Thanks to the buoyant economy and the strength of the Chinese Renminbi ("RMB") against US dollars, China has been in the spotlight of private equity investment for longer than a decade. There are primarily two private equity deal structures, i.e. offshore deal structure and onshore deal structure. In the past, investors are accustomed to consummating transactions through offshore deal structure to overcome the inconvertibility of RMB and China's market-entry restrictions. However, this structure recently began facing challenges from some Chinese regulatory changes restricting round-trip investment. Meanwhile, the onshore structure is encouraged by high returns from domestic IPO (especially in the GEM market) and various incentives offered by some local governments to attract private equity investors. The change of circumstances has certainly raised the interest of the private equity industry in exploring the prospect of onshore RMB-denominated fund. In fact, some early movers have already established onshore fund structures.
According to a market report, RMB-denominated private equity fund investment achieved US$3 billion closing of deals in China in 2009, which outstripped foreign-currency-denominated funds and took eighty percent of the domestic merger and acquisition transactions. In the first half of 2010, twenty four RMB funds were set up and raised US$1.13 billion capital. Recently, a few leading international funds have announced plans to establish RMB-denominated funds. Blackstone Group, for example, entered into a financial cooperation memorandum with the government of Shanghai Pudong in August 2009, which announced that it plans to establish its first regional RMB-denominated private fund in Shanghai. In January 2010, Carlyle
signed a memorandum with Beijing government preparing for establishing its RMB-denominated fund. Encouraging news came in March 2010 which confirms that Carlyle and Fosun established China's first foreign-invested partnership to run an onshore RMB-denominated fund in Shanghai.
Foreign–invested RMB-denominated fund commonly refers to the fund raised by foreign private equity firms within China and abroad and investing through an onshore structure in private equity of PRC enterprises ("RMB Fund"). Besides the above, there are other types of RMB funds operating in China, which are (i) "industrial funds" mainly formed with the state fund and managed by the central and local government; and (ii) domestic private equity investment funds purely funded and managed by domestic investors and fund managers in China. In addition, foreign-invested fund management enterprises may also set up onshore entities to manage RMB Funds to earn fees.
This article reviews China's latest regulatory development in relation to the private equity industry and discusses the legal options available for establishing RMB Funds.
Regulatory Framework in Relation to Onshore RMB Fund
China' regulations and practices relating to onshore foreign-invested RMB funds are still at the early stage of development. There is currently no clear and consistent regulatory system at the national level governing the establishment and operation of RMB Fund. The Chinese law on RMB Fund consists of fragmented policies, ministerial regulations and a large number of local incentive measures issued by some local governments.
On the national level, the laws were a combination of national policies and regulations of the State Council and different regulatory departments, each of which focuses on different issues concerning the private equity investment in China. For example, the Ministry of Commerce ("MOFCOM"), the Ministry of Science, Technology ("MOST") and some other authorities at national level issued in 2001 and then amended in 2003 a set of rules allowing foreign investors to set up the foreign-invested venture capital investment enterprises ("FIVCIE"), pool domestic capital and invest in domestic technology-advanced enterprises. Another national legislation is Provisional Measures on Administration of Venture Capital Investment Enterprises, issued by the National Development and Reform Commission ("NDRC") in conjunction with other ministries in November 2005, which sets out some rules in regard to formation and operation of venture capital investment firms in China and outlines the scope of operation of and national supporting policies available to private equity firms. The NDRC measures also require venture capital funds and relevant management entities established in China to register with NDRC.
Recent national level regulations and policies in relation to RMB Fund include:
i. Notice on Issues Relating to Approving Foreign-invested Venture Capital Investment Enterprises and Foreign-invested Venture Capital Investment Management Enterprises issued by MOFCOM on 5 March 2009, which lifted the threshold of its approving authority over establishment of a FIVCIE from US$50 mil to US$100 mil. A similar measure was released by MOST, MOFCOM's co-regulator on FIVCIE. On the same date, MOFCOM also delegated its authorities of approving foreign investors or foreign-invested enterprises ("FIEs") to acquire domestic enterprises with the transaction value less than US$100 mil to its provincial counterparts, provided the industries concerned fall into the "encouraged" or "permitted" category.
ii. Administrative Measures for Foreign Enterprises and Individuals to Establish Partnership Enterprises in China ("Measures") issued by the State Council in December 2009, which for the first time allowed foreign investors to directly establish foreign-invested limited liability partnerships ("FILP"). The Measures have provided foreign investors with a familiar legal vehicle to set up RMB Fund.
