Private Equity 2024 Comparisons

China’s private equity (PE) and M&A market has been gradually recovering from the COVID-19 pandemic, but it is still faced with challenges in 2024 due to the global macroeconomic slowdown.

It is no secret that the PE and M&A market experienced a significant downturn in 2023, reportedly reaching the lowest point in a decade according to various market research agencies. The Chinese M&A market saw a decline of approximately 20–30% in 2023, with cross-border transactions experiencing a particularly drastic drop.

According to PwC, in 2023, the total transaction value of M&A deals in China was USD333.1 billion, which represents a 28% decrease compared with that in 2022. Similarly, Deloitte found that, in 2023, a total of 8,821 M&A deals were announced in the Chinese market, a year-on-year decrease of 5.18%. The transaction value was approximately CNY1.899 trillion, down by about 22.86% compared with 2022.

Despite a general decline in the Chinese market in 2023, transactions in certain sectors and industries remained active. For example, investments by state-controlled enterprises in 2023 increased by 6.4% according to Deloitte; investments in information, energy, high-tech and other industries were all increasing. Furthermore, Chinese enterprises’ outbound investments increased drastically.

In the first half of 2024, investors remained cautious. It was reported that, in total, there were 3,674 Chinese M&A deals, representing a decrease of 3.32% compared with 2023. The transaction value was approximately CNY709.9 billion, down by about 12.45% from 2023.

The Chinese market in 2024 is poised to see increased activity in several key areas, including internal consolidation among enterprises, robust overseas investments by Chinese companies, potential market exits by foreign-invested enterprises and heightened M&A activity by state-owned enterprises.

First, the overall recovery of the Chinese market in 2024 is likely to be relatively slow. The economic downturn is expected to prompt some smaller or less profitable enterprises to consider selling at reasonable prices to industry leaders or more capable and ambitious companies. Consequently, horizontal consolidation within industries will remain a significant trend in the Chinese market in 2024. In the first half of 2024, horizontal consolidation deals accounted for 22.22% of all M&A deals in China.

Second, Chinese enterprises are actively pursuing overseas investments. This trend may result in an increase in cross-border M&A as Chinese companies expedite their global expansion and enhance their international presence.

Additionally, factors such as geopolitical tensions and uncertainties in China-US relations may prompt foreign-invested enterprises in China to consider exiting the Chinese market; this could lead to an increase in such transactions.

Moreover, since the State-owned Assets Supervision and Administration Commission convened a special meeting in June 2023 to enhance the quality of listed companies and promote M&A activities, state-owned enterprises have become more active in the capital market. State-owned enterprises are expected to further engage in M&A within their traditional sectors and strategic emerging industries in 2024, with the aim of optimising the structure of state-owned capital.

Improved Regulatory Framework for PE Funds

In 2023, a series of regulatory policies were issued in the PE fund sector, leading to a reshaping of the regulatory framework for PE funds. The most significant development was the enactment of the Private Investment Fund Supervision and Administration Regulation in September 2023, which is the first administrative regulation in the private investment fund sector and also promotes healthy and regulated development of the PE fund industry within a legal framework.

Following the Private Investment Fund Supervision and Administration Regulation, certain related policies and supporting rules have been introduced, resulting in noticeable changes in this industry. On the one hand, non-compliant PE funds have been swiftly purged, with over 900 PE firms being deregistered and hundreds being penalised for violations in 2024. On the other hand, leading PE firms are actively enhancing their research and investment capabilities following the latest regulatory requirements.

With the Increased Difficulty of IPO Exits, a Trend Towards M&A Exits Has Emerged

Since 2023, China’s A-share IPO requirements have become increasingly stringent, and the path to overseas listings is also being affected by tighter regulation, forcing many companies to terminate their listing plans. Statistics indicate that, out of the 313 companies that successfully completed IPOs on the A-share market in 2023, 237 involved PE fund investments, representing a penetration rate of 75.7%. However, in terms of investment returns for PE funds, the average multiple of investment returns as of the IPO date was 4.8 in 2023, down 10% from 5.37 in the previous year. Due to these constraints, many PE funds are now exploring M&A exits as a new plan.

New Company Law Implemented

The new Company Law of the PRC came into effect on 1 July 2024. This revision is the most extensive since the law was first enacted in 1993, involving reforms in the company capital system, the refinement of shareholder rights, and adjustments to corporate governance structures, etc. These changes are expected to impact various aspects of PE fund activities, including fundraising, investment, management, and exit strategies.

