How to Choose an Investment Structure in China

When entering the Chinese market, it is crucial for a foreign investor to choose the best investment vehicle for their business. Understanding, the benefits and drawbacks of investing with or without a domestic partner (WFOE vs. JV), as well as the related decision whether to pursue a Greenfield or Merger and Acquisition (M&A) are central aspects in structuring an investment in China. This article will discuss the pros and cons of each available option, why WFOE Greenfield investments are by far the most popular for foreign investors, and how the 2020 Foreign Investment Law (FIL) has simplified several issues surrounding choosing an investment vehicle in China.

Choosing Investment Structure, a Joint-Venture, Wholly Foreign Owned Enterprise, or Representative Office:

When entering the Chinese market foreign investors Wholly Owned Foreign Enterprises (WFOE), Joint-Ventures (JV), and Representative Offices (RO) are the most popular types of business structures available to foreign investors.

A Wholly Owned Foreign Enterprise (WFOE) refers to a foreign investment in China made without a domestic Chinese partner. This allows an investor to avoid issues related to negotiating an agreement with a domestic partner, control all major aspects of his business, and move quickly and independently to changing market conditions. However, entering a market with no personal contacts, limited supply chains, and limited infrastructure carries fundamental risks.

Alternatively, a Joint-Venture (JV) is an investment undertaken between a foreign investor and a domestic partner. A JV provides a foreign investor resources, language skills and an understanding of the market, and local contacts especially when in comes to State-Owned Enterprises (SOE). Partnering with a domestic firm can grant a foreign investor access in sensitive industries like aviation and internet security. However, JV by their very nature include fundamental difficulties that stem from working with a partner with potentially divergent interests in an environment in which they are much more familiar.

It is also worth noting that foreign investors can also choose to establish a Representative Office (RO) within China. This corporate structure only gives a foreign individual or business the ability to formally represent themselves within China. It does not give them the right to conduct business within China outside of hiring office staff through a HR agency and leasing an office space and so is of limited value to most foreign investors. However, RO can be an important opportunity for foreign investors to “test the water” before pursuing a greater investment in China.

Choosing Greenfield or M&A:

In addition to choosing a venture structure, foreign investors must decide between pursuing a Greenfield investment or Merger and Acquisition (M&A) in China.

Greenfield investment refers to an investment that establishes its own business and does not rely on the purchase of or merger with a pre-existing business to acquire assets, supply chains, talent and infrastructure. Pursuing an investment from the ground up provides investors with greater quality control and the ability to build a corporate structure that integrates easily into a larger international business.

Mergers and Acquisitions (M&A) on the other hand refer to an invest that rely on the purchase of or merger with a pre-existing business to establish itself in the Chinese market. If the underlying assets are valuable, then this form of market entrance can provide a solid base to expand operations within China. However, acquiring pre-existing assets in a market in which an investor is unfamiliar carries strong operational risk for similar reasons to Joint-Ventures mentioned before. It should be stressed however, that this does not make M&A unviable as a form of market entrance.

Ultimately, Greenfield investments are closely associated with WFOE and Mergers and Acquisitions (M&A) with JV. However, these are separate decisions and many WFOE have wholly acquired the assets of a domestic firm to enter the Chinese market while many JV’s have created entirely new businesses together. Understanding the differences between WFOE vs. JV and Greenfield vs. M&A is crucial for any foreign investor entering the Chinese market.

The Dominance of WFOE Greenfield Investments:

Despite the apparent benefits that derive from seeking a domestic partner while enter the Chinese market place the preference of foreign investors towards WFOE Greenfield investments is clear. Over of 70% of all FDI into China came in the form of greenfield investments, and over 60% into foreign controlled vehicles. What is the reason for this apparent dominance?

Ultimately the difficulty in negotiating a satisfactory agreement between two parties, the difficulties of two sets of management, and the risk of inequitable control of operations and assets based in China, outweigh the networking benefits and know-how gained by working with a local partner in China’s complicated domestic market. Better for a foreign investor to control the assets themselves and improve their chances for success. Indeed, the primary motivation for a Foreign Investor to pursue a JV is to enter an industry in which foreign investment is restricted to JV by the government. Restrictions that are quickly being reduced in number by reforms in China’s investment law.

The 2020 Foreign Investment Law:

The 2020 Foreign Investment Law seeks to promote foreign investment into China by drastically simplifying regulations surrounding foreign investment, emphasize investor equality under Chinese law, and further reduce the number of industries in which foreign investment is restricted. The specifics of the 2020 FIL are beyond the scope of this article but be sure to check out Acadia Advisory Group’s article analyzing the new law in more detail.

What does this mean for foreign investors in China? By facilitating foreign investment into China, and removing the specific benefits allotted to JVs as well as investment barriers, the FIL will most likely ensure the continued dominance of the WFOE Greenfield investment vehicle. By facilitating foreign investors preferred investment vehicle, as well as more stringently enforcing laws related to intellectual property, China is strongly signaling that is seeks to be a continued pre-eminent destination for FDI in the coming decade.