Investment Fund Law Blog - Legal News Updates for Investment Fund Managers & Investors : Pillsbury Winthrop Shaw Pittman LLP

Written by Michael Wu and Judy Deng

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.

Written by Michael Wu

Pillsbury recently conducted a survey of nearly 200 individuals involved in operating and investing in mid-sized Chinese companies.  The results revealed that 55% expect to seek financing within the next 24 months and 43% expect to do so this year.  The survey also confirmed that Chinese executives believe that the U.S. still offers the most opportunities for foreign expansion.  Thirty-eight percent of respondents said the U.S. and Canada offer the most opportunities for foreign expansion, while 26% said that other parts of Asia, including Australia and New Zealand, offered the most opportunities, and 11% favored Latin America.  In terms of capital market financing, Chinese executives felt by a wide margin (42%) that an IPO or other public offering was the most effective way to raise capital, followed by a PIPE transaction (24%) and bank financing (22%).  Just 12% thought a convertible debt financing the most effective.  Please click here to view our press release and here to view the full survey. 

Written by Michael Wu and Judy Deng

Although fund managers may form private equity funds of funds in China that have non-Chinese investors (hereinafter referred to as “foreign-invested fund of funds” or “FIE FoFs”), they need to be aware of certain currency conversion issues that may apply based on how the FIE FoF operates.  Foreign-invested funds of funds may be subject to currency conversion issues that do not affect other onshore, or China-based, foreign-invested investment funds because the Administration Regulations on Foreign-Invested Venture Capital Enterprises issued in 2003 (the “FIVCE Regulations”), which are the only comprehensive regulations pertaining to foreign-invested investment funds in China, did not explicitly contemplate the establishment of FIE FoFs.  For more information regarding the FIVCE Regulations, please see Introduction to RMB funds. 

The FIVCE Regulations generally require that a foreign-invested investment fund’s portfolio companies be private companies in the high technology industry.  Thus, the regulatory authorities may determine that a FIE FoF that only invests in other onshore investment funds (i.e., a FIE FoF that does not make direct investments in private Chinese companies in the high technology industry), should not be a foreign-invested investment fund covered by the FIVCE Regulations (a “FIVCE”).  To the extent a FIE FoF is not a FIVCE, it may not be able to convert non-renminbi (“RMB”) currency of its foreign investors into RMB for purposes of investing in onshore investment funds. 

In August of 2008, China’s State Administration of Foreign Exchange issued “Circular 142,” which provides that foreign invested enterprises (“FIEs”) may not convert their non-RMB currency into RMB for onshore investment, unless the FIEs are organized as “equity investment enterprises” and approved by the regulatory authorities.  Currently, there is no clear guidance regarding what qualifies as an “equity investment enterprise,” but most industry professionals believe that a foreign-invested holding company (“Holding Company”) or FIVCE may qualify.  Unfortunately, most FIE FoFs will not qualify as Holding Companies because Holding Companies are subject to substantial capitalization requirements and direct investment experience in China.  Thus, if a FIE FoF is not deemed a FIVCE, and is consequently treated as a FIE, it may need to qualify as a Holding Company in order to convert its non-RMB currency into RMB. 

While the current landscape in China for FIE FoFs may deter some fund managers from forming FIE FoFs, being able to raise a fund of funds that can accept both RMB and non-RMB currencies may motivate other managers to form FIE FoFs.  Please feel free to contact us with any questions regarding foreign-invested funds of funds. 

Written by Michael Wu and Judy Deng

A Chinese foreign-invested fund management company (“FIE FMC”) is a fund management company formed in China with at least one non-Chinese owner.  FIE FMCs are generally formed to manage foreign-invested PE/VC funds located in China (“Foreign-Invested RMB Fund”), such as Foreign-Invested Venture Capital Enterprises (“FIVCEs”) and Foreign-Invested Equity Investment Enterprises (“FIEIEs”).  A FIE FMC is subject to national regulations promulgated by China’s Ministry of Finance (“MOFCOM”), as well as applicable local regulations based on where the FIE FMC is registered.  The following highlights some of the key requirements and considerations for FIE FMCs.

• Under the national regulations, in order to qualify as a FIE FMC, an entity must have at least three fund management professionals, each of which must have at least three years of venture capital or private equity fund management experience.  The applicable local regulations may have different, more rigorous standards.
• Under the national regulations, a FIE FMC must have at least US$150,000 of net capital, also referred to as “registered capital,” which must be wired to the account of the FIE FMC generally within one to three years of registering as a FIE FMC with the appropriate regulatory authority.  The net capital requirements under the local regulations vary greatly from city to city and can be as high as US$2,000,000.  
• Retaining a FIE FMC may help a Foreign-Invested RMB Fund reduce its tax exposure in China.  For example, if a Foreign-Invested RMB Fund retains a FIE FMC to serve as its management company, the Foreign-Invested RMB Fund may be able to reduce the tax exposure that arises from being deemed a “permanent establishment” of its offshore investors.  
• Currently, there is no practical way for a FIE FMC to convert foreign currency into RMB to invest into a Foreign-Invested RMB Fund. Although some local authorities are attempting to address this issue, for the time being, a FIE FMC may only invest its foreign currency into a Foreign-Invested RMB Fund indirectly through an offshore affiliate. 

Individuals who are thinking about forming a FIE FMC should contact us to determine what the local regulations are for FIE FMCs in the various jurisdictions and/or for any other advice regarding FIE FMCs or Foreign-Invested RMB Funds. 

Written by Judy Deng

On September 5, 2010, the China Insurance Regulatory Commission (CIRC) issued a circular (“CIRC Circular 79”) to explicitly permit China’s insurance companies to invest their assets in private equity. Such investments may be either direct or indirect, making China’s insurance companies potential equity investors in onshore industrial companies as well as limited partners in onshore private equity funds (known as “RMB funds”).

In direct investment projects, the portfolio companies are required to be growth-stage, mature or strategic new-industry companies or what are considered “pre-IPO” companies.

In the case of indirect investments (i.e., investments in private equity funds), there are detailed requirements as to the qualifications of the target private equity firms, including minimum registered capital (RMB100 million), management team (10 experienced managers), exit history (3 exits) and pre-investment assets under management (RMB3 billion). The aggregate investment in any one private equity fund may not exceed 20% of the fund’s total offering size.

CIRC Circular 79 also clarifies that outbound equity investment by Chinese insurance companies is governed by a 2007 regulation.