Formation and Operation of PE Funds

PE funds are investment vehicles established to raise capital from investors in a non-public manner. These funds are managed by fund managers for the purpose of investment activities. In China, PE funds can be structured as a company, a limited partnership or mere contractual arrangements.

The China Securities Regulatory Commission (CSRC) is the primary regulatory authority overseeing securities and capital markets. The Asset Management Association of China (AMAC) serves as a self-regulatory organisation that supervises and regulates the activities of PE fund managers and other asset management institutions in China.

PE fund managers are required to register with the AMAC and complete the necessary filing procedures after successfully raising private capital. The formation, governance structure, fundraising, investment activities, reporting obligations, information disclosure, liquidation, and distribution of PE funds are subject to various rules and regulations issued by the CSRC and AMAC. Furthermore, foreign investors participating in PE funds formed in China must also comply with foreign investment regulations and foreign exchange control requirements in China.

Restrictions on Foreign Investments

The Law of the People’s Republic of China on Foreign Investment provides national treatment to foreign investors, except for investments made in any industry listed on the negative list. In general, foreign investment controls no longer apply to foreign financial sponsors if the investment is not made in a negative-listed industry. However, national security reviews may still be required for investments that might have an impact on national welfare. Additionally, China has its own foreign exchange control regime, subjecting the inflow or outflow of funds to government clearance.

For sectors on the negative list, foreign PE funds may still invest in restricted sectors if certain requirements are met (eg, co-operation with a Chinese partner and the Chinese partner maintaining controlling ownership), and with prior approval from the relevant regulatory authorities. However, foreign investors are prohibited from directly or indirectly holding equity interests in companies engaged in prohibited sectors.

To invest in restricted or prohibited sectors, some foreign investors utilise a variable interest entity (VIE) structure instead of direct or indirect stock ownership. However, the Chinese government has posed increasing challenges to this VIE structure in recent years. In 2023, the CSRC proposed a new filing-based regulatory regime for overseas listings of companies with VIE structures, introducing more uncertainties for companies employing such a structure.

Antitrust Review

The State Administration for Market Regulation (SAMR) is the regulatory authority responsible for antitrust review in China. Under law, a transaction will be subject to Chinese antitrust clearance if it results in a change of control of the target company and meets the following PRC antitrust filing thresholds:

• if two or more participants each generate a turnover exceeding CNY800 million in China in the last fiscal year; and
• if the total turnover generated by all participants in China in the last fiscal year exceeds CNY4 billion or if the total worldwide turnover exceeds CNY12 billion.

In transactions triggering antitrust review, the parties involved are required to make a prior declaration to the SAMR, and the transaction should not proceed until antitrust clearance is obtained. It is important to note that, under PRC merger filing rules, minority investments by multiple financial sponsors in the same target may be considered as joint control if these sponsors possess significant veto rights over operational matters. Consequently, some financial sponsors deliberately refrain from acquiring veto rights at the board or shareholder level to avoid triggering the need for merger clearance when making minority investments in a target.

National Security Review

The Working Mechanism Office for the Security Review of Foreign Investment (an agency established within the National Development and Reform Commission) is the regulatory authority responsible for national security review in China. Foreign investments falling within the following scope are subject to national security review:

• investments in the military related industries; and
• investments in control over other critical sectors related to national security, including significant agricultural products, energy and resources, equipment manufacturing, infrastructure, transportation services, cultural products and services, information technology and internet products and services, financial services and key technologies.

Currently, the Chinese government does not provide a clear list of specific types of projects that are subject to the national security review. In practice, foreign investors or relevant domestic parties usually engage professional legal advisors to review the project before implementing the transaction. If there are factors that may give rise to a national security concern, they may take the initiative to report to the authority for advice on whether a national security review is required.

ESG

In recent years, a significant amount of funds have flowed into ESG-related services and investment products, leading to a substantial increase in the number of PE funds oriented towards ESG investment. AMAC has actively encouraged the establishment and implementation of ESG-related investment funds. It has issued the Recommendations on the Green Investment Self-Assessment Report Framework for Fund Managers and the Green Investment Self-Assessment Form for Fund Managers. PE fund managers are required to conduct an annual self-assessment of their green investment practices and submit the report and form to the AMAC.

In September 2023, Beijing introduced the first industry-wide standard for ESG-related investment funds, known as the Guidelines for Sustainable Investment Information Disclosure by Private Equity Fund Managers (the “Guidelines”). The Guidelines encourage PE fund managers registered and established in China to publish at least one annual sustainable investment report to the public.

