The Year of Rabbit continued to see the proliferation of RMB funds and portfolio investments made by RMB funds. As of Q3 of 2011, 63 RMB funds were raised in mainland China and the total capital raised for investments in mainland China was estimated to be RMB4.2 billion (Source: Zero2IPO). Perhaps no longer a new term, “RMB funds” generally refer to the investment funds organized as corporations, limited partnerships or other unincorporated forms in China that invest in non-public companies primarily located in China. Over the past five years, RMB funds have become the investment vehicle of choice for many non-Chinese fund managers, as they have certain advantages over non-Chinese funds investing into China, including: (1) access to domestic Chinese investors (i.e., limited partners), which generally are more inclined to invest through a China-registered fund, than a non-Chinese fund; and (2) the ability to permit large non-Chinese institutional investors, which only have non-Chinese currencies, to capitalize on the regulations designed to attract foreign investment into China (e.g., the “Qualified Foreign Limited Partnership” or “QFLP” regime in Shanghai, Beijing and other RMB fund hubs).
Yet, it is notable that less than half of the capital raised in RMB funds from domestic Chinese investors has come from state owned institutional investors. To date, due to regulatory reasons, state-owned institutional investors, particularly government institutions, government-funded guidance funds and universities, have been playing a very limited role as limited partners in private equity and venture capital funds in China (Source: First Financial Daily). Over the past couple years, China’s regulators, including the National Reform and Development Commission (NDRC), China Securities Regulatory Commission (CSRC), China Banking Regulatory Commission (CBRC), China Insurance Regulatory Commission (CIRC) and People’s Bank of China (PBOC), have implemented legislation designed to allow certain institutions greater flexibility to make equity investments in private companies. However, much of this legislation has yet to be implemented and official guidance thus far has been limited. Thus, we haven’t seen a significant increase in investments into RMB funds by state-owned institutional investors.
The following lists certain of the key state-owned institutional investors and the regulatory developments in 2011 that have impacted or will impact their equity investment capabilities.
- Securities Companies. Securities companies are now officially permitted to make direct equity investments in Chinese companies pursuant to a set of guidelines issued by the CSRC in July 2011. The guidelines permit securities companies to directly invest in Chinese entities or form “direct investment funds” (“DIF”) to raise and manage capital for equity investment into such companies, provided that (i) a securities company must form an intermediary known as a “direct investment subsidiary”; (ii) the aggregate capital employed by a securities company in its direct investment business may not exceed 15% of its net assets; and (iii) the securities companies abide by certain restrictions regarding fund raising (e.g., they can only raise capital in a private offering from institutional investors and may not have more than 50 investors). Prior to the issuance of the guidelines, the CSRC only approved the direct investment of securities companies on a special approval or case-by-case basis. Reportedly, China International Capital Corporation Limited (CICC) became the first securities company to raise an equity investment fund approved pursuant to the guidelines.
- Pension Funds. The Administrative Measures on Enterprise Pension Funds (“Measures”) were amended early this year and went into effect on May 1, 2011. The amended Measures removed the previous investment limit regarding the capital that may be used in “stock investments” by a pension fund, which had been 20% of its net assets. However, the Measures still require that no more than 30% of a pension fund’s net assets be invested in “rights instruments such as stock and investment-nature insurance products, and stock funds.” Apparently, there is still some uncertainty regarding whether the terms “stock” and “rights instruments” were intended to include private equity investments. As such, many industry experts believe that it would be some time before pension funds are officially permitted to make private equity investments.
- Commercial Banks. Under the Commercial Banks Law (amended in 2003), commercial banks are restricted from making equity investments in “domestic” enterprises. Although this restriction is currently still in place, some commercial banks reportedly seek to make indirect investments into domestic equity investment projects, such as investing through an offshore intermediary.
- Insurance Companies. There was no new guidance in 2011 regarding whether Chinese insurance companies may make outbound private equity investments. In addition, many industry experts have concluded that an insurance company may not act as a limited partner in an equity investment fund unless it is managed by the insurance company. In 2011, China Life reportedly became the first insurance company to obtain a private equity investment license under the 2010 regulation. For a discussion on the 2010 regulation, please see our blog post titled “China Permits Insurance Companies to Invest in Private Equity.”
Over the past several years, non-Chinese fund managers have shown great interest in raising capital from Chinese limited partners. However, for regulatory and practical reasons, the fund raising efforts of non-Chinese fund managers have not been as successful as hoped. In addition to the regulatory restrictions specifically affecting state-owned institutional investors, as discussed above, there are a number of other hurdles that must be overcome before a limited partner may or will invest in a RMB fund. The following are two examples of the hurdles non-Chinese fund managers currently face when attempting to fund raise from domestic Chinese investors.
- NDRC Recordation. In early 2011, the NDRC issued a Notice to reinforce the “recordation” requirement applicable to equity investment enterprises (“EIEs”) primarily in six provinces/municipalities. Institutional EIEs with investment capital of more than RMB500 million are required to obtain a recordation with the national office of NDRC, while other EIEs need to be recorded with the regional offices of NDRC. Currently, there is no explicit requirement or process for recording a foreign-invested EIE with NDRC, which would pose a hurdle on such EIEs’ efforts to raise capital from the National Social Security Foundation. However, some of the larger, foreign-invested RMB funds have been successful in obtaining recordation with NDRC on a case-by-case basis.
- Structuring. How a fund is structured is critical to fund raising. A fund with any foreign equity investment will be considered as a foreign-invested enterprise (with limited exceptions, such as certain funds blessed by the QFLP regime), and thus restricted from investing in various industrial sectors, such as internet, automobile, certain energy industries and certain real estate developments. Domestic Chinese investors often prefer to invest in a purely domestic fund, which does not have the same restrictions as foreign-invested funds. To address this issue, some fund managers have structured their funds as “parallel funds,” which is accomplished through a contractual arrangement between two separate funds to share management, deal sourcing and exit opportunities.
The industry is hoping that the regulators will enact an Amended Securities Investment Fund Law (SIFL), which many believe will include guidance on private equity investment. However, even if private equity investment is thoroughly covered in the SIFL, we speculate that the provisions will be focused on investor protections, rather than on clarifying the investment capabilities of various investor groups.
As always, we will continue to provide timely updates on new developments affecting private equity and venture capital investment in China, as they occur, in 2012.