VC vexed

As far as my email inbox is concerned, the words “DLA Piper news flash” usually spell some impending trouble in venture capital paradise.

I’m not suggesting bad karma, just that the law firm’s updates are not a once-a-week event and, when they do come, I tend to set aside a few minutes to read them. And then re-read them. Legal terminology is not easy to digest.

The July 1 bulletin contained updates on new rules implemented by the State Administration of Foreign Exchange (SAFE) that could complicate venture capital (VC) and private equity (PE) deals in China.

Basically, the offshore special purpose vehicles (SPV) used by venture capitalists to take money in and out of China are coming under closer scrutiny. If they set up an onshore subsidiary or make any cross-border M&A deals, approval is now required from both the Ministry of Commerce and SAFE. To get this approval, the SPV must submit evidence of a three-year track record of investments. It must also disclose assorted financial information and meet shareholder structuring requirements.

Further tightening measures are expected and more foreign VC and PE deals are likely to run into trouble for not dotting all the ‘i’s and crossing the ‘t’s.

The end goal for Beijing is to encourage more emerging Chinese companies to list on domestic exchanges. It is part of the widely-reported effort to reduce liquidity and improve governance in the markets by bringing in well-run companies – Hong Kong red chips become Chinese blue chips while strong start-ups provide solid growth opportunities.

This isn’t good news for the typical foreign VC/PE fund. The domestic market is volatile, a far cry from the reliable, well-informed valuations on NASDAQ. With Chinese stocks currently overpriced and analysts struggling to predict if and when the cards will come tumbling down, what investor would want to risk an A-share exit?

And even if a fund settles for a domestic IPO, the proceeds are in renminbi, which poses further problems in terms of getting back into US dollars and out of the country. The long-term solution is to set up a renminbi-denominated fund, but that means making a commitment to China that might not suit overall strategy.

DLA Piper’s verdict is not an optimistic one: “We believe that the [new rules], together with the government's unwritten policy to encourage onshore listings, may herald another dry period for offshore investments into China and offshore listings of PRC companies.”