Normally, PE investors will engage external legal counsel to conduct comprehensive legal due diligence when dealing with Chinese target companies. The key areas of focus in the legal due diligence process typically include corporate structure and governance, licences, regulatory compliance, material contracts, real estate and property, intellectual property rights, management and employee matters, financial and tax matters, insurance, environment, health and safety matters, administrative penalties, litigation and disputes.

The legal due diligence process in China is typically conducted through a combination of public information searches, legal document reviews, management interviews, site visits and discussions with relevant stakeholders. The outcome of the legal due diligence review for PE transactions is usually the issuance of a red-flag report that summarises key concerns and proposed mitigations. Compared with strategic investors, PE investors are more concerned about issues that may impact the valuation of the target company and their exit strategy, such as non-compliance issues that could hinder the target’s IPO.

Vendor due diligence is less common for PE transactions in China, as buyers usually prefer to conduct their own legal due diligence through their own legal counsels. However, in auction sales, sell-side legal advisers in China will sometimes provide reports or fact books that summarise the findings of the vendor due diligence for the purpose of costs control and transaction efficiency. These reports cover various legal aspects of the target company, including corporate structure, regulatory compliance, contracts, litigation, intellectual property and other relevant areas. The content and format of these reports may vary depending on the specific transaction and the preferences of the seller and their advisers.

Normally, sell-side advisers will only provide very limited reliance on the vendor due diligence reports to potential buyers. They may issue letters stating that the reports were prepared based on information provided by the seller, and that the buyer can rely on them to a certain extent. However, it is still recommended for buyers to conduct their own due diligence to verify the accuracy and completeness of the information provided in the vendor due diligence reports, as reliance is often limited in nature.

In China, most acquisitions by PE funds are carried out through private sale and purchase agreements. The auction approach is less commonly employed. If state-owned assets are involved, the transaction generally should go through an open bidding procedure with relevant exchanges. For listed companies, deals are typically concluded through methods like private placements, block trading and tender offers.

In a privately negotiated transaction, the parties typically begin by negotiating and signing a term sheet that outlines key commercial and legal terms, although most terms in the term sheet are not legally binding. This is followed by due diligence and the preparation and negotiation of transaction documents. The term sheet can be renegotiated or supplemented according to the findings of due diligence and the negotiations between relevant parties. In contrast, in an auction sale, sellers are normally in a more advantageous position to set transaction terms, while buyers tend to have less bargaining power and may focus more on key terms, especially in judicial auctions. For listed companies, transaction structure and terms are subject to applicable securities rules and disclosure requirements and therefore tend to be less flexible.

The PE-backed buyer is typically structured as a limited liability partnership that usually has one general partner (GP) and several limited partners (LPs). The GP manages the partnership and assumes unlimited liability, while the LPs assume limited liability within the scope of their respective capital contribution. The specific transaction structure of a deal is subject to various factors, including tax considerations, legal requirements, confidentiality concerns and the nature of the target company. PE funds often establish multiple layers of special purpose vehicles overseas for involvement in acquisition documentation and are less likely to become a direct contracting party of transaction documents. The multilayered structure helps mitigate risk, optimise tax efficiency and maintain confidentiality, thus ensuring better protection and flexibility in managing the PE funds’ investments.

In China, PE buyers typically rely on the capital they have raised for their investments. The use of debt financing, such as bank loans, is not prevalent in the Chinese market for PE transactions. This is partly due to the stringent legal system for financing and foreign exchange in China. When it comes to transactions involving offshore levels, the dynamics change. Specifically, if the target company is an offshore holding company of a Chinese enterprise, a combination of equity and debt financing becomes more common. In such cases, the PE buyer may leverage offshore financing sources to structure a deal that combines both equity and debt.

Consortium deals are common in Chinese PE transactions, especially when the target is of high quality or high value with promising prospects. Co-investment by other external investors alongside the lead PE fund or GP is also common in China. LPs often actively seek co-investment rights with the GP of the fund. Based on the specific deal, consortia may include both PE funds and corporate investors.

Fixed price, completion accounts and a performance-based valuation adjustment mechanism (VAM) are the predominant forms of consideration structures used in PE transactions in China. It is also not uncommon for the transaction parties to adopt more flexible consideration mechanisms, such as earn-outs, deferred payment and roll-over structures, when there are uncertainties regarding the post-closing performance of the target company. These mechanisms provide flexibility in addressing potential risks and aligning the interests of the parties involved.

