Earlier this year, the People’s Bank of China (PBoC) issued its Administrative Measures over Pilot Projects on Settlement of Overseas Direct Investments in Renminbi (the “PBoC Measures”). The PBoC Measures permit the PBoC, under a pilot project, to loan renminbi to Chinese investors to fund outbound acquisitions. The PBoC Measures are expected to have a positive impact on leveraged buy-out (LBO) firms in China that acquire interests in non-Chinese companies. Effectively, the PBoC Measures extends the M&A loan capacity of Chinese banks from Chinese domestic M&A transactions to overseas, non-Chinese M&A transactions. For a more detailed discussion of the PBoC Measures, please click here.
Written by Michael Wu
California’s Department of Corporations (the “Department”) intends to issue emergency regulations to address the elimination of the “private adviser exemption” under Section 203(b)(3) of the Investment Advisers Act of 1940, as amended (the “Advisers Act”). Currently, an investment adviser in California may rely on the private adviser exemption by virtue of California Department of Corporations Rule 260.204.9, which specifically refers to the private adviser exemption under Section 203(b)(3) of the Advisers Act. The Dodd-Frank Wall Street Reform and Consumer Protection Act will eliminate the private adviser exemption under Section 203(b)(3) effective as of July 21, 2011, which in turn would affect a California investment adviser’s ability to rely on Rule 260.204.9. The Department will issue emergency regulations amending Rule 260.204.9 to preserve the status quo. Therefore, California investment advisers that currently rely on the exemption from registration for private advisers will be able to continue to rely on that exemption until the Department adopts a final rule regarding private fund advisers. For more information about this new development please click here.
On March 22, 2011, U.S. House Oversight Committee Chairman Darrell Issa (R., Calif.), sent a sharply worded letter to Chairman Mary Schapiro of the Securities and Exchange Commission (the “SEC”), in which he demanded that the SEC justify several of its rules regarding raising capital, including the “quiet period” that restricts a company’s communications ahead of an initial public offering (“IPO”) and the rules that limit the number of investors in private companies to 499. The immediate impetus of this letter (the “Issa Letter”) appeared to be the recent decision by Facebook to issue shares exclusively to non-U.S. investors due to the requirement for a private company to file financial statements with the SEC once it has more than 499 U.S. equity holders, as well as the general decline of the overall IPO market in the U.S.
The Issa Letter accuses the SEC of stifling capital creation and causing the decline of the IPO market in the U.S. by clinging to obsolete and inflexible laws and regulations. Chairman Issa asks whether the decline in public equity listings and issuances have been driven by the expansion and complexity of SEC regulations, the expansion of personal liability under the Sarbanes-Oxley Act of 2002, the new uncertainty surrounding regulations to be issued pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), securities class action lawsuits and the expansion of other regulatory, legal or compliance burdens. Chairman Issa railed against the prohibition on promotional statements made between the time that a registration statement has been filed and the time it becomes effective as a violation of an issuer’s rights under the First Amendment. Chairman Issa further finds fault in the inability of the SEC to fashion rules to permit effective early stage capital formation, accuses the SEC of certain conflicts of interest and ineptitude in its staff, and suggests that “sophisticated” investors, regardless of whether they satisfy the “accredited” investor standard, should be permitted to invest in private placements.
On April 6, 2011, Chairman Schapiro responded to Chairman Issa in a detailed and heavily footnoted tome (the “Shapiro Letter”) that sought to correct some of the basic misunderstandings in the Issa Letter. The Schapiro Letter provides an interesting and brief history of the development of private offerings, the development of the private markets, the IPO process, the rationale behind public reporting, and the SEC’s views towards capital raising strategies. Much of this discussion is either relevant to investment fund managers or directly on point with their businesses, and certainly worth a read.
Chairman Issa raises some interesting points and the combative tone of his letter should not be a reason to simply dismiss his concerns. There are, however, two interesting questions that Chairman Issa could have raised with the SEC, but did not, the answers to which may have been even more productive to the discussion.
First, does the SEC believe that if it was self-funded, it would be more responsive to the needs of the capital markets and be able to better balance its dual mandates of creating efficient capital markets and protecting shareholders? It should be noted that early drafts of the Dodd-Frank Act stated that the SEC was to be self-funded, but that language was later removed when our two political parties agreed on specific budget numbers for the SEC, which they believed would permit the SEC to meet its significant new and continuing obligations. Once the Dodd-Frank Act became law, a bi-partisan Congress promptly ignored these funding mandates and has continued to impede the effectiveness of the SEC through the budget process.
Second, does the SEC believe that significantly increasing the number of investors to which a private company can sell shares, without providing full and fair disclosure, would shrink the public markets, make fewer investment opportunities available to ordinary investors, and accelerate the wealth divide that is threatening to destabilize the U.S.? The securities laws were meant to level the playing field among investors, and the SEC over the years has attempted to enforce this mandate through the registration process and its enforcement actions. Larry Ribstein provides a thoughtful view of this dilemma here.
