According to a research agency’s statistics, 406 deals were completed in the Chinese mergers and acquisitions (M&A) market during the first half of 2013, 383 of which were cases with disclosed amounts involving a total transaction amount of US$40.34 billion.
In particular, private equity (PE)/venture capital (VC) funds participated in 163 M&A deals, involving a total transaction amount of US$17.52 billion, nearly nine times more than in the same period last year. These deals covered 21 primary industries such as biotechnology/healthcare, energy and mineral resources, real estate, machinery manufacturing and the internet. In PE M&A deals, PE investors and target companies are often faced with the problem of how to cope with various kinds of legal risks, boundaries between rights and obligations, as well as remedies.
A PE investor gains a stake in an investee or target company by making an equity investment in it. Such investments can be divided into two types by method of operation: capital increase investment and equity M&A investment. In the equity M&A investment, a PE investor acquires all or part of the registered capital of the target company’s shareholders, who will then retire or have their percentages of shareholding reduced. Taking into account other things such as legal risks associated with PE involvement in M&A deals – such as the independence of a fund and the protection of the investor’s rights to information about the target company – and problems regarding the legal effect of some clauses – such as the determination of a PE party’s rights of priority and the implementation of legal remedies – the parties to an M&A deal may seek to spread and balance risks by designing some clauses, as described below, in a series of agreements with relevant parties and financial regulators.
Within the existing legal framework in China, the parties to a PE M&A project usually specify their pre-emptions by agreeing to specific clauses. Additional rights of priority can be determined in the articles of association or a capital contribution agreement. The Interim Measures Governing Venture Capital Enterprises provide that “a venture capital firm may invest in a non-listed company with equity and preference shares, convertible preference shares or other quasi equities”. However, this provision does not contain any viable operation schemes. There are some problems with the level of legal effect as well. The pre-emption restrictions may be evaded by setting up an offshore company. A typical way is for a PE investor and a business operator to jointly incorporate an offshore company, such as a Cayman Islands company, which wholly owns a target company. The Cayman Islands Companies Law contains a regime for preferred stock rights, and so the PE party could own the preferred shares of the target company.
The use of a clause on buy-back rights has built a final and most fundamental risk protection system for PE investors. However, such a clause faces two problems: first, whether the clause can grant remedies through judicial proceedings; and second, in case an investment fails the business operator is often unable to pay the investment amount. This clause is significant in applying pressure to the business operator to assure that an investment objective – an initial public offering or the achievement of a target accordingly – is attained.
Anti-dilution protection clause
The anti-dilution provision has two control objectives. The first is to avoid further financing by a target company that results in the equity acquired by a PE investor being diluted, and thus the PE investor will be unable to obtain the desired return on investment. The second goal is to avoid further investment by a PE investor so that the equities owned by other shareholders of a target company are diluted, and they will lose their operating rights of the company. In practice, the anti-dilution provision between a PE investor and a target company will contain a default clause, which means if a business operator prompts a target company to seek further financing it breaches the contract and should pay liquidated damages.
The base of liquidated damages is equal to the difference in the reduced equity percentage of a PE investor as a result of the issue of new shares. Liquidated damages are paid in shares so that the anti-dilution provision can ultimately achieve the objective of not having the PE investor’s equity diluted. Since PE investors do not participate in the business of a target company, they need to strengthen their rights to information so that they know about the financial position and business operations of the target company for timely identifying and evading risks. According to China’s Company Law, the shareholder of a company has the right to access to, and the right to be informed of, the financial position and relevant information of a company. However, PE parties hope to obtain information that is far more comprehensive and detailed than that specified under the Company Law. If a business operator refuses to provide the information that is beyond the legal limits, it is difficult for a PE party to obtain judicial remedies.
The control objective for this clause is to enable a PE party to fully understand all of the business information of a target company in such a way that the PE party is able to understand any business information of the target company based on its own needs. To overcome the above legal risks, here are the ways for reference. First, the PE party can assign a member to the board of the target company, and the person in charge of the project in the PE fund can also concurrently serve as a member of the supervisory board of the target company.
Second, a PE fund may invest in setting up a finance-related consulting company in order to enter into a consultancy agreement with the target company. The consulting company has the right to know all the business figures of the target company, and can provide support for the financial analysis of the target company’s operations as well as for the analysis of core issue investment and financing channels.
In conclusion, the PE parties and business operators of the target companies they acquired are the core parties to M&A deals. To improve the mechanism for spreading and balancing the legal risks between the two parties is the core legal issue in PE M&A deals.
Ye Wen is a partner and Zuo Kun is a lawyer at Concord & Partners
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