In general, PE fund sellers usually prefer consideration structures that provide upfront cash proceeds, such as fixed-price with or without locked-box, while PE fund buyers may consider earn-outs, deferred consideration or a performance-based VAM to reduce future uncertainties and incentivise future performance management.

PE funds usually have more experience and resources to negotiate and enforce the terms of the consideration mechanism. They may also have more sophisticated mechanisms for protecting their interests, such as indemnification provisions or escrow arrangements. Corporate sellers or buyers may have different risk appetites, and compared with PE buyers, corporate buyers tend to be more inclined to offer higher prices and a more favourable consideration to sellers. This is often due to the potential strategic advantages and synergies they see in acquiring the target company.

The fixed-price locked-box consideration structure is not commonly used in PE transactions when dealing with Chinese target companies. In fixed-price locked-box consideration structures, the equity price is agreed upon and fixed at the time of the transaction, and interest is typically not charged on the equity price. Besides, it is not typical to charge (reverse) interest on the leakage during the locked-box period.

In transactions structured with a completion accounts mechanism, it is common to include a dispute-resolution mechanism to address any disagreement regarding the closing account adjustment items, and the parties often appoint an independent expert, such as an accounting firm or a valuation specialist, to review and resolve disagreements related to the adjustments made to the purchase price based on the completion accounts. It is also important to include provisions regarding:

• the method for selecting such an auditor;
• a specified timeframe to resolve any disputes;
• the scope of items and amounts that can be considered in resolving the dispute; and
• the allocation of fees and expenses between the parties.

As for transactions structured with other consideration mechanisms, such as fixed-price, earn-outs, or a performance-based VAM, the parties typically rely on the general dispute resolution provisions outlined in the transaction documentation to resolve any disputes that may arise.

The level of conditionality in PE transactions in China can vary depending on the specific deal and parties involved. In general, PE transactions in China typically include substantive closing conditions such as:

• corporate authorisations to execute the transaction documents;
• receipt of internal and external approvals or consents;
• completion of certain governmental registrations or filings;
• continued accuracy of representations and warranties from signing to closing;
• no material adverse changes between signing and closing; and
• other conditions related to key legal due diligence findings, such as the completion of corporate restricting and the rectification of certain non-compliance issues; financing of the closing funds is typically not considered a closing condition in China.

The requirement for third-party consent as a closing condition is primarily determined by the target company’s contractual obligations and the potential material adverse impact on the company if such consent is not obtained. This is particularly relevant when there are important contracts that may impact the success of the transaction. For example, the commercial banks or key customers of the target company may demand prior consent if there is a change of control in the company. Failure to obtain these consents could lead to the imposition of accelerated loan repayment plans by banks, early termination of contracts by customers or cancellation of the target company’s vendor qualifications. In such cases, obtaining third-party consents will be considered as a closing condition.

“Hell or high water” undertakings are not commonly seen in PE transactions in China, particularly in cases where the regulatory approvals (such as antitrust clearance, national security review and approvals in relation to restricted foreign investment areas) are significant conditions to complete the deal. The parties are required to make reasonable best efforts to fulfil the regulatory condition as promptly as practicable. If the regulatory condition cannot be fulfilled prior to the agreed long-stop date, it is common for the non-breaching party to have the right to terminate the agreement without any break fee.

While break fees are not unheard of in China, they are not as prevalent in the market. In limited situations where break fees do apply, the typical triggers for such fees may include instances where the seller fails to fulfil its obligations or breaches the terms of the agreement, leading to termination of the deal. In China, there is no legal restriction on break fees, allowing parties to negotiate and agree upon the amount. However, it is important to consider the enforceability of break fees under PRC Civil Code and potential challenges in court if the amount is deemed excessive or a penalty rather than a genuine pre-estimate of damages. Courts in China tend to scrutinise the reasonableness of liquidated damages, including break fees, and may adjust or limit their enforcement if found to be excessive or unconscionable. In this regard, the volume of break fees, if applicable, is often limited to 130% of the actual losses incurred by a non-breaching party arising from the termination of the transaction.

Reverse break fees, where the buyer pays a fee to the seller in the event of a deal’s termination, are also uncommon in China. However, it is possible for parties to negotiate and include reverse break fees if they deem it appropriate and mutually beneficial to allocate the risk of deal failure.

In PE transactions in China, the acquisition agreement can be terminated either through mutual agreement or through the exercise of a unilateral termination right based on specific agreed-upon circumstances. These circumstances may include:

• failure to fulfil closing conditions before the long-stop date;
• breach of representations and warranties;
• discovery of undisclosed material negative matters;
• occurrence of material adverse effect; and
• insolvency, liquidation or dissolution of a party.

