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O'Melveny Publishes New Comprehensive Report on RMB Funds

October 15, 2011

 

RMB funds are now as a fixture of the international private equity and venture capital market. From having designed the limited partnership agreement for the first foreign-invested RMB fund in 2004 to helping implement the first pilot RMB fund (试点外商投资股权投资企业) or “QFLP” regime in 2011, O’Melveny is deeply embedded in the RMB funds movement. In this our third paper on the subject — we assume the imperative of an RMB fund strategy and turn our attention to the lessons learned and best practices. Many of the highest profile private equity houses have adopted an RMB fund strategy as a top priority. These include names such as The Blackstone Group, The Carlyle Group, Goldman Sachs, KKR, Morgan Stanley, TPG, as well as many others who have not publicized their initiatives. In addition, many seasoned VC houses in China are already on their third or fourth vintage of RMB fund. These include names such as IDG, SAIF, and many others taking a much localized approach. Today, the question for international investors is no longer “should we establish an RMB fund platform?” but rather “how many RMB fund strategies — and what kind — should we deploy?”

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RMB funds are now as a fixture of the international private equity and venture capital market. From having designed the limited partnership agreement for the first foreign-invested RMB fund in 2004 to helping implement the first pilot RMB fund (试点外商投资股权投资企业) or “QFLP” regime in 2011, O’Melveny is deeply embedded in the RMB funds movement. In this our third paper on the subject — we assume the imperative of an RMB fund strategy and turn our attention to the lessons learned and best practices. Many of the highest profile private equity houses have adopted an RMB fund strategy as a top priority. These include names such as The Blackstone Group, The Carlyle Group, Goldman Sachs, KKR, Morgan Stanley, TPG, as well as many others who have not publicized their initiatives. In addition, many seasoned VC houses in China are already on their third or fourth vintage of RMB fund. These include names such as IDG, SAIF, and many others taking a much localized approach. Today, the question for international investors is no longer “should we establish an RMB fund platform?” but rather “how many RMB fund strategies — and what kind — should we deploy?”

In a recent survey of 140 PE/VC firms targeting China, more than 30% reported that they are managing both US dollar and RMB funds. A similar survey of 35 international firms indicated that more than one-third of their exits in 2010 were on the Chinese domestic capital markets, a figure nearly on par with the roughly 42% that were on non-China capital markets (the balance were offshore and onshore trade sales). Similarly, domestic PE/VC firms are also raising US dollar funds, with 20% out of a sample size of 456 reporting that they are managing either one US dollar fund or some form of a parallel US dollar/RMB fund.

O’Melveny has navigated the complexities of RMB funds and taken account of their many pros and cons, and we believe a careful review of the RMB fund movement is appropriate. The ideal foreign managed or foreign invested RMB fund structure should come as close as possible to matching or exceeding deal execution capabilities of domestic Chinese investors. This means no need for foreign currency conversion approvals, no need for foreign investment approvals, no need for curtailing targets in industry sectors allowed by the Foreign Investment Catalogue (外商投资产业指导目录), and no interference with exiting investments due to myriad foreign investor-related regulatory burdens.

 

Reflection on earlier trends

 
A review of the predictions from our last installment, in 2009, confirms that we have accurately identified the most significant trends. Onshore fund-raising is a reality. The amount of capital raised by RMB funds outstripped that raised by US dollar-denominated funds targeting China for the first time in 2009, and then repeated that feat in 2010, as the amount raised by RMB funds more than doubled. NSSF (全国社会保障基金) deployed more than RMB8 billion into onshore private equity funds; it continues to invest from its more than RMB70 billion in capital earmarked for alternative investments and is preparing the final stages of offshore fund investments. The China Development Bank (in the form of CDB Capital) invested in its nineteenth private equity fund in 2010 and has partnered with Suzhou Industrial Park to announce a nationwide fund-of-funds of RMB60 billion to make pure RMB fund investments. Chinese insurance companies were authorized in 2010 to begin deploying RMB200 billion into the private equity space. Other incumbent Chinese LPs, such as government guidance funds, high-net-worth individuals, and certain SOEs, also continue to be active and gain experience. With fund-raising proceeding at such a furious pace, specialized RMB fund placement agents are beginning to take root in China, a cottage industry that was almost unthinkable a year or so back. Many of these are local firms rapidly building significant brand names.