iii. Administrative Provisions of Registration of Foreign-Invested Partnership Enterprises ("Provisions") issued by the State Administration for Industry and Commerce ("SAIC") in January 2010. The Provisions provided the procedure with respect to establishment of a FILP, which eventually made it possible in practice to set up a RMB Fund in the form of FILP.
iv. Several Opinions on Further Improving the Work of Utilizing Foreign Investment ("Opinions") issued by China's State Council in January 2010. In the Opinions, the State Council announced that it would continue to encourage investment by onshore foreign-invested venture capital and make use of private equity investment as an effective means of utilizing foreign investment. The State Council also committed to continue to improve the current exit legal system.
On the local level, some municipalities such as Beijing, Shanghai, Tianjin, Chongqing have all introduced different rules and incentive measures to attract investors to establish onshore funds and/or fund management entities. Notwithstanding limitation on applicability, these measures shed light on the local practice. The followings are some examples of the local rules and measures:
Beijing:
i. Opinions for Promoting the Development of Equity Investment Funds jointly issued by the Beijing Financial Service Office, the Beijing Bureau of Finance, the Beijing Tax Bureau and the Beijing Administration for Industry and Commerce on 19 January 2009.
ii. Tentative Measures for the Establishment of Foreign-invested Investment Fund Management Enterprises in Beijing issued by the Beijing Financial Service Office, Bureau of Commerce of Beijing, the Beijing Development and Reform Commission and the Beijing Administration for Industry and Commerce on 4 January 2010.
(Collectively the "Beijing Regulations")
Shanghai:
i. Notice in relation to the Registration of Equity Investment Enterprises in Shanghai issued by the Shanghai Municipal Government in August 2008;
ii. Measures for Promoting the Development of Equity Investment Enterprises in Pudong New District of Shanghai issued by the government of the Pudong District of Shanghai in March 2009;
iii. Tentative Measures for Establishing Foreign-invested Equity Investment Management Enterprises in Pudong New District of Shanghai issued by the government of the Pudong District of Shanghai in June 2009.
(Collectively the "Shanghai Regulations")
Tianjin:
i. Opinions on Registration for Private Equity Investment Funds and Private Equity Investment Management Enterprises issued by the Tianjin Administration for Industry and Commerce in November 2007;
ii. Tentative Measures on the Registration and Filing of Equity Investment Funds and Equity Investment Management Enterprises in Tianjin issued by the Tianjin Financial Service Office, the Tianjin Bureau of Finance, the Tianjin Tax Bureau, the Tianjin Administration for Industry and Commerce and the Tianjin Development and Reform Commission in November 2008.
(Collectively the "Tianjin Regulations")
Pursuant to the Shanghai Regulations and Tianjin Regulations a RMB Fund and the related management enterprises may be established either as a company or as a limited liability partnership. In contrast, the Beijing Regulations require a foreign-invested private equity fund management enterprises ("Fund Management Company") be organized in the form of limited liability company, though a RMB Fund may be established as either a limited liability partnership or a limited liability company.
Basic requirements for establishing a RMB Fund in Shanghai under the Shanghai Regulations include:
i. the minimum registered capital of RMB100 mil in cash;
ii. the minimum capital contribution by each individual investor being RMB5 mil;
iii. the registered capital of a domestic fund management enterprise organized in the form of a company with limited liability being RMB1 mil minimum;
iv. the registered capital of a foreign-invested fund management enterprise being US$2 mil minimum;
v. the maximum number of shareholders or partners for a private equity investment fund in the form of a limited liability company or a limited partnership being fifty, or two hundred in the case of a joint stock company;
Beijing has not yet released details of its requirements for forming a RMB Fund, but it has clarified the details on forming a Fund Management Company. In particular, a Fund Management Company
i. may be organized as a limited liability company with the registered capital no less than US$2 mil;
ii. must have a least two employees of senior management personnel, of whom each must have at least two years satisfactory private equity fund management experience;
iii. is allowed to engage in the activities of private equity investment management and consultation;
iv. is entitled to the same policy supports rendered to domestic private equity funds;
v. is eligible for the financial support from the Beijing Municipal Private Equity Development Fund upon meeting certain conditions etc..
Tianjin is the first city expressly encouraging private equity investment. Its requirements for setting up a RMB Fund include:
i. a RMB Fund may be organized as a company, partnership or be formed pursuant to contractual or trust arrangements;
ii. the registered capital of a RMB Fund shall be over RMB10 mil.;
iii. the registered capital of a fund management company shall be at least RMB1 mil or RMB5 mil respectively for a limited liability company or a joint stock company;
iv. business scope of a RMB Fund is limited to investment in equity of unlisted enterprises and provision of consulting services relating to finance and investment, etc..
