The Boundary Of Private Equity Contracts Involving In Corporate Governance

To solve the Principal-Agent problems caused by extreme asymmetry of information,Private Equity funds and entrepreneurs often sign a series of Private Equity contracts to reduce agency costs.However,the nature of companies determines that their contracts are mainly characterized by “unfree contracts”.Private Equity contracts often relate to arrangements of shareholders' rights,distribution of company's profits,establishment of corporate power,etc.What kinds of these rights are uncorrectable or the inherent rights of shareholders? Shall any of them become invalid because of differences from the laws and regulations? The boundary of contracts and organizational laws needs to be clarified.For the determination of Private Equity contracts' involvement in corporate governance,a possible starting point is to start with the role it plays.The first chapter of this article begins with the theoretical foundation of the link between Private Equity activities and corporate governance.Private Equity funds first contribute to companies to become shareholders.And referring to shareholders' involvement in corporate governance,especially in the context of funds' participation,it should be clear that corporate governance of target companies faces the recombination action of shareholder activism and capital short-sightedness.On theone hand,when Private Equity funds enter target companies,they often seek to participate in companies' management,so as to improve their value by changing management strategies,streamlining business operations,or expanding business scale,and ultimately realize profits through the sale of equity of target companies.Therefore,Private Equity funds can be regarded as right interpreters of shareholder activism.Capital,on the other hand,always seems to be inevitably in the shadow of profit-orientation so that Private Equity funds,which should have been long-term investors,tend to “contribute fast and withdraw fast”,even causing corporate managers' myopia in order to obtain capital input and individuals' professional achievements.In addition,Private Equity funds and entrepreneurs have different behavioral starting points and represent contrary interests because of their different roles.The agency costs between the two is high.While bringing cash flow to the company,the Private Equity funds carry the vision that the company can return more cash,and this consistent belief will affect its relationship with the entrepreneurs and enterprises.At the same time,Private Equity funds need to face and deal with the information asymmetry and agency cost problems that exist in the equity investment activities.Through contractual design,Private Equity funds can filter projects by articles of staged investment and performance compensation,also restrain entrepreneurs' exaggeration about company's prospects and the project quality excessively.By taking control of some special powers,Private Equity funds supervise target companies,to avoid the company's performance deviating from expectations without knowing.In addition,Private Equity funds can directly provide advice to management and attract outstanding managers to bring professional management to the company.So to speak,after Private Equity funds' involvement in corporate governance,they mainly play an added role in investment screening,post-investment supervision,and professional management.These aspects are also the starting points for divergence ofequity funds to improve and challenge the governance of target companies.Following the train of thought from macro to micro and from theory to practice,the second chapter of this paper further clarifies the arrangements for Private Equity contracts involving in corporate governance.Starting from the basic structure of Private Equity contracts,it is generally acknowledged that Private Equity contracts mainly include five parts as to protect and exercise the functions of screening and supervision,also balance its interests with entrepreneurs.The first one is to inject funds through phased investment;Second,Private Equity funds have more managerial control;Third,most of economic compensation for entrepreneurs comes from the value-added of their holdings;Fourth,the interests of Private Equity funds are protected in the form of convertible preferred shares,which affects entrepreneurial enthusiasm;Fifth,they rely on implicit contracts-a reputational market to limit the opportunistic behavior of equity funds.The above basic structure is like a human skeleton,and specific terms of a Private Equity contract can be classified based on return on investment and investment security,which are most concerned by Private Equity investors when they start equity investments.These specific terms can be roughly divided into three categories as economic factors,control factors and other terms.Economic factors refer to the terms that enable investors to obtain investment income through liquidation events.Control factors refer to the terms that enable investors to obtain or maintain control over the target company,including enabling investors to veto certain decisions or directly control the company.Economic-factors' clauses focus on the distribution of interests between investors and entrepreneurs.Control-factors' clauses focus on how to rationally allocate the control rights of company.Other clauses perform as a complement,which provides guarantees for investment returns and security,also set up appropriate incentives and constraints for entrepreneurs to form checks and balances.Obviously,this is an academic analysis and it can also be regarded as thehope of people.As to whether a certain case of equity investment can truly demonstrate the corporate governance effects of Private Equity contracts,it is necessary to keep it in context.Based on the above discussion,the third chapter discusses the contractual boundary of Private Equity activities by taking priority clauses as examples.Essentially,the contractual boundary of Private Equity articles involves the compulsion and freedom of company laws.The contractual logic in corporate laws itself is different from the contractual logic in contract laws.When a company contract involves corporate governance,concerns about the interest parties involved are stronger and more specific.Not only that,as Private Equity activities,the institutional supply in China is far from adequate.The first of them is our preferred stock mechanism which is still far from being constructed.Regarding whether the shareholder rights and obligations involved in various classes can be differentiated and configured,the company laws neither expressly prohibit nor have a definite authorizing provision,which makes many Private Equity clauses carry their own risks of non-compliance and the market participants are inevitably scrupulousness.Although the freedom of contract is the basic spirit in commercial law,the freedom and coercion of Private Equity contracts can never be simply explained by the perspective of contract law,which may lead to a one-sided emphasis on the freedom of contract and the autonomy of private law,while neglecting the company's status and interests.Taking the application of priority clauses as examples,the contractual arrangements for Private Equity contracts still face many constraints.For the right of dividends preference,the company law only clearly gives the right to make special arrangements for the difference in the “quantity” of dividends distributed by different shareholders.As the “order”-whether the provisions of company constitution or shareholder agreements can be passed to distribute profits in various orders,there is no normative basis which,nevertheless,is the very concern of Private Equity funds.Regarding the right of preferential liquidation,the company law does not leave any room for articles about the “quantity” among shareholders when the company liquidates,which lays the first risk for agreements of preferential liquidation rights in the Private Equity contracts.The second risk lies in the allocation order because the attitude of the company law remains unclear.With respect to the right of first refusal,companies limited by shares are subject to the basic principle of “shares can be freely transferable” thus have no room for arrangement.Even if it is a limited liability company,it must be designed within the framework of legal compliance.The preferential right of subscription is currently limited to companies of limited liability,and it is only clear that shareholders may not make capital contributions according to the proportion of capital contribution.Whether the order of subscription contractual or not is not clearly defined,let alone whether the replenishment allows shareholders to freely agree the order of subscription is still unreliable,and the compliance of the over-allotment rights is even more subject to compliance.In a word,Private Equity contracts tend to make some special arrangements for distribution of control rights,voting rights,and profit distribution of target companies.However,the content of these special arrangements may not be in line with the established principles and rules of existing company laws,such as principles of the equality of shareholder,free transfer of shares and so on.To explore the freedom and coercion of Private Equity contracts,it shall never be explained simply by using the perspective of contract laws.This may bring about unilateral emphasis tendency towards freedom of contract and autonomy of private law,but negligence of the dominant position and interests of the company.The involvement of Private Equity contracts in corporate governance should be a matter of systematicness.