Investment Fund Law Blog
Background
As of 2007, an increasing number of private equity and venture capital funds investing in high-technology companies in China have registered with the Chinese government as Renminbi (“RMB”) funds. There are two types of RMB funds: domestic RMB funds and foreign-invested RMB funds. Domestic RMB funds are fully owned by Chinese investors, while foreign-invested RMB funds may be partially or fully owned by non-Chinese investors. Both types of RMB funds are organized under Chinese law and use RMB to invest in Chinese companies. The focus of this summary is on foreign-invested RMB funds.
Although non-Chinese managers have been able to form foreign-invested RMB funds for nearly five years, very few such RMB funds were formed until 2007. Market and policy reasons were the main drivers of renewed interest in RMB funds in 2007, including:
- the RMB fund manager’s ability to raise capital from domestic investors and local Chinese governments[i];
- the policy and regulatory changes that have significantly restricted the use of “round-trip”[ii] investment structures historically used by offshore funds to invest in China;
- the passage of laws or regulations that have made foreign investment into China through foreign-invested RMB funds much more streamlined and less burdensome[iii];
- the domestic IPO market, which has performed relatively well in recent years and permits a foreign-invested RMB fund to exit from its China portfolio investments through a domestic listing with an attractive valuation; and
- early indication that China is likely to implement new tax, foreign currency, partnership and foreign investment laws or regulations, which may be more favorable to foreign-invested RMB funds and their managers and investors.
Establishing a foreign-invested RMB fund
In order to establish a foreign-invested RMB fund in China, an application must be submitted to the local provincial administrative department under the Ministry of Commerce. The application will then be examined by the Ministry of Commerce and the Ministry of Science and Technology, which will either approve or deny the application. Typically, this process takes several months.
A foreign-invested RMB fund may be formed as an “Incorporated FIVCE” or a “Non-Legal Person FIVCE.” Except as described below, the relationship between the fund sponsor (i.e., the “necessary investor,” as defined below) and the passive investors may be governed by terms that are familiar to U.S. managers and U.S. investors, such as the terms typically found in a limited partnership agreement for a U.S. fund.
Incorporated FIVCE. There are two types of Incorporated FIVCE: an equity joint venture and an incorporated cooperative joint venture. If an RMB fund is formed as an Incorporated FIVCE, each investor’s liability is limited to the amount of its capital commitment. An Incorporated FIVCE is subject to double taxation, but may benefit from certain tax incentives at the entity level. If the RMB fund is formed as an equity joint venture, the RMB fund’s ability to distribute profits and allocate gains/losses is generally based on the percentage interest of the investors.[iv] In contrast, if the RMB fund is formed as an incorporated cooperative joint venture, the distribution of profits and allocation of gains/losses are governed by contract. Thus, an incorporated cooperative joint venture has the flexibility to implement a “carried interest” or performance-based allocation. An Incorporated FIVCE’s minimum registered capital, or the fund’s total capital commitments, is US$5 million and all registered capital must be contributed within five years. The Necessary Investor must commit at least 30% of the total capital commitments of all of the investors.
Non-Legal Person FIVCE. If an RMB fund is formed as a Non-Legal Person FIVCE, or an unincorporated cooperative joint venture, the RMB fund’s governing documents may limit a passive investor’s liability to the amount of its capital commitment. Although the law regarding Non-Legal Person FIVCE is still developing, it is generally recognized that a properly structured Non-Legal Person FIVCE that has the support of the local authorities, may achieve a tax pass-through status similar to a U.S. limited partnership. Like an incorporated cooperative joint venture, under this structure, the distribution of profits and allocation of gains/losses are governed by contract. Thus, an unincorporated cooperative joint venture also has the flexibility to implement a “carried interest” or performance-based allocation. A Non-Legal Person FIVCE’s minimum registered capital is US$10 million and all registered capital must be contributed within five years. The Necessary Investor must commit at least 1% of the total capital commitments of all of the investors. The Necessary Investor is subject to unlimited liability.
As the Non-Legal Person FIVCE structure generally allows more favorable tax treatment, it tends to be the more favored of the two structures. A U.S. manager interested in enabling its U.S. investors to invest in a foreign-invested RMB fund could set up a feeder fund for its U.S. investors, which would invest substantially all of its investable assets through a Hong Kong entity[v] into the foreign-invested RMB fund, which would serve as the master fund and invest directly into high technology companies in China.
A U.S. manager qualifies as a Necessary Investor if it has managed at least US$100 million over the last three years, of which, US$50 million was invested in private equity or venture capital deals involving qualified high technology companies. If a U.S. manager does not qualify as a Necessary Investor, with proper structuring, the U.S. manager may satisfy this requirement by affiliating itself with a Chinese manager that does qualify as a Necessary Investor. A Chinese manager qualifies as a Necessary Investor if it has managed RMB100 million during the last three years, of which, RMB50 million was invested in private equity or venture capital deals involving qualified high technology companies.
Conclusion
RMB funds appear to have the full support of the Chinese regulators, as developing China’s high technology industry is a high priority for the Chinese government. By investing in China through a foreign-invested RMB fund, either by itself or through an affiliation with a Chinese manager, U.S. private equity and venture capital fund managers could potentially discover significant investment opportunities and attract a new pool of investors.
[i] There are an increasing number of Chinese sources of capital available to RMB funds, including (i) China’s national social security foundation; (ii) several provincial and municipal governments, such as those of Tianjin, Jiangsu, Shanghai and Beijing, which may invest in RMB funds via their respective “guidance funds,” and (iii) a growing number of wealthy Chinese entrepreneurs.
[ii] A “round-trip” investment structure involves a foreign private equity or venture capital fund investing in foreign holding companies set up by Chinese individuals or entities to make investments back into China.
[iii] Of particular relevance is the passage of the Administrative Regulations on Foreign-Invested Venture Capital Enterprises (the “FIVCE Regulation”). All foreign-invested RMB funds are subject to the rules and requirements of the FIVCE Regulation. The FIVCE Regulation is helpful to U.S. managers as it permits terms commonly found in U.S. private equity funds (e.g., carried interest) to be incorporated into a foreign-invested RMB fund.
[iv] RMB funds structured as equity joint ventures may make disproportionate distributions of profits and/or allocations of gains/losses only with the approval of the local regulatory authorities.
[v] The Hong Kong entity would be formed for the purpose of taking advantage of the tax-treaty between China and Hong Kong.