 

Competition among local jurisdictions is now a feature of the landscape. Shanghai’s introduction of Pilot RMB Funds for foreign investors is a model that was quickly replicated by Chongqing, Beijing, and most recently in Tianjin in October 2011. Each of the main jurisdictions considers itself in competition with the others to attract the right portfolio of GPs and LPs for further development of the industry.

 

National-level regulators such as the NDRC (中华人民共和国国家发展和改革委员会) and the CSRC (中国证券监督管理委员会) have also adopted more active roles. In February 2011, the NDRC issued the first-ever national circular regarding the supervision and recordal of private equity RMB funds1, reflecting increased interest from the central government authorities in establishing adequate regulatory control over this growing investment sector. Meanwhile, the CSRC is attempting to bring the private equity sector into its jurisdiction and is reportedly closer to issuing an amended investment funds regulation, expanding the scope of its authority to private equity funds, venture capital funds, and other areas.

 

While not yet complete as a matter of national law, restrictions on the ability of foreign-invested or controlled general partners (GPs) to raise “pure” RMB funds, i.e., those raised exclusively from onshore limited partners (LPs) in China, have eroded. This started with a bold pronouncement by Shanghai to classify certain RMB funds as retaining their domestic classification. Other jurisdictions have issued similar statements, and the tide for this policy to become accepted ultimately by central authorities appears plausible in the longer term. While MOFCOM (中华人民共和国商务部) issued a circular in February 2011 which classifies those foreign-invested partnerships whose main businesses are investing as foreign investors, it did not seek to assert similar authority over investment partnerships having a foreign-invested GP as its only foreign-invested partner.

 

First things first — who is your local team and who are your local partners?

 

Who were the first movers into the foreign-managed RMB fund space and what made them successful? The earliest adopters tended to be sponsors who had a preexisting deep bench of local investment professionals on the ground. They also had historical experience with important local partners, through previous co-investment activity with local investors and the cultivation of longstanding relationships with relevant government agencies. Some also leveraged relationships with emerging general local partners in the local investment space.

 

Cooperation with local governments and state-owned enterprises at the GP/manager level is also a key strategy. A recent example is Carlyle’s Beijing RMB fund. Carlyle successfully entered into an 80:20 joint venture with the Beijing-owned Capital Operation and Management Center, an investment arm of the Beijing State Assets Bureau (北京市人民政府国有资产监督管理委员会), to serve as advisor to the RMB fund.2 Many of the foreign-related RMB funds have chosen to partner with local governments or local state-owned enterprises in varying degrees.

 

Developing an investment track record onshore is another important strategy. Certain Chinese LPs cannot invest in a first-time RMB fund for various internally specific and regulatory reasons. 

 

Focus on one or more specific locations, be practical

 

A truly nationwide foreign-managed RMB fund does not (yet) exist. Funds tend to adopt some form of regional focus; certain sponsors have decided to deploy multiple RMB fund strategies across various regions and with different Chinese partners. The early foreign-invested RMB funds gravitated toward setting up in those cities where their anchor Chinese LP resided (usually one or more government guidance funds). Funds with a more diversified LP base still need the cooperation of a facilitating local jurisdiction. These include Shanghai, Tianjin, Beijing, Shenzhen, Chongqing, Suzhou, Wuxi, and others. Even funds having no particular LP constituency in a single locality must choose the optimal location for establishment, a decision that significantly impacts the operations of the fund. Without a facilitating government authority, rigid regulatory mechanics can impede operations.

 

While the selection of location can be affected by dozens of factors, below are some of the more important issues that a fund manager should consider when choosing the most favorable location from a regulatory perspective:

 

Comparison of the local incentives 

 

Today, most of the major cities in China have issued their own rules concerning private equity funds and offer various incentives to promote the private equity industry. For example, Tianjin, one of the earliest movers and most active cities for RMB fund developments, has issued numerous regulations regarding the private equity fund industry since November 2007.3 Shanghai took its first step toward regulating equity investment funds in August 20084 and thereafter issued a series of rules establishing the supervision regime for both domestic and foreign-invested funds and managers.5 Beijing followed this lead in January 20096 and Suzhou and Chongqing have also promulgated their own local rules and taken similar approaches.