The longstop date is typically negotiated between the parties and depends on various factors, including the complexity of the deal, regulatory requirements and other relevant considerations. It is commonly set between three to six months in PE transactions in China but can extend up to six months to one year in more complex transactions.

PE-backed transactions often involve higher-level risk mitigation measures due to the nature of the investment and the shorter-term ownership horizon of PE funds. It is common for PE buyers requiring sellers to provide a comprehensive list of representations and warranties and detailed disclosures in the transaction documents, and the sellers are required to compensate the buyer for false representations and warranties. Furthermore, PE investors often employ various strategies to mitigate investment risks, including price adjustment mechanisms, deferred payments, escrow arrangements and the implementation of preferential and flexible exit mechanisms in the transaction documents. Such exit mechanisms may include tag-along rights, drag-along rights, put options, and liquidation preference rights. In exit transactions, PE sellers generally aim for clean exits by minimising the scope and survival periods of their warranties and imposing caps on indemnity liabilities to the greatest extent possible.

On the other hand, in transactions where the seller or buyer is a strategic investor, there may be a greater level of reliance on the buyer’s own due diligence and business judgement as the strategic investor usually has a deeper understanding of the industry and the specific business being acquired. However, in general, strategic investors share similar risk allocation strategies as PE investors, such as utilising price adjustments, representations and warranties, indemnification, and termination provisions.

To achieve a clean exit, a PE seller would typically limit the scope of warranties and subsequent indemnifications, especially when the seller only holds a minority stake in a target company (which is often the case in China). It is common for PE sellers to provide only fundamental warranties related to the ownership and title of the shares being sold, in the absence of encumbrances and due authorisation to complete the transaction. Operational warranties and warranties concerning the financial and material assets of the target company are less likely to be accepted by a PE seller who is a minority shareholder.

However, if a PE seller is a majority shareholder, its warranties would generally be more comprehensive and may extend to knowledge of the target company’s management, as they are usually responsible for its operation. It is rare for the target company’s management to issue warranties directly to the buyer, as they are typically not party to the transaction.

In PE transactions in China, the buyer usually does not accept the seller’s general reference to the data room and will require the seller to accurately disclose the specific exceptions to the representations and warranties through a disclosure letter. This practice ensures that any specific matters or information disclosed in the data room are expressly accounted for and do not serve as exceptions to the warranties. Whether the buyer is PE-backed or not does not typically impact the warranties provided by a PE seller.

The customary limits on liability for a seller’s warranties and indemnities can also vary but may include provisions such as caps on liability, de minimis thresholds (minimum claim amount), baskets (thresholds that must be exceeded before claims can be made), deductibles (amounts the buyer must bear before the seller becomes liable) and survival periods (periods during which claims can be made). The specific limitations will depend on the terms negotiated between the parties and the particular circumstances of the transaction.

In PE transactions in China, the buyer usually requests that the seller eliminate the key issues with high-risk exposure before closing. Alternatively, the buyer may seek a reduction in the purchase price to account for such risks. Instalment payments, an escrow or retention arrangement, post-closing adjustments and indemnification provisions are commonly used to increase the enforceability of the seller’s indemnifications. The escrow or retention amount may be used to satisfy claims for breaches of fundamental warranties, business warranties, and tax or other indemnities.

Warranty and indemnity (W&I) insurance is not commonly seen in PE transactions in China, but in certain cross-border transactions, foreign PE investors may consider purchasing W&I insurance as a means to mitigate potential risk exposure. The coverage of the insurance can extend to both fundamental warranties and business warranties, and in some cases may also include tax-related matters. The specific coverage and terms of the W&I insurance policy would be subject to negotiation between the parties and the insurance provider.

Litigation in connection with PE transactions is not commonly seen in China. The parties often opt for domestic or international arbitration as the preferred method for resolving disputes, as arbitration is generally considered to be more flexible and equitable, with greater confidentiality in China. The selection of arbitration institutions in Beijing, Shanghai, Hong Kong and Singapore is more common in PE transactions in China.

In terms of the most commonly disputed provisions in PE transactions, they typically involve representations and warranties, indemnities, earn-outs, valuation adjustments, redemptions, put options, and shareholder or parent guarantees. These provisions often give rise to disagreements and potential disputes between the parties.