The balance between effective regulation for investor protection and efficient capital markets to encourage responsible investment is a delicate one that we can expect to be treated quite indelicately in the current political climate.
Written by Michael Wu
On January 26, 2011, the SEC proposed a rule that would require SEC-registered advisers to hedge funds, private equity funds and other private funds to report information to the Financial Stability Oversight Council (“FSOC”) that would enable it to monitor risk to the U.S. financial system. The information would be reported to the FSOC on Form PF and the information reported on Form PF would be confidential.
The proposed rule would subject large advisers to hedge funds, “liquidity funds” (i.e., unregistered money market funds) and private equity funds to heightened reporting requirements. Under the proposed rule, a large adviser is an adviser with $1 billion or more in hedge fund, liquidity fund or private equity fund assets under management. All other advisers would be regarded as smaller advisers. The SEC anticipates that most advisers will be smaller advisers, but that the large advisers represent a significant portion of private fund assets.
Smaller advisers would be required to file Form PF once a year and would report only basic information about their hedge funds, private equity funds and/or other private funds, such as information regarding leverage, credit providers, investor concentration, fund performance, fund strategy, counterparty credit risk and the use of trading and clearing mechanisms.
Large advisers would be required to file Form PF quarterly and would provide more detailed information than smaller advisers. The information reported would depend on the type of private fund that the large adviser manages.
- Large advisers to hedge funds would report, on an aggregated basis, information regarding exposures by asset class, geographical concentration and turnover. If a hedge fund has a net asset value of at least $500 million, the adviser would report information regarding the fund’s investments, leverage, risk profile and liquidity.
- Large advisers to liquidity funds would report the types of assets in their liquidity funds, information relevant to the risks of the funds, and the extent to which the liquidity funds comply with Rule 2a-7 of the Investment Company Act of 1940, as amended.
- Large advisers to private equity funds would respond to questions regarding the extent of leverage incurred by their funds’ portfolio companies, the use of bridge financing and their funds’ investments in financial institutions.
The SEC’s public comment period on the proposed rule will last 60 days.
Written by Michael Wu
Earlier this month, the Institutional Limited Partners Association (“ILPA”) published Version 2.0 of its Private Equity Principles (the “Principles”). The Principles set forth the ILPA’s take on the best practices in establishing private equity partnerships between limited partners (“LPs”) and the general partner (“GP”). The Principles focus on three guiding tenets for developing effective partnership agreements: Alignment of Interest Between LPs and GP, Fund Governance and Transparency to Investors. The revised version of the Principles incorporate feedback from GPs, LPs and third parties in the industry to increase “focus, clarity and practicality.”
The following are the key changes from the prior version of the Principles under each of the three guiding tenets:
Alignment of Interest Between LPs and GP
- GP cash contributions are preferred to fee waivers
- European-style waterfalls (i.e., all contributions plus preferred returns are paid before the GP receives any carry) is preferred to American-style waterfalls (i.e., deal-by-deal), though with certain safeguards, such as carry escrows of 30% or more, 125% NAV tests and interim clawbacks, the American-style waterfall could be acceptable
- GP clawbacks should be net of taxes, “fully and timely repaid” and should extend beyond the term of the fund
- Joint and several liability of the GP’s members is preferred, but a joint and several guaranty from a substantial parent company or individual GP member may be acceptable, and LPs should be able to enforce the GP clawback guaranty
- Lower management fees should be charged at the end of the investment period, the formation of a successor fund and if the term of the fund is extended
- Deal sourcing fees should be a GP expense
- LP clawbacks for indemnification should be capped at 25% of the capital commitments and should not apply after two years from the date of distribution
- Term of the fund may only be increased in one-year increments and only with the consent of a majority of the Advisory Committee or the LPs, and if such consent is not obtained, the fund should be fully liquidated within one year of the end of the fund’s term
- GP should not co-invest with the fund (i.e., GP’s entire interest should be through the fund)
- Advisory Committee should review and approve any fees generated by an affiliate of the GP, whether charged to the fund or a portfolio company
- GP may be removed for “cause” and the fund terminated for “cause” upon a majority vote of the LPs
- A 2/3 in interest of the LPs may terminate/suspend the commitment period without fault and a 3/4 in interest of the LPs may remove GP and dissolve the fund without fault
- GP should accommodate LP investment policies and provide applicable excuse rights
- A majority in interest of the LPs may make general amendments; a super-majority in interest of the LPs may make “certain amendments” (e.g., investor-specific provisions) and amendments affecting the fund’s investment strategy and the fund’s economics; and amendments negatively affecting any LP’s economics, require the consent of such LP
- Where the interest of the LPs and the GP is not aligned, a reasonable minority of the members of the Advisory Committee may engage independent counsel at the expense of the fund
Transparency to Investors
- Annual reports should be delivered within 90 days of the end of the year
- Annual and quarterly reports should be provided to LPs regarding a portfolio company’s debt
- Funds should use the ILPA’s standardized form of capital call and distribution notice template
Finally, the ILPA’s release also set forth best practices for Advisory Committees. More information about the Principles can be found here.