 

While these competing local incentives are numerous, we have found that the differences are much less marked in practice. Many of the most important incentives have begun to converge on common themes such as:

 

•    business scopes with broad powers to invest into a wide range of investment classes;

•    disclosure requirements and minimizing intrusion on fund operations;

•    pass-through tax treatment;

•    financial subsidies for a certain percentage of locally retained tax revenue; and

•    other miscellaneous subsidies.

 

The better approach is one that focuses on negotiating for incentives tailored to the fund’s substantial operations as opposed to chasing certain ill-understood tax incentives and other subsidies that turn out to be inconsequential in practice. That said, the cities do present some material differences. These include avoiding large thresholds for registered capital commitments for GP, manager, and the fund, as well as acquiring agreement on tax matters that are truly consequential. For example, O’Melveny clients have been better served by robust agreements that shield the carried interest from business tax plus ordinary income tax and provide transparency for taxes applicable to LPs as opposed to chasing after the meager tax refunds advertised by certain jurisdictions which are all premised on top-line rates of tax.

Foreign exchange settlement programs — Pilot funds, QFLP, and their variants

In general, the capital account for settlement of RMB inbound to or outbound from China remains closed. This means any transfer or conversion of currency across the border for purposes of investment or debt (and transactions which are in the form of current account items but have the substantive nature of investment or debt) is subject to either discretionary SAFE (国家外汇管理局) approval, or more liberal SAFE registration formalities but restricted to limited circumstances. Following the issuance of Circular 142 in the summer of 2008,7 enforcement of these historical restrictions was brought to bear against onshore RMB funds having foreign investors. Since then, onshore RMB funds having foreign investment have been required to transact in non-RMB currency to execute investments in Chinese companies. This means their target companies need to accept non-RMB currency and take it upon themselves to settle into RMB on an as-needed basis as RMB-denominated expenses arise — a very awkward process. This method of deploying capital puts foreign-invested RMB funds at a competitive disadvantage with wholly domestic RMB funds, which can invest directly in RMB.

 

In response, local governments targeting the development of the PE industry lobbied SAFE to resolve this issue. Shanghai was the first to do this by issuing the long-awaited Implementation Measures on Pilot Program of Foreign-Invested Equity Investment Enterprises in Shanghai on December 24, 2010, a process we participated in with the Shanghai Financial Office (上海市金融服务办公室).8 Known as “QFLP” or Pilot Fund Rules, these rules allow certain locally approved funds to convert foreign limited partner contributions from non-RMB currency to RMB at the fund level. The Shanghai Pilot Fund established by Hony Capital was the first to utilize this new conversion process, for a Hebei investment target.  The procedure allows the funds’ target companies to accept direct RMB investments the same as they would accept from pure local funds. Beijing, Chongqing, and Tianjin have also drafted similar foreign exchange procedures.  

 

Pilot Areas for NDRC Recordal

In February this year, the NDRC issued the first nationwide circular setting forth the mechanisms for supervision and recordal (备案) of private equity funds in certain pilot areas. These are Beijing, Tianjin, Shanghai, Jiangsu province, Zhejiang province, and Hubei province. This new development may impact a GP’s decision to establish a fund in one of the pilot areas, especially when that GP is targeting institutional Chinese LPs. For example, NSSF has invested only in private equity funds that have been recorded with the NDRC, and as a practical matter, a GP may need to establish in one of the pilot areas in order to garner NSSF’s investment. In addition, though not explicitly stated in any published rules, the NDRC recordal could be an important factor for other Chinese institutional LPs, such as insurance companies, which were officially approved to invest in the private equity business in September 2010.9 The impact of the new NDRC circular is discussed in a later section of this paper.

 

Choice of legal structure: what’s popular, what’s not, and why

The market is awash in RMB fund structures. This paper presents some of the building blocks for a structure tailored to the specific needs of the parties. These choices include the: 

 

•    stand-alone pure RMB fund structure;

•    parallel or dual offshore/onshore structure;

•    pilot foreign-invested structure or QFLP;

•    corporate evergreen capital structure; and

•    locally approved foreign-invested venture capital enterprise 

 

In each structure, a Chinese partnership enterprise will normally be used as the legal form of the fund vehicle and ideally be classified as an Equity Investment Fund or 股权投资企业 (“EIF”). In addition, where foreign investment is involved, the fund vehicle may be in the form of a foreign-invested partnership enterprise or 外商投资合伙企业 (“FIP”).