In China, the delisting of public companies can be categorised into two types: forced delisting and voluntary delisting. Forced delisting occurs when the listed company fails to meet the regulatory or listing requirements, leading to its mandatory removal from the exchange. This could be due, for example, to financial instability or a major violation of law. On the other hand, in the case of voluntary delisting, a company decides to delist itself from the stock exchange. In practice, voluntary delisting of Chinese companies is quite rare. However, Chinese companies listed overseas are more frequently engaged in public-to-privates transactions.

In China, when an investor holds 5% or more of a listed company’s shares after a proposed transaction, it must prepare and submit a report on the change of shareholding to the CSRC and the stock exchange within three days, notify the listed company and make a public announcement. The investor is generally not allowed to trade the shares until after the public announcement.

The investor must follow similar reporting and disclosure obligations post-initial transaction every time it acquires or disposes of 5% or more of the shares of the listed company on an accumulative basis. In addition to these disclosure obligations, the investor should generally suspend trading of the listed company’s shares for a certain period, typically until three business days have elapsed after the public announcement date.

If the investor fails to comply with the above-described reporting and disclosure obligations and acquires 5% or more of the shares of the listed company, the investor is not permitted to exercise its voting rights in relation to the newly acquired shares for 36 months.

Furthermore, an investor holding 5% or more of a listed company’s shares is required to notify the listed company and make a public announcement every time its shareholding ratio increases or decreases by 1% or more on an accumulative basis.

In China, 30% is the mandatory offer threshold. If an investor obtains more than 30% of a listed company’s shares, whether through an agreement transfer, voting rights agreement or other arrangements, indirect acquisition or secondary market transactions, the investor must make a tender offer to all other shareholders to acquire all of the remaining shares of the company unless an exemption applies. If the investor holds 30% of a listed company’s shares and wishes to acquire more shares, it must make a tender offer to all other shareholders to acquire all or part of the remaining shares of the company.

There are certain exemptions on the mandatory tender offer, such as proposed share transfer between entities controlled by the same final beneficiary, or where the purpose of the transaction is to save the listed company from severe financial difficulties and the investor undertakes to not dispose of its shares within three years.

Cash is more commonly used in China as consideration. PRC law generally does not restrict non-cash payment, but compared with cash, it appears to be less flexible with other forms of consideration. In a tender offer, the offer price for shares of the same category shall not be less than the highest price paid by the investor for such shares within a six-month period preceding the date of the indicative announcement on acquisition by offer. If the offer price is less than the mathematical average value of the daily weighted average prices for such shares over 30 trading days before the date of the indicative announcement, the financial consultant engaged by the investor shall analyse the trading of such shares within the latest six-month period and confirm whether the share prices are being manipulated, whether the investor has failed to disclose persons acting in concert with it, whether the investor has obtained the shares of the company by way of other payment arrangements during the past six months and the reasonableness of the offer price.

Although the law does not restrict the use of offer conditions, most takeover offers only set customary regulatory conditions, such as obtaining certain regulatory approvals and necessary internal approvals, with few extra special conditions.

It is unusual for the bidder to obtain financing as a condition on a tender offer. Instead, the bidder is required to demonstrate its payment ability prior to the offer by way of a deposit, a letter of guarantee issued by a bank, etc.

In China, it is uncommon for a bidder to seek deal security measures such as break fees, match rights, force-the-vote provisions or non-solicitation provisions.

If a bidder does not seek or obtain 100% ownership of a public company or permission to convert it into a private company, it normally cannot have extra governance rights except those in relation to its shareholding.

In China, it is quite rare for a bidder to obtain financing for payment of the consideration; therefore, there are no specific regulations regarding the setting of a particular threshold, and no specific mechanism for a debt push-down into the target after a successful offer.

The Company Law of the PRC (2023 Revision) introduced a new mechanism where, if a company merges with a subsidiary that holds not less than 90% equity or shares, the merger does not need approval at the subsidiary’s shareholders’ meeting, and the minority shareholders shall be served with a notice and shall have the right to request that the company acquire their equity or shares at a reasonable price. Said new mechanism is very similar to the squeeze-out mechanism in foreign countries, but it only occurs in the circumstance of a merger between the company and its subsidiary.

Under PRC law, a shareholder can “pre-accept” a tender offer, which indicates its preliminary intent to agree to accept the offer and shall not constitute an irrevocable and binding undertaking until three trading days before the end of the acquisition period specified in the acquisition report prepared by the bidder. In other words, the pre-acceptance of the tender offer is not binding before this three-day period. However, once this period begins, the acceptance becomes binding and cannot be revoked by the shareholder, even if a better offer is made.

