Hong Kong: The CSRC’s “No Objection” Letter: Continuing Uncertainty for Venture Capitalists Looking to Exit from PRC Investments through the Hong Kong Capital Markets

Last Updated: 18 November 2002

Article by Michael G. Chin and Barbara W.K. Mok

One of the biggest deterrents for investors looking to put venture capital into China is finding a suitable exit from their investment. With the continuing absence of a domestic growth enterprise market suitable for listing small to medium-sized high-tech companies, Hong Kong’s GEM board should represent one of the more viable avenues of exit for venture capital investment in PRC enterprises.

Unfortunately, the Hong Kong Stock Exchange’s reliance on the blessing of regulators in China continues to bring uncertainty for private equity investors looking to access the Hong Kong capital markets.

Currently, Hong Kong Exchanges and Clearing requires a "no objection" letter from the China Securities Regulatory Commission ("CSRC") before allowing the listing of a non-PRC company in Hong Kong.

Venture capitalists are usually only willing to put their money into a company if there is a clear route to getting it out again.

Many are prepared to wait for years, but they have investors of their own who, knowing the high risk involved in venture capital funding, want to be sure that at some time, the money is coming back. Without a clear method of realising investments, the amount of venture capital flowing into China’s cash-hungry enterprises will continue to be limited.

The obvious home for the enterprises would be China’s own markets in Shanghai and Shenzhen, but regulators favour the state-owned enterprises over those which have come up through the private sector. Happily, this now appears to be changing, and an increasing number of private companies are being listed on China’s stock exchanges.

Regulators have recognised that the long-term prospects of the former SOEs are usually limited, posing a threat to investors who could find themselves left holding stocks in moribund companies. The outlook for successful private companies to keep markets growing is much brighter.

The number of listed private companies has now reached 200, still only 15 per cent of the total, and there is still resistance among some politicians to allowing private companies to become too much of a force on the stock markets – so once again, an exit route is blocked, or at least, narrowed.

The opportunities for investment by foreign venture capital companies has also been restricted, but there are signs of relaxation and rule changes that could open up the market. Early in September, reports began circulating in Beijing of important developments which included raising the percentage of capital that could be invested from the current 50 per cent. Foreigners would also be allowed to pump capital into previously restricted sectors such as finance, real estate, transport and retailing.

The establishment of clear rules on venture capital is expected to attract more capital, as many companies have been deterred by the vague regulation, and the resultant widespread irregularities.

If changes to the rules are to encourage more venture capital into China, the requirement for a satisfactory exit route for investors will become even more pressing. According to a survey by market researchers Zero2ipo.com, of 325 venture capital companies in China, only six had been able to realise investments through the usual channels of stake transfer, merger and acquisition, and stock sales. Many of the others just lost money.

In theory, venture capitalist could arrange listings on China’s stock exchanges – the regulations are in place, but so far have not been widely used.

With the US markets usually out of reach for many venture-capital-invested PRC enterprises, the Hong Kong capital markets should offer a solution. In particular, the Growth Enterprise Market, with its more relaxed listing requirements, should represent a convenient and attractive exit avenue, and some mainland venture-capital-funded operations have taken advantage of the market.

It is now possible to directly list the shares of a PRC company on the Hong Kong stock markets, often referred to as an H share listing. As well as this type of H share listing, another way of taking a PRC company public is by restructuring the PRC enterprise into a Wholly Foreign Owned Enterprise ("WFOE"), and listing the offshore foreign holding company.

Unfortunately there are still a number of restrictions which make the H share listing route less attractive to venture capital companies. If the VC invests as a promoter of the PRC company, there is a three-year lock up on transfer of such shares, and only the newly issued H shares are generally capable of being listed, all of which adversely affect the liquidity of the VC's investment capital.

Instead, venture capital is more usually channelled into a PRC enterprise through an offshore company, which requires the restructuring of the PRC enterprise into a WFOE with the target of listing the offshore entity.

If the PRC enterprise is owned by individuals, this should require only a straightforward share swap of the WFOE's shares for the offshore company's shares, as there is currently nothing which precludes a PRC national from holding shares in a foreign company.

However, there is still a major hurdle to jump – Chinese foreign-funded companies which want to list on the GEM require a local PRC law firm to issue a legal opinion as to compliance with relevant laws in the PRC which must be endorsed through a letter of "no objection" from the CSRC.

Before issuing the required "no objection letter", the current practice of the CSRC will be to carefully review the restructuring, in particular, the amount, and manner in which the consideration was paid for the share capital of the WFOE. Unfortunately, the CSRC’s basis for objection has tended to stray beyond those founded on legal compliance considerations. For example, the practice of the CSRC has been to object to any restructuring whereby the consideration paid for the share capital of the WFOE is below perceived net asset value of the PRC enterprise or is effected through an outright share swap, neither of which are precluded under PRC law.

Any concern regarding the offshore listed entity’s PRC subsidiary compliance with the laws of its home jurisdiction can and should be provided by the issuer and its own professional advisers vis-a-vis a legal opinion.

With the ever-changing policies of the CSRC with regards to its approval criteria, venture capitalists with one eye on exiting through Hong Kong will still need to structure their investments in the PRC very carefully but without any real certainty as to whether they’ll be allowed through the gate.

Jones Day Commentaries are a publication of Jones, Day, Reavis & Pogue and should not be construed as legal advice on any specific facts or circumstances. The contents are intended for general informational purposes only and may not be quoted or referred to in any other publication or proceeding without the prior written consent of the Firm, to be given or withheld at its discretion. The mailing of this publication is not intended to create, and receipt of it does not constitute, an attorney-client relationship.

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