Private Equity Direct - Summer 2011 - Stepping Behind the Regulatory Curtain in PRC
An ever-growing spirit of openness is driving the continued growth of private equity markets in China. Foreign private equity fund managers are flocking to the market, enticed by friendlier regulation, a developing tax code and the rapidly expanding population of entrepreneurs hungry for capital.
Regulation has become so 'foreigner friendly' that non-PRC registered firms operating in the country are on track to outnumber the number of domestic firms. According to figures from the Centre for Asia Private Equity Research Group, at the end of 2010 there were 169 registered foreign funds (up from 132 in 2009, and from 9 in 2001) compared to 265 Chinese ones. The importance of this shift cannot be overstated. China now accounts for 10% of the global private equity fundraising market — up from less than 1% only 3 years ago.
Getting an accurate measure of exactly what is happening in China is difficult due to the overwhelming opacity of information. Failures are often hidden, and the successes are sometimes overstated. The limited data that is available paints a positive picture however and most managers operating in the country feel confident about the future, both short- and long-term.
In addition to the abolishment of preferential tax treatment for foreign firms (which was tied to operating only in restricted markets) and the creation of Chinese Anti-Monopoly Laws in 2008, there have been some other important regulatory changes. In August 2010, for example, the government lifted restrictions on registered insurance companies placing funds with private equity firms. Strict limits still apply, however, with such companies being able to invest a maximum of 5% in Private Equity funds. If fully invested, this would total approximately U.S.$36 billion. Another significant source of governance money in the Private Equity market is the National Social Security Fund, which to date has pumped $12 billion into the local Private Equity market and plans to add up to a further $1.5 billion a year.
With so much easy money on offer, why isn't every deal getting done? Despite the ongoing inflow of funds and the general buzz about China as a whole, doing business in the PRC is complicated and challenging and many strategies used in U.S. and European markets are either illegal or unfeasible in China.
PAYING THE TOLL
Peter Fuhrman, Chairman and CEO of China First Capital, explains that perhaps the biggest challenge, for both Chinese private companies and the foreign Private Equity firms looking to fund them, is becoming fully compliant with China's tax and accounting rules. More companies, he says, are shut out of the capital markets for this reason than any other.
Many areas in China have remarkably lax accounting and tax procedures. However, as the IPO market grows to maturity, the scrutiny on IPO companies means that many private firms preparing for a listing must take on more robust reporting and become more vigilant in record keeping. This, in turn, means the company will pay higher tax rates, thus lowering the available cash which can result in a reduction in market share because other non-Private Equity backed firms will pay lower rates. The natural flow on is a potential hit to IPO valuation.
There are several ways to combat these issues, like injecting more cash into the newly compliant business. Fuhrman explains that most Chinese companies with profits of less than Rmb 30 million can raise at least five times more Private Equity capital than they will pay in increased annual taxes. Private Equity funds need to accept that a percentage of the investment will go to paying local Chinese taxes but since only compliant companies will be approved for a domestic Chinese IPO, the higher taxes are a necessary price of doing business and achieving historically high Chinese IPO valuations.
With this in mind, non-Chinese investors have considerable incentive to structure deals to minimize taxes. Jay Bakst, an international tax partner specializing in alternative investments at EisnerAmper, highlights the main structuring objectives: First, regarding dividends and capital gains from the PRC target, you should ensure you are able to obtain the U.S. federal 15% tax rate for U.S. individual taxable investors in private equity funds. Second, structure the investment to minimize PRC withholding tax on dividends from, and disposition of, shares of the Chinese target while ensuring that a full U.S. foreign tax credit is available in respect of any PRC withholding tax that cannot be avoided Another aim is to avoid UBIT (unrelated business income tax) for U.S. tax-exempt investors in Private Equity funds.
Other key structuring objectives focus on the PRC target company itself. Consideration should be given to the possibility of reducing the taxable profits of the Chinese target — which are typically taxed at the PRC Enterprise Income Tax rate of 25% — by offsetting any interest on third-party debt used to finance the acquisition.
In addition, correctly structuring the deal will allow foreign investors, who may otherwise be restricted or prohibited, to participate more completely in the transaction. Regulatory compliance is complicated and time consuming and must be given the appropriate consideration at the outset.
The rules are complex and sometimes less than clear but the Chinese government is taking steps to streamline the process and attract foreign investment, as well as further develop the rapidly growing local Private Equity market. As the market and regulators evolve so will the rules and the confidence of foreign investors in achieving their investment objectives in this rapidly developing Private Equity market. Keeping a close eye on these changes will allow U.S. investors to maximize returns and grow a solid base in what could soon be the largest market in the world.
Private Equity Direct - Summer 2011 Issue