On January 11, 2011, the Shanghai Municipal Government released its Implementation Measures on Trial Projects of Foreign-Invested Equity Investment Enterprises in Shanghai (the “Shanghai RMB Fund Regulation”), which will become effective on January 23, 2011. Prior to the release of this regulation, it was widely expected that the Shanghai Municipal Government would launch a Qualified Foreign Limited Partners (“QFLP”) legal regime to help large international institutional investors invest in Shanghai-based private equity funds. Although the Shanghai RMB Fund Regulation was implemented in response to such expectations, we believe it is just the first of many regulations designed to confer national treatment to private equity funds formed by non-Chinese fund managers. For more information regarding the Shanghai RMB Fund Regulation, please see A Red Envelope From Shanghai? New RMB Fund Rules Create Opportunities for Non-Chinese Fund Managers.
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.
Since 2007 there have been a number of circulars (i.e., ordinances issued by industrial regulators) and regulations pertaining to whether Chinese insurance companies are permitted to invest their assets in offshore (i.e., outside of China) private equity. The following summarizes the relevant laws pertaining to this issue.
- In 2007, the China Insurance Regulatory Commission (“CIRC”), jointly with China’s central bank (“People’s Bank of China”) and the State Administration of Foreign Exchange (“SAFE”), issued a circular to permit Chinese insurance companies to make certain types of offshore investments. Specifically, the circular stated that Chinese insurance companies were permitted to invest in offshore capital markets products, fixed income products, equity investments and public companies. Although the circular permitted offshore “equity investments,” which under applicable Chinese law includes private equity investments, so far there have not been any publicly reported investments by Chinese insurance companies in offshore private equity in reliance on the circular.
- In August of 2010, the CIRC issued a circular to clarify certain investment policies applicable to insurance assets (“2010 Insurance Policies”). The 2010 Insurance Policies explicitly permit Chinese insurance companies to invest in offshore publicly issued bonds, investment funds and publicly traded stock; however, investment in offshore private equity was not explicitly listed as a permitted investment. Accordingly, after the 2010 Insurance Policies were issued, it was not clear whether Chinese insurance companies could invest in offshore private equity.
- In September of 2010, the CIRC issued a circular permitting Chinese insurance companies to invest in private companies and private equity located in China. This circular suggests that Chinese insurance companies are not permitted to invest in offshore private equity. Please refer to the blog titled China Permits Insurance Companies to Invest in Private Equity for additional information regarding the 2010 circular.
- In addition, there is no consensus regarding whether a Qualified Domestic Institutional Investor (“QDII”) may make offshore private equity investments under the QDII regulations. Under the QDII regulations, a QDII may apply for a quota to convert its RMB into foreign currency for purposes of making offshore investments. The QDII regulations enable Chinese investors to participate in offshore capital markets by investing in the products offered by QDIIs. The investment scope of QDIIs is strictly limited to banking products, bonds, public securities traded on specified stock exchanges, structured products and futures.
Unfortunately, the circulars and regulations above do not provide clear guidance regarding whether Chinese insurance companies may invest in offshore private equity. Accordingly, non-Chinese private equity fund managers should contact us before accepting any investment from Chinese insurance companies to determine the risks of such investment and the extent to which such investment is permitted under applicable law in China.
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.
Most of the “RMB fund” structures currently being used to enable non-Chinese investors to participate in private equity and venture capital investments in China are tax driven. However, some fund managers are using a RMB fund structure that is not designed to address a particular tax issue, but instead is designed to enable non-Chinese investors to participate in investments in China that, as a regulatory matter, are generally only available to domestic Chinese investors.
At this time, non-Chinese investors may only invest in certain “encouraged” or “permitted” sectors of China’s economy (e.g., the high tech, equipment manufacturing and new materials industries). Although the Ministry of Commerce’s Foreign Investment Department is expected to increase the number of sectors that are “encouraged” or “permitted,” the extent of such increase and the time frame within which such increase will occur remain unclear.
In order to enable non-Chinese investors to participate in other sectors of China’s economy, some fund managers have utilized a China parallel fund structure. Unlike a U.S. parallel fund structure, which generally involves two funds that invest side by side, on a pro rata basis, in the same assets, a China parallel fund structure generally involves two funds – one formed outside of China for non-Chinese investors and one formed in China for Chinese domestic investors – that each invest in assets that are not available to the other fund.
The offshore fund would typically receive an option to participate in investments made by the domestic fund in the sectors reserved for domestic Chinese investors and the domestic fund would receive an option to participate in investments made by the offshore fund in companies domiciled outside of China (which due to currency control issues may not be attractive to the domestic fund). If the restricted sectors subsequently become available to non-Chinese investors as a result of a revision to the foreign investment catalogue by the Ministry of Commerce’s Foreign Investment Department, the offshore fund would presumably exercise the option and participate in any gains that had accrued since the option was granted. The parallel fund structure, therefore, potentially allows non-Chinese investors to gain immediate access to sectors that are not yet “encouraged” or “permitted” but that are expected to eventually be opened to non-Chinese investors.