The Tianjin Regulations set out the following key requirements for setting up a fund management enterprise:
i. a private equity fund management enterprise may be formed as a limited liability company or a limited partnership;
ii. a private equity fund management enterprise must have at least registered capital RMB1 mil for a limited liability company, or RMB5 mil for a joint stock company. The registered capital must be contributed in cash;
iii. the major investor must have been in the satisfactory financial condition during the past two years, and must not have been subject to any material administrative or judicial penalties;
iv. the management team must have proven record of investment experience, and must comprise of at least three senior managers, each of whom must have two or more years of experience in equity investment (or related business experience), including at least one senior manager who has five or more years of experience in equity investment and business management,etc..
All the above regulations offer various tax incentives to RMB Fund, its investors or managers.
Under the regulations, private equity fund and foreign-invested private equity fund management enterprises are encouraged. Foreign general partner ("GP"), limited partner ("LP") or fund manager may either: (i) establish an onshore equity investment management company or partnership (only limited liability company in Beijing) to manage a RMB Fund by entering into a fund management contract with the GP of a RMB Fund; and/or (ii) directly invest into the RMB Fund (in the form of a company or FILP) as GP or through certain existing affiliated subsidiaries established in China.
Legal Structures of Onshore RMB Funds
Current practice in relation to formation of a RMB Fund in China is different. When structuring a RMB Fund, fund sponsors often take into account such factors as the incentive policies, the intended business sectors to invest on the deal level, the need of foreign exchange conversion, tax efficiency, the need of raising domestic fund, possible exit routes etc..
To launch a RMB Fund, fund company (or partnership), GP and management entities must all be established within China. Broadly speaking, fund sponsors or mangers currently have three legal options in structuring an onshore RMB Fund and its management enterprise, i.e. to set up a FIVCIE and/or FIVCIE management enterprises, an FIE or partnership with onshore FIE as GP and its management enterprise, and a FILP without onshore GP and its management enterprise.
Structure A: Corporate/Cooperative Joint Venture ("CJV") FIVCIE
The FIVCIE model was provided in Administrative Provisions on Foreign Invested Venture Capital Investment Enterprises issued in January 2003. To form a FIVCIE, the investors and the contemplated FIVCIE must meet various requirements, including the number of investors, qualified mandatory investor, number of qualified professionals, satisfactory compliance record and required number of qualified professionals of the mandatory investors etc.. The investors must apply for approval from MOFCOM (who will consult MOST) and then register the FIVCIE with SAIC.
Under the FIVCIE model, foreign investors may set up either a company with legal person status or a CJV FIVCIE with non-legal person status. If a FIVCIE is incorporated with legal person status, the FIVCIE is required to have at least US$5 mil as the registered capital, and there must be, among other things, at least one qualified "mandatory investor" contributing no less than thirty percent of the total registered capital. If a FIVCIE is set up as an entity with "non-legal-person" (i.e. "CJV"), US$10 mil is required as the minimum registered capital. FIVCIE must have at least one mandatory investor undertaking to contribute no less than one percent of
the registered capital and assuming joint liabilities with FIVCIE. FIVCIE is permitted to pool Chinese or foreign capital but is only allowed to invest in high-tech or new-tech companies. In addition, a FIVCIE is only allowed to invest with its self-owned cash. Debt financing, investing with borrowed capital, investment in securities or non-self-use real property are all prohibited.
The common structure of the FIVCIE structure is illustrated in the flowchart below (variations may be needed in practice):
Main pros and cons of structuring a RMB Fund as a FIVCIE include:
Pros:
● an onshore entity can be formed to raise domestic and foreign capital;
● FIVCIE is allowed to convert the investment fund in foreign exchange into RMB or the other way when repatriating fund;
● MOFCOM approval power is delegated to its provincial counterparts for
FIVCIE with total capital of US$100 mil or less;
● capital reduction/repatriation needs no prior government approval, rovided the remaining capital is sufficient for committed investment;
● investment by FIVCIE needs to file only with MOFCOM office at the location of the target company, which is of the authority to approve the investment Processing of the filing will take no more than fifteen days (in contrast, ninety days in an ordinary inbound direct foreign investment case), provided the investment projects falling into the "encouraged" or "permitted" industry categories;
● injection of capital into FIVCIE may be made in accordance to the progress of the investment plan within five years from the registration date, which is longer comparing to other types of FIEs;
● pass-through taxation is allowed for FIVCIE with non-legal-person status and withholding taxation basis at the rate of ten percent or less may be granted to foreign investors in a non-legal person FIVCIE subject to the approval of tax authority;
● FIVCIE may be qualified for deduction at seventy percent of its equity investment amount against its taxable income on the third year after holding the relevant equity;
● FIVCIE management enterprises are allowed to establish either in the form of a partnership or company to manage FIVCIE, which may help foreign investors to diversify revenue streams;
● no onshore layer of GP/wholly foreign-owned enterprises ("WFOE") is needed, which may offer preferred tax advantages;
● according to the Opinions, China will allow more FIEs to be listed in its domestic stock exchanges.