 

Stand-alone pure RMB fund structure

 

This structure (see Chart 1 in PDF) continues to be one of the most popular. Numerous local governments are granting business licenses to either an FIP (which may present tax efficiencies) or a wholly foreign owned enterprise to give sufficient comfort that such entity has the legal capacity to raise and manage an onshore RMB fund. This fund vehicle is exclusively funded by onshore LPs investing in RMB. This may include indigenous LPs and foreign-invested entities in China that have RMB available for investment. While this structure is the best tested in terms of operations, it does not deploy offshore LP funds, and when managed by a GP who manages offshore funds too, raises more severe conflict of interest questions. Such structures may be used to build smaller-scale strategic relationships with certain local LPs and/or serve as a component to some of the other structures discussed below. In addition, many of these structures served as the first stage of the pilot fund structures discussed below.

Parallel or dual offshore/onshore structure

This structure (see Chart 2 in PDF) involves the establishment of a stand-alone pure RMB fund structure similar to that previously discussed. Separately, a traditional offshore fund structure is used to cater to offshore LPs. This offshore fund is typically managed by an entity that is affiliated with the GP of the onshore fund. The two funds, through their GPs, will have an agreement pursuant to which they will both co-invest. The co-investment arrangement varies from that of “reasonable efforts” obligations to more formal mechanics that seek to require investment participation by the offshore fund into all deals made by the onshore fund. Since the offshore fund is not allowed to invest in all targets into which the onshore fund may invest, some arrangement must be provided to cover such contingencies. Different funds have developed proprietary methods for making this arrangement. Conversely, the onshore fund may also have difficulties investing into targets into which the offshore fund invests, but lately this has become less of an issue as more onshore funds have obtained deal-by-deal approvals to invest offshore.

 

This structure has suffered criticism over the years because of the difficulties faced by some funds in delivering on co-investment promises. Certain funds known to the market allowed only the onshore fund to invest in lucrative deals without any participation by the offshore fund.

Notwithstanding such criticism, this remains a popular legal structure utilized by foreign GPs, and increasingly by local GPs that have decided to expand their offering to include offshore investors. The hot commercial issue arising from this structure is the concern of LPs about the discrepancy between which deals are available for both onshore and offshore vehicles and which are not, whether because of regulatory impediments or because the portfolio company simply chooses not to accept US dollars, and the resulting conflicts of interest. Many offshore LPs have expressed concerns that, because it is easier to make investments from the pure RMB fund given the lack of any approval process for pure onshore deals, the GP’s investment team will concentrate on making investments beyond the USD fund’s reach. Indeed, such conflicts have on occasion proved a “deal breaker” for some LPs; a major North American LP, for example, recently declined a substantial investment into the USD side of a dual fund we established purely on account of this issue. We would note that there is certain validity to this concern as the offshore LPs in a small number of dual funds have been dissatisfied with the extent to which deals have been allocated to the offshore side.

 

Despite the consternation of LPs, certain GPs have successfully managed the potential for friction. The key to conflict resolution is mutual trust: no conflict resolution mechanism will convince an LP to back a GP if the LP feels the GP would treat it badly. There have nonetheless been various attempts by GPs, whether at the instigation of their LPs or at their own initiative, to bridge the gap between the two vehicles by including terms in their fund documentation that either prevent or discourage certain conflicts from arising, or increasingly, by introducing other mitigating mechanisms.