In China, it is common to implement equity incentivisation for employees, typically including senior management and other key employees. These incentives are usually provided through employee stock-ownership plans, which may feature restricted shares and stock options. Shares allocated for these incentive programmes are often held by a nominee appointed by the company’s founder through a limited partnership. In practice, before a company undergoes equity financing, the shares reserved for employee incentive plans generally range from 10% to 15% of the total shares, of which 50–70% are typically allocated to the management team.

Management participation in PE transactions is relatively uncommon in the Chinese market. When management does choose to participate, they generally need to purchase shares at the same price as the PE investor. Alternatively, they may exercise their rights under an existing employee stock-ownership plan. This ensures that management’s investment is aligned with the PE investor’s terms, maintaining fairness and consistency in the transaction.

Vesting and leaver provisions are key components when structuring equity incentives for management in PE transactions in China. These provisions are particularly relevant for shares or options obtained under employee stock-ownership plans.

Vesting provisions generally depend on negotiations between the PE investor and the management team. A typical vesting schedule for management options is four years, with 25% of the shares vesting after the first year and the remainder vesting periodically over the following three years. Vesting conditions often include the achievement of certain performance goals.

Typically, the company or the controlling shareholder retains the right to acquire management shares if a manager’s employment is terminated. Leaver provisions are often categorised into “good-leaver” and “bad-leaver” provisions. A good leaver might leave the company due to retirement, disability or death, while a bad leaver might leave under other circumstances. Under both good- and bad-leaver scenarios, any unexercised options or shares are usually cancelled. For exercised shares, a good leaver can either retain the shares until exit events or have them redeemed by the company at the exercise cost, fair market value or net asset value. In contrast, a bad leaver will have their shares redeemed at the fair market value or exercise cost (whichever is lower), with the company being entitled to deduct any damages caused by the bad leaver.

The customary restrictive covenants for management shareholders typically include non-compete, confidentiality, non-solicitation, non-disparagement and full-time commitment clauses. These provisions ensure that management does not engage in competitive activities, disclose sensitive information, solicit company employees or clients, or make negative statements about the company. Additionally, key individuals in management are often required to maintain their positions at the target company for a specified period to ensure continuity and stability.

Typically, manager shareholders do not receive more protection than other minority shareholders. However, if a manager shareholder is crucial to the target company’s operations and management, they might negotiate for board seats or veto rights over significant corporate decisions. While PE investors usually resist giving manager shareholders the power to control or limit their exit, these investors are often restricted from transferring shares to the target company’s competitors.

In China, PE investors are more commonly seen as minority shareholders of the target company. In such cases, PE investors usually do not directly participate in the daily operations of the company, but they will seek a series of minority shareholder protection rights in the transaction documents.

Board Appointment Rights

PE funds would usually require the right to appoint at least one representative to the board of directors of the portfolio company. The representative can provide oversight and help align the company’s strategic direction with the fund’s investment objectives. Normally, the director nomination rights will be allocated to shareholders pursuant to their respective equity ratios, but PE funds may strive for more nomination rights through negotiations. On the other hand, if there are many investors in the target company, that company and its actual controller may want to control the number of board members. In this case, only shareholders with a certain threshold of shareholding (such as 5%) can enjoy the right to nominate directors.

Reserved Matters

If a PE fund only serves as a minority shareholder, it may not be able to have dominant power over all major aspects of decision making, so it is typical to negotiate a list of veto rights to retain the veto power of the PE fund on certain matters that are of vital importance, including (but not limited to) major acquisitions or divestitures, changes to the company’s capital structure, a change of board composition, related party transactions, employee incentive plans, company listing plans, amendments to the company’s articles of incorporation, approval of annual budgets or business plans, and liquidation, dissolution and other major issues in the company. The exact list of reserved matters is typically outlined in the shareholders’ agreement or other governing documents.

Information Rights

A PE fund has the statutory rights under PRC Company Law to review relevant company decision-making documents (eg, shareholders’ resolutions and board resolutions) and financial documents (including financial statements, accounting books and accounting vouchers). In addition to the statutory rights, a PE fund often negotiates for more information access to the portfolio company through negotiations. This may include regular financial and operational updates, access to management reports, the right to request additional information or reports as needed to monitor the company’s performance and specialised audits by its engaged auditors.

