PitchBook reports that even though 2022’s dry powder was lower than in either 2020 and 2021, a significant amount of capital has been deployed and remains to be deployed, including in deals involving Chinese companies and assets in China owned by U.S and non-Chinese companies. We know this because we are part of some of these deals, as companies and investors try to make sense of the China market and forecast the future there and in other promising markets.
An Overview of Venture Capital vs. Private Equity
In the venture capital and private equity space, “dry powder” means cash that has been committed by investors to a fund but that has not yet been called (transferred to) or deployed (invested) by the fund.
These funds are cyclical in nature, usually with a 5-7 year investment horizon before the fund’s assets are liquidated and a new fund is started. Successful VC and PE groups have multiple funds running at the same time.
Funds tend to specialize in one or more geographical areas (e.g. China or Vietnam) and industries within those areas (LCD sourcing) that often cut across geographical boundaries. Generally speaking, VC funds focus on early stage companies, while PE funds focus on mid- to late-stage companies, often dealing with ownership transitions. Venture capital funds often take minority interests, and it is not uncommon for private equity groups to take majority stakes.
What Types of Lawyers Get Involved?
All investment groups will work with one or more law firms that run the legal side of their deals. Some law firms are large enough to handle all deal flow from their PE or VC clients, while others need more than one firm. As a boutique international law firm, we are often called in to work with law firms of all sizes that either do not have their own international team or do not have the language or country expertise required to carry the entire transaction.
We work very well with other firms and split the transaction work based on our expertise. For deals involving Brazil, Mexico, China, Spain, or Portugal, we have boots on the ground. For many other countries in South and Southeast Asia, LatAm, and Europe, we have both in-house competence and an outsized number of foreign languages (more than 15) under our belt to make due diligence and correspondence easier.
How Do Lawyers Help Move a PE Deal Forward?
Sometimes PE to PE transactions involve China or other international assets that have been in operation for more than the life of a fund. And in other transactions the seller’s management team does not have firsthand or significant legacy knowledge of the China or other international business operations.
This lack of institutional knowledge is problematic, mainly for the buyer. But it is also the seller’s issue to resolve if they want to sell the business without setting aside a large portion of the purchase price in escrow for indemnity obligations.
Buyer’s counsel will always push for the broadest representations and warranties possible, and the buyer needs to be able to rely on the seller to a large extent. Seller’s counsel will never advise the seller to agree to representations and warranties that stretch beyond the seller’s ownership involvement or the current management’s involvement.
Representation & Warranty Insurance
In this potential stalemate scenario, the buyer and seller will usually agree to procure representation and warranty (R&W) insurance. This allows the buyer to receive some peace of mind regarding the seller’s reps and warranties. And it allows the seller some peace of mind because the R&W insurer will be responsible to step in and make buyer whole as the first line of defense in the indemnity bucket.
Of course, when R&W insurance comes into play will be a matter of heated negotiation between the R&W insurer. And like all insurance policies, the coverage terms will be reflected in the premium and the amount in the required indemnity bucket.
Procuring R&W insurance does not obviate the need for buyer’s counsel to conduct robust due diligence. The R&W insurer requires a detailed diligence memorandum or report from the buyer’s legal counsel. Often the questions – and especially the follow-up questions – are the most important service we provide because those inquiries lead to previously undisclosed documents and facts about the business.
We rarely find a smoking gun, but we almost always find concerning information that the seller has decided to “inadvertently omit” or try to gloss over (like unregistered IP, expired contracts, nonexistent contracts, or misclassification of employees as independent contractors within an “acceptable level” of noncompliance).
Where Do We Go From Here?
With China’s latest concession allowing Public Company Accounting Oversight Board (PCAOB) audits and its recent seeming success, it is possible that China may play more by the normal rules of business. We are skeptical that this forced compliance at the public company level (impacting about 200 Chinese companies listed on U.S. exchanges) will trickle down to the private company level. As always when dealing with China, it is important to know who is on the other side of the deal and their tendency to follow the rules.
This is especially important for private equity firms that will be required to provide their own representations and warranties in 5-7 years (or sooner) when they are ready to divest their portfolio’s China assets.
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