The year 2006 saw a record level of private equity deals in Asia, further reinforcing the trends established in 2005. Up to the end of 2006, the transaction total in the Asian private equity industry amounted to $50.7bn (£25.3bn), an increase of an astonishing 206% from 2005.

Focusing on some of the main players in the Asian private equity industry in 2006, Japan saw an increase of approximately $4bn (£2bn) in the amount of incoming funds — up 10% on 2005. While in South Korea, private equity investments reached $579.6m (£289m) — an increase of 29% from 2005.

Out of all of the emerging markets in Asia, the People’s Republic of China (PRC) probably saw the most impressive growth and was ranked first for the largest fresh funds pool for a single country, raising $4.6bn (£2.3bn) in 2006. Many of these private equity deals are structured using offshore vehicles, in particular British Virgin Islands (BVI) and Cayman Islands vehicles. The BVI was the country with the second-largest sum of direct investment in the PRC in 2006, with investments totalling $11.25bn (£5.6bn), representing an increase of 25% from 2005. Cayman ranked eighth-largest in terms of direct investment in the PRC in 2006 with investments totalling $2.1bn (£1.04bn), representing an increase of 8% from 2005. In fact, the aggregate direct investment in the PRC from the BVI and Cayman accounted for more than 25% of the PRC’s total foreign direct investment inflow in 2006.

In recent years, companies based in east Asia, particularly the PRC, have increasingly turned to private equity as a means to finance their businesses, while foreign investors often prefer to invest in businesses in these emerging markets through offshore structures, in particular mutual funds and offshore holding companies.

Offshore funds are used because the investors are generally not subject to taxation (e.g. withholding tax or income tax). In addition, the offshore funds are not as heavily regulated as the funds that are established in other countries and are generally not subject to regulations of the country where the investors are based.

Offshore holding companies are popular with foreign investors for many reasons. There is great flexibility in structuring the company so as to allow for different rights and returns (e.g. by having different classes of shares). The use of these offshore holding companies assists with listings on international stock exchanges. Bermuda and Cayman have been two of the most popular offshore jurisdictions for these offshore holding companies, mainly due to the acceptance of these jurisdictions by various stock exchanges such as NASDAQ, the Singapore stock exchange, the Hong Kong stock exchange and the London Stock Exchange. Over the past year or so, the London Alternative Investment Market (AIM) is being increasingly favoured as a stock exchange and BVI and Jersey companies are frequently used by Asian clients and private equity houses seeking an exit option. Many offshore jurisdictions are common law jurisdictions such as Bermuda, Cayman and BVI and generally offer corporate governance features that are more familiar to international private equity firms.

Mauritius is also popular because of its double-taxation treaty network and it is well utilised for PRC, Indian, African and Middle Eastern deals. In view of the progressive elimination of the preferential tax regime for foreign private equity investors in the PRC, through the introduction of a new Enterprise Income
Tax law early this year, it is expected that Mauritius will become more attractive due to its double-taxation treaty with the PRC.

For example, a typical structure involving an offshore fund in a private equity transaction in Taiwan would be where the investment manager, usually also incorporated offshore, and the investors place management and participating shares respectively into an offshore fund. In this structure, save for certain exceptions (e.g. where the rights of the holders of the participating shares are varied), only the holders of the management shares are entitled to vote but the holders of the management shares will not be entitled to receive any dividend or distributions from the offshore fund. The holders of the participating shares, on the other hand, are entitled to receive dividends or distributions from the offshore fund but generally, they will have no right to vote. Therefore, the investment manager will generally have control over the offshore fund.

In contrast, typical PRC-based structures using offshore holding companies in a private equity transaction would have institutional private equity investors and PRC shareholders subscribing for new shares in a BVI or Cayman offshore holding company which, in turn, holds interests in a PRC wholly foreign-owned enterprise (WFOE) or other assets or investments in the PRC. A WFOE is usually established in the form of a limited liability company which has its own registered capital, is a separate legal identity distinct from its foreign investors and is an independent legal person capable of contracting and bearing liability on its own behalf. Convertible bonds or notes that are convertible into shares of the offshore holding company may also be issued to assist with the financing of the acquisition or set up of this structure.

In an alternative structure, the investments from foreign investors are streamed into a PRC equity joint venture (EJV) or co-operative joint venture (CJV) via a BVI or Cayman offshore holding company which, in turn, holds interests in the EJV or CJV.

An EJV is a limited liability company and it has a legal identity distinct from the investors. CJVs can be formed as either a structure with a separate legal identity or one with no separate legal identity from its investors.

The main difference between an EJV and a CJV is that the risks, losses and profits of the EJV are shared between the parties in proportion to their respective contributions to the registered capital. The risks, losses and profits of the CJV are shared between the parties in accordance with any agreement or arrangement that they may have, irrespective of the proportion of the parties’ contributions to the CJV’s registered capital.

A WFOE has certain advantages over either joint venture structure, particularly because setting up a WFOE is usually easier and faster, as a joint venture would usually involve extensive and protracted negotiations between the parties on the joint venture contract.

One of the main disadvantages with a WFOE is that investors who are new to the PRC often find it extremely difficult to start without the assistance of a PRC partner. This is because knowledge of local markets and conditions is important and, particularly, good local contact or relationship with local governmental authorities is often essential to the establishment of a foreign investment entity.

Despite this there continues to be an increasing number of foreign investment structures set up in the PRC utilising offshore vehicles and, with the PRC now opening its doors even further, we expect the same private equity trend to continue in 2007. As one of the highest-growth economies in the world and the most significant emerging market, the PRC will continue to be the dominant focus of private equity investments in Asia.

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