It is very rare for a PE fund to be held liable for a portfolio company’s liabilities. Under PRC law, liability is generally attributed to the legal entity of the portfolio company itself, unless the concept of “piercing the corporate veil” can be applied to hold the PE fund liable. This is typically done in cases where the fund has abused the corporate structure or used it to defraud creditors, evade legal obligations or engage in other unlawful activities, effectively disregarding the separate legal existence of the company.

Furthermore, since the PE fund is normally acting as the minority shareholder of the company, it will not participate in the daily operations of the portfolio company. Therefore, the PE fund will not accept any contractual joint liability for the actions of its portfolio company.

In general, IPOs, equity transfers, buybacks, mergers, and liquidations are the primary exit routes for PE investors. Among these options, IPOs remain the most common exit path for PE investors. According to a report by Zero2IPO (a research agency), IPO exits accounted for 54% of publicly recorded PE investor exits in 2023. However, it is worth noting that the IPO market in China experienced a temporary slowdown in 2023 due to market and regulatory factors, resulting in a decrease in the number of IPOs. As a result, investors have increasingly turned to equity transfers and buyback transactions as alternative exit strategies. In 2023, equity transfers were chosen as the exit strategy by 24% of PE investors, while an additional 15% opted for buyback exits.

In PE transaction documents, it is customary for PE investors, the target company, as well as its founders and controlling shareholders to agree on multiple potential exit routes. This provides flexibility to select the most appropriate exit strategy based on the prevailing circumstances at the time of the exit triggers. However, it should be noted that once a PE investor opts for an IPO exit, there are stringent restrictions on equity transfers during the IPO application period. Consequently, the implementation of dual- or triple-track exit plans is rarely observed in practice.

Whether a PE fund can roll over or reinvest upon exit depends on the provisions stipulated in its fund agreement. However, if the PE fund includes special types of investors such as government-guided funds, government investors or state-owned capital investors, there are generally more stringent limitations imposed on fund rollovers or reinvestments.

Drag Rights

It is common for drag-along rights to be included in shareholders’ agreements or other governing documents to protect the interests of the majority shareholders and provide flexibility in exit strategies. These rights are particularly important for institutional investors, including PE funds, who consider trade sales as potential exit alternatives.

The drag threshold, which refers to the minimum ownership percentage required for the exercise of drag rights, can vary. In China, the typical drag threshold is often set at a majority ownership percentage, such as more than 50% of the shares with voting rights. This means that if the dragging shareholders collectively hold at least the specified ownership percentage, they can compel the minority shareholders to sell their shares in a transaction. However, the selling party must usually offer the same terms and conditions to the other parties. In addition, the exercise of the drag-along rights is usually required to be based on an agreed valuation price and needs to be completed within a certain period of time.

Tag Rights

Tag-along rights are commonly seen in equity arrangements and are often used in practice. Tag-along rights comprise a group of clauses that together have the effect of allowing one party in a company (normally the minority shareholder) to also take part in a sale of shares by the other party to a non-shareholder under the same terms and conditions. PE investors often seek tag-along rights in situations where other shareholders, particularly controlling shareholders, or founder shareholders are exiting. Institutional co-investors generally enjoy exit rights consistent with those of PE investors.

There is no typical threshold for tag-along rights in China, and the specific tag thresholds can be negotiated and may vary depending on the circumstances of each transaction. PE investors will aim to negotiate more favourable triggering thresholds for tag rights in their favour.

In China, the lock-up periods applicable to PE investors in an IPO exit typically differ based on their shareholding and timing of acquisition. For minority shareholders, the lock-up period is usually one year, while controlling shareholders are subject to a longer lock-up period of 36 months. However, for companies without an actual controller, shareholders collectively holding 51% of all issued shares prior to the IPO will face a 36-month lock-up period, excluding qualified VC funds. Moreover, any investor acquiring shares within 12 months before a company’s IPO application will be subject to a 36-month lock-up period starting from the date of acquisition.

Following the expiration of the lock-up period, PE sellers holding at least 5% of the shares may encounter certain restrictions and disclosure obligations when transferring shares acquired prior to the IPO. For instance, consecutive block trading or centralised bidding system transfers within 90 days should not exceed 1–2% of the total outstanding shares of the company. Additionally, if a seller holding over 5% of the shares intends to transfer shares via a centralised bidding system, they must announce their intent and the number of shares to be transferred in advance. Occasionally, underwriters may require major shareholders to sign commitment letters regarding share transfers after an IPO.

Furthermore, “relationship agreements” between the PE seller and the issuer on the post-IPO relationship are very rare in China.