Jingtian & Gongcheng in China, told VCJ in March. SAFE didn’t detail the legal documents required for approval and it didn’t say how long the process would take, Xu said.
The one piece of good news that came out of the SAFE circular was that the government would “grandfather” existing WOFEs, such Sina.com, that U.S. venture firms established before passage of the regulation. Most PE firms told VCJ at the time that while the initial effects on private equity in China were grim, they believed that SAFE had no intention of discouraging private equity firms from investing in China, and was instead attempting to tax the vast fortunes that Chinese entrepreneurs were accruing in overseas tax havens. There was a widely held belief that the agency would repair the damage by issuing a clarification for its first circular.
That wasn’t to be. When SAFE issued its follow-up, Circular No. 29, in late April, it “effectively closed all of the loopholes” private equity firms could have used to get around the first circular,” says Stephen Toronto, lead counsel in China for law firm Morrison & Foerster.
Still there was hope among China cognoscenti, who told attendees at a VCJ-sponsored China conference in late May that many in China’s private equity industry believed that SAFE’s effort to regulate private equity investments went beyond its mandate. That theory suggested that either China’s Ministry of Commerce or the State Tax Administration would act to reign in the regulators at SAFE.
It is now clear that the problems created by SAFE won’t be resolved any time soon. Li-Ping Lu, director of research for SAFE, addressed an Intel-sponsored gathering of China PE investors in Beijing in late June. He insisted that SAFE recognized the need for foreign venture capital, that China’s small and medium enterprises need the expertise of foreign private equity firms, and that domestic private equity firms need to learn from foreign PE firms to make their own investments outside of China. Lu added that PE firms had misunderstood the intent of the new regulations, which he said were aimed at controlling local investments abroad by Chinese nationals and issues of foreign exchange. And yet Lu ended his talk with the chilling statement: “Many current [private equity] investments are in breech of investment regulations.”
Michael Scown, Intel Capital’s legal counsel in China, in a rare demonstration of frustration and concern, sharply questioned Lu about his presentation. He suggested that reality was quite a different world from that described by Lu. Scown, mindful that Intel had just announced its first country-specific $200 million venture fund for China, noted that PE firms were trying to find workarounds, such as offering bridge loans to their portfolio companies or incorporating their portfolio companies as Limited Liability Companies in China.
Robert Xie, head of private equity for the Bank of China, China’s third largest domestic bank, delivered an even more acerbic response to Lu. Xie said flatly that PE firms’ plans for further investment in China are being shelved because current applications to SAFE are not being approved and because SAFE staffers are unable to answer PE firms’ questions. The direct refutation of a government official’s presentation in his presence, unthinkable even in the recent past, seemed to electrify the PE attendees, who appeared ready to hoist Xie onto their shoulders and march around the room.
Asked about rumors of a pending “intra-agency” statement or clarifying circular, Lu told the visibly angry audience that the rumors are just that, and that none of the three ministries mentioned have direct responsibility for regulation of private equity investing. Lu did say that a new circular from SAFE is possible in the next six months to one year, all but extinguishing any hope for PE execs at the several firms that have been having trouble raising China-specific funds.
The head of a large, public bank told VCJ that “all WOFE-structured companies have ceased to receive any further VC investment” until the current situation is resolved. He estimated that it would take “at least six months to clear up the current situation. In the meantime a backlog of applications is piling up [at SAFE] that will take another six months to be approved.”
An executive at a foreign investment firm told VCJ that his firm “had a deal [in the works in China] but that investors had stopped working on the deal. It’s my understanding that all VCs have stopped investing in China at present or are seeking other ways to invest in China.”
The only firms in China that appear to be profiting from all the confusion are law firms. They say they’ve never been busier.