Cons:
● FIVCIE is a legal vehicle mainly invest in high-tech or new tech enterprises;
● establishment of FIVCIE needs approval from MOST, which may prolong and complicate the approval process;
● to be the mandatory investor of FIVCIE structured as a company, it must contribute at least thirty percent of the registered capital of the FIVCIE; or it shall contribute one percent of the registered capital and assume joint liabilities with FIVCIE;
● no pass-through taxation for the FIVCIE structured as an onshore company;
● portfolio investments are subject to investment restrictions generally applied to foreign investment;
● FIVCIE is unable to provide debt financing (except legally issued orporate bond) or hold other non-self-use assets in its own name.
Structure B: a FILP without Foreign-invested Onshore GP
Following the adoption of the Measures and the Provisions, the route for foreign GP to directly set up an onshore RMB Fund in the form of FILP becomes clear, despite some clarifications remain needed with respect to procedures. It was made clear by Article 5 of the Provisions that SAIC at the provincial level are responsible for registering FILPs primarily engaging in investment business, though SAIC is required to actively consult with other authorities in registering investment FILP where needed.
Whilst it is still not entirely sure about the approval required for the portfolio investments, the Measures generally require the FILP to conform to relevant industrial policies guiding foreign investment. The Provisions also reiterate that the investors shall obtain all the relevant approvals before applying for setting up the FILP, provided that the investment is subject to the government approval under a law, a regulation or a provision of the State Council. In addition, if the FILP is established to carry out an investment project in China that requires the government approval, the investors of the FILP shall obtain such an approval before setting up the FILP. Given the restrictions on foreign investment still apply to FILP, some approving or filing requirements, theoretically, may exist for door keeping, though it is remains to be seen how the system is to be applied to RMB Fund organized as a FILP.
With respect to the foreign exchange conversion restrictions applied to FIE under Circular 142 of State Administration of Foreign Exchange ("SAFE") (see p. 14 for the restrictions under Circular 142), the new regulations does not offer a welcoming clarification. The FILP investors are required to pay the capital contribution to the FILP in accordance with the partnership agreement. Theoretically, this should be understood as that conversion of foreign exchange to be contributed by the foreign partner is allowed. However, for an investment FILP, it is not yet clear whether SAFE would set any conditions on the conversion.
It was reported that Shanghai will soon adopt a quota system (similar to the foreign exchange control system applied to Qualified Foreign Institutional Investors) to allow foreign-invested GP to convert its investment capital and to participate into RMB Fund. How the foreign exchange restrictions will be dealt with by SAFE and the local governments encouraging private equity investment remain a question.
Below the chart shows the common structure of a FILP organized with no onshore GP(variations may be needed in practice):
Since some aspects of the rules relating to FILP remain to be clarified in practice, many attributes of the structure still depend on the future clarifications. Below are some main anticipated pros and cons:
Pros:
● investors to FILP are of flexibility in defining the terms of their partnership agreement;
● theoretically, it should be allowed to convert capital from foreign exchange into RMB or the other way when repatriating fund, though further clarifications may be needed;
● FILP is allowed to pool domestic and foreign capital;
● pass-through taxation should be allowed subject to approval;
● streamlined procedures may be applied to forming FILP;
● investors can agree on the schedule of capital contribution and repatriation;
● FILP is eligible for local incentive polices in major cities;
● unlike corporate entity, there is no trapped fund in a FILP;
● for the foreign GP, capital may be contributed in a form other than cash, including management services;
● preferred structure for taxation, though rules are to be clarified;
● FLIP may act as GP of other investment projects;
● a successful case in Shanghai is available(Carlyle and Fosun).
Cons:
● currently, a FILP is not permitted to act as a shareholder of a company in a domestic IPO, which means that it currently appears difficult for FILP to exit from domestic IPO;
● portfolio investment is subject to stricter investment restrictions than FIEs;
● taxation rules are unclear in regard to the income derived by the FILP passing through to the foreign partner on withholding tax basis;
● FILP may be unable to provide debt financing or hold assets in its own name.
Structure C: FIE or Partnership with an Onshore FIE as GP
Some foreign fund sponsors seek alternative structures to set up RMB Fund to avoid drawbacks of other structures. They set up onshore WFOE without the business scope of "private equity investment" to engage in private equity investment. The WFOE is often used as a platform to overcome China's foreign exchange control or as an indirect holding entity to the portfolio investment. Some foreign investors make use of various contractual controls to set up pure domestic RMB funds to cover the source of fund and circumvent China's scrutiny on foreign investment restrictions. It should be noted that these structures are result-oriented and may sometime bring risks to the investors.
Some local practice shows that offshore fund advisors or an offshore GP may set up WFOEs in China as its onshore management enterprise or onshore GP. The GP's WFOE (often acting as the onshore GP) jointly with domestic LPs forms a RMB Fund company or FILP. It should be noted that SAFE issued in 2008 Circular 142, which prohibits FIEs (including WFOE) without "investment" in its business scope, unless there are otherwise legal provisions, from converting its capital in foreign currency into RMB for domestic equity investment purpose, and requires the FIE's capital be used strictly for its approved business scope. It should be difficult in anywhere else other than where there is a special local regulation permitting so. Circular 142 has raised significantly the difficulty of investing in equity of other enterprises through a WFOE. However, the foreign-invested equity fund management enterprises established in Pudong Shanghai is able to convert foreign exchange into RMB to make its capital contribution as a GP into RMB Fund, though the conversion is capped at one percent of the aggregate amount of the RMB Fund.
Nonetheless, it should be noted that Circular 142 or other similar restrictions shall not affect existing entities in China that own lawful RMB income to invest in domestic equity with RMB. For those foreign fund sponsors that cross-border transferring funding is not necessary, a domestic partnership may be an effective vehicle at the portfolio investment level, as it is subject to neither foreign investment restriction nor governmental approval.
Below the chart shows the common structure of a RMB Fund organized with an onshore FIE GP (variations may be needed in practice):
Main pros and cons this structure is summarized as below:
Pros:
● local rules benefits may be available;
● it is allowed to pool domestic capital at the fund level;
● RMB Fund may not be subject to foreign investment restrictions and approvals;
● RMB Fund may not be subject to foreign exchange controls, but at the GP level the control may apply when contributing capital into the fund or repatriating fund.
Cons:
● it would be difficult for the WFOE/GP to be approved with a business scope of equity investment in a location where no such local encouraging rule is applicable;
● it may be an inefficient tax structure due to multilayer structure;
● capital trap exists at the WFOE/GP level;
● it is difficult to repatriate capital at the WFOE/GP level;
● foreign exchange conversion is subject to restriction of SAFE Circular 142 at the WFOE/GP level, etc.
Conclusions
RMB Fund offers a new way for foreign investors to share the benefit of China's fast growing economy. However, China's regulatory environment in respect of onshore RMB Fund, like other emerging markets, is still at an early stage of development. There remain many impediments and uncertainties hampering international fund sponsors and managers to enter into the market with a sizable onshore operation. It is the hope of all that the regulatory authorities will soon be able to draw up a clear and efficient path for foreign investors to enter into and withdraw from the market.
For the fast evolving regulations and divergent practice, forming and operating an onshore RMB Fund can be very intricate and challenging tasks, especially in an unfamiliar jurisdiction. Foreign fund sponsors and managers should carefully overhaul every detail of their onshore structure whether existing or envisaged to ensure they will achieve the desire and enjoy the benefits on offer, whilst avoiding the drawbacks to the extent possible. It is particularly important for fund sponsors to look into the local rules and regulations and set up effective communication channels with the local governments, as local rules play important roles and they are subject to local interpretation.
About the author:
Steven Wei Su is a partner at Guo Lian PRC Lawyers based in Beijing. His practice focuses on China-related private equity/venture capital, mergers and acquisitions, general corporate and commercial dispute settlement. Before joining Guo Lian PRC Lawyers, he spent ten years working with international law firms and a key regulator of the PRC government as a legal officer. If you wish to contact the author, please write to ssu@guolian.com.cn or call 008613552639569.