 

At one level, the fund documentation will include wording to the effect that the two fund components will seek to invest on a preagreed basis (e.g., pro rated to their respective commitments) but that they are under no obligation to do so in the event that one (typically the USD fund) is restricted from investing. This will often be backed up by an obligation on the part of the GP to provide certain information to the LPs if the USD fund is excluded from a deal. This has been the predominant approach to date. However, for GPs that are willing to accept greater constraints, we have developed a full range of rules that they can consider — individually or in combination — to bridge the gap between the two funds. For example, the GP can agree that it will invest from the RMB fund alone only with the approval of its offshore LPs, that if the USD fund is excluded from a deal it would catch up on future deals by having more of future deals allocated to it, or that the RMB fund will not invest into restricted industries so that, at least in principle, every deal is available to all RMB and USD LPs. There are also mechanisms that, whilst not restricting the GP outright, would serve to incentivize it to treat the offshore fund fairly; for example, a prohibition on raising a successor RMB fund until the existing USD fund has reached full investment would provide some protection to the LPs in the knowledge that excessive deal allocations to the RMB fund would freeze the RMB fund out of the onshore-deal market until the USD fund is deployed. A more radical approach involves creating financial disincentives for the GP in the event that it does not treat the two funds equally — for example, by including a provision where the management fee would step down for the USD fund in the event that the RMB fund is fully invested — although GPs so far have resisted such an approach.

In any event, each mechanism should be analyzed in the light of the specific circumstances. For instance, LPs are far less likely to be concerned about conflicts if the GP raises a USD fund much larger than the RMB component, given that the GP would have nothing to gain by favoring a small subset of its LPs over the remaining majority LPs (that is, assuming they have long-term ambitions to raise future funds). By way of example, we recently acted for a sovereign wealth fund that is typically vocal on the conflicts issue, but was nonetheless comfortable investing into a particular dual structure as the GP agreed to limit the RMB fund size to less than 3% of the total amount raised for the USD fund.

Several of our GP clients are even going a step further and advocating a “one fund” concept, assuring their investors they will be treated equally irrespective of the fund they invest through. Whilst this has proved difficult in practice, we are working on a number of interesting settlement mechanisms that are further bridging the gap between onshore and offshore funds. The techniques involved are complex, and beyond the scope of this paper, but recent developments in the offshore RMB market in Hong Kong, SAFE procedures created to facilitate RMB denominated bonds (“dim sum” bonds), increased holdings of RMB by foreign-owned or controlled entities in China, and MOFCOM’s move to allow cross-border equity investments into Chinese companies to be made in RMB, are increasing the options that are available to GPs. LPs also have interesting techniques at their disposal, whereby they can agree to modify their returns to reflect the returns they would have received had they invested in all deals on a pro-rata basis irrespective of whether their money was actually used to invest in the deal.

 

Pilot foreign invested structure or QFLP

This structure (see Chart 3 in PDF) involves the use of local government approvals to allow for a channel for direct foreign investment into an otherwise pure RMB fund. The structure essentially involves the creation of a stand-alone pure RMB fund structure followed by the introduction of one or more foreign LPs. The unique aspect of this structure is that it allows the fund to convert foreign exchange contributed by foreign partners into RMB at the fund level so that RMB can be transferred to target companies. The amount of the foreign exchange convertible at the fund level is subject to a preapproved limit from SAFE at the time of establishment. At the outset, the other unique feature of this structure was that foreign LPs must invest directly into the onshore fund (not via an offshore fund) and must be independently qualified under the terms of the local pilot fund regime. However, in practice, local governments are granting a surprising amount of flexibility to the QFLPs.  Many QFLPs have been allowed to set up as 100% foreign invested format with no Chinese LPs in the fund vehicle (see Chart 4 in PDF). This allows the GP to set up an onshore parallel pure RMB fund vehicle for Chinese LPs which is not subject to any foreign-investment restrictions. In addition, some funds have obtained expedited foreign exchange conversion permission to hold RMB even before a deal is ready to be closed. This structure may replace the parallel or dual offshore/onshore structure once a track record is more fully developed provided the foreign exchange mechanics work as planned.   

 

Corporate evergreen capital structure

This structure (see Chart 5 in PDF) involves the use of a historical operating company in China that has self-generated RMB. The self-generated RMB may be freely invested into onshore targets without a cumbersome SAFE conversion process. In addition, depending on the tier of structure employed, certain corporate funds also do not have to deal with MOFCOM approval issues to make investments. However, these types of structures cannot be established overnight as they usually are a result of a long period of ordinary operations in China. Even so, they continue to gain popularity and also serve as LPs in other RMB funds in various ways. They can be used to facilitate economic sharing in certain situations. There is also scope for institutional LPs, especially those that have a presence in the PRC, to build up their own RMB pools as their investments achieve exits, assuming they can persuade their GP to pay them onshore and in local currency.

 

Locally approved foreign-invested venture capital enterprise

This structure (see Chart 6 in PDF) involves the establishment of a locally MOFCOM-approved, foreign-invested venture capital enterprise or 外商投资创业投资企业 (“FIVCIE”). These were the first vehicles to serve as de facto RMB funds for the deployment of both onshore and offshore capital. O’Melveny helped launch the original FIVCIE and has worked with many others, assisting with their deployment into onshore investments in various locations across China. Newly formed FIVCIEs, however, began to lose popularity when practices began to change in late 2009 following the issuance of SAFE Circular 142. While this structure has become overshadowed by the other structures, it is starting to regain popularity in certain situations. These include cases in which the local government wants to utilize FIVCIE rules as part of its pilot program or where the local government is endorsing the FIVCIE and willing to facilitate its operations for targets within a specific jurisdiction or jurisdictions. In addition, historical FIVCIEs can recycle or redeploy self-generated RMB in much the same way as a QFLP fund.

 

Each of these structures has its own advantages and disadvantages. Below is a summary of the key factors fund managers may want to consider when structuring an RMB fund:

 

Comparison of the basic structures

See Table 1 in PDF.

 

Top commercial points driven by regulatory conditions and onshore market practices — learn them well

The commercial terms of RMB funds (from the first FIVCIE established in 2004 to pure domestic partnership funds established since June 1, 2007, to the first foreign-invested partnership formed on March 3, 2010) vary considerably. Nonetheless, experience has shown that certain market norms have developed. In the early stages, industrial investment funds (产业投资基金) gave LPs de facto GP roles such as veto rights over investment committee decisions. Fortunately, such practices seem to have been successfully shaken off by GPs in more modern Chinese partnership funds. Another wave of market change was instigated by the numerous LP investments made by NSSF with fund agreements that contained much more traditional terms regarding the respective roles of GP and LPs. Over time, onshore fund structures have evolved significantly and some convergence between onshore and offshore terms can be observed. In particular, onshore fund legal entity structures have followed international counterparts fairly closely in regard to the use of various onshore feeder vehicles to accommodate different interests.

 

The following is a sampling of some frequently negotiated terms and related issues for RMB funds:

 

Waterfall and carried interest

In the offshore space, the debate has traditionally been between a whole-fund waterfall (the prevalent theme in Europe and Asia) and deal-by-deal carry (favored in the United States). Following the Asian model, many NSSF-invested funds have opted to use a whole-fund waterfall, and this early practice continues to influence newer funds. In many cases, though, especially where NSSF has not invested, the waterfall has become so heavily negotiated and difficult to understand — whether from a logical standpoint or simply in terms of how the returns will be distributed — that putting the waterfall into either of these two categories, let alone discerning any broader themes as to what constitutes prevailing market practice, can be a challenge. That said, an 80–20 split between the LPs and GP appears to be the current norm. A clawback at the end of a fund’s life is often provided, although the formulation of the triggering event(s) and security arrangement(s) for the clawback varies from fund to fund. Similar to offshore funds, more recent RMB funds adopt a fixed percentage annual rate of preferred return, 8 to 10% appearing to be most common. Preferred returns are generally coupled with a GP catch-up. Pure preferred returns are quite rare.

 

GP participation

Similar to offshore funds, GPs of RMB funds typically commit at least 1–3% to the fund to ensure alignment of interest with LPs. Such GP participation is typically contributed in cash as opposed to the waiver of management fees, as in some offshore funds. There are also certain issues unique to GPs of RMB funds. For example, to serve as the GP of an RMB fund, a foreign-invested GP needs to apply for a business license that permits equity investment management. In addition, most local jurisdictions require a fund manager to have a minimum registered capital. For foreign-invested managers, both Beijing and Shanghai require a minimum registered capital of USD2 million. Moreover, to qualify for investment from PRC insurance companies, GPs must have a registered capital of no less than RMB100 million and a proven track record. Finally, under the Shanghai QFLP Rules, wholly foreign-owned GPs should invest no more than 5% in an onshore fund to ensure that the fund can invest in industries restricted from foreign investment as well as invest without approvals.

 

Management fee and fee income

Management fees paid by RMB funds (especially more recent ones) are similar to those paid by offshore funds: 1–2% of capital commitments during the investment period and 1–2% of invested capital thereafter. When negotiating with a more recent fund, NSSF requested that management fees step down when a successor fund is raised; this will likely become a more heavily negotiated point for RMB funds. In addition, since foreign GPs and affiliates thereof are more likely to receive fee income directly from portfolio companies, the question of whether such fee income should be treated in whole or in part as income of the fund is likely to become the subject of intense negotiation as well, much as it has in the offshore space, although some of the more sophisticated setoff and splitting mechanisms utilized by foreign GPs have not yet made their way into the onshore space.

 

Establishment date and initial closing

In a typical offshore fund, the GP will set up a fund with minimum capital. Although the fund’s term will start from the relevant establishment date, the initial closing usually takes place at a later time. Due to regulatory requirements, the initial closing of an RMB fund has to occur simultaneously with the establishment of the fund. A letter of commitment for each LP needs to be submitted to the AIC (工商行政管理局) to establish the fund. This frequently causes tension between the GP and LPs as certain LPs may change course before the fund is established. Foreign LPs will have a hard time understanding the mechanism. In addition, in the case of a FIVCIE, investors are required by law to pay in 15% of their commitments within three months of the issuance of the business license of the FIVCIE. Such peculiar requirements will likely require more explanations when dealing with a foreign LP, and we have generally found that LPs are receptive to such explanations when they understand that these peculiarities are driven by regulatory, not commercial, factors.

 

Drawdowns

The drawdown mechanism of most RMB funds is generally in line with the offshore fund practice, i.e., most GPs make “capital calls” on an as needed basis. Due to regulatory or other reasons, the drawdown mechanism of some RMB funds deviates from this practice. For example, in an FIVCIE, regardless of the investment period, all commitments have to be paid in within five years from the establishment of the FIVCIE. In RMB funds that have SOEs as LPs, such SOE LPs often request that all of the commitments be contributed upfront or through a fixed installment arrangement (e.g., four installments within two years). The reason behind such a request is that, due to local practice in state-owned assets management, SOEs have to obtain an approval before they can deploy funds. The approval is usually a lengthy and time-consuming process. As a result, SOE LPs prefer to get the required approval upfront instead of going back to the government authority each time a capital call is issued. Such a mechanism, however, may not be feasible if the other LPs in the fund object. Some GPs have also sought upfront deployment when their LP base has significant high-net-worth involvement or there is a significant risk of potential LP defaults.

 

Co-investment rules

The co-investment arrangements in the RMB fund market vary considerably. In an FIVCIE, LPs are rarely offered any co-investment opportunity; the GP generally reserves the right to allocate opportunities to other funds managed by it under certain conditions. In a pure RMB fund within a parallel structure, the co-investment provisions are generally in line with the offshore fund market norm. In a pure RMB fund of a relatively small size or a pure RMB fund managed by a Chinese GP, the fund agreement is often silent on co-investment. In a pure RMB fund with institutional LPs or an RMB fund managed by a foreign-brand GP, fund agreements often provide for co-investment rights, but the provisions tend to be less detailed than in the offshore arena and give the GP broad discretion.

 

Conflicts of interest

Most FIVCIEs and pure RMB funds managed by foreign GPs apply conflict of interest rules similar to those adopted for their offshore funds; for pure RMB funds managed by Chinese GPs, the conflicts of interest provisions are relatively general and simple. This is partially due to the restrictions under the PRC Partnership Law, which prohibit a GP from engaging in business that competes with the fund by itself or together with others. Since such a provision is, in practice, quite broad,  a sizable number of RMB funds have asked LPs to acknowledge and agree that certain activities (e.g., investment by the GP’s other existing funds, etc.) do not constitute competing business of the RMB fund; the enforceability of this arrangement has not been tested. For an RMB fund within a parallel fund structure, there are special conflicts of interest concerns as discussed in the earlier section of this paper. As in offshore funds, an investor advisory committee serves to clear conflicts in RMB funds.

 

Investment scope

Unlike offshore funds whose investment scope is mainly driven by commercial reasons, the investment scope of some RMB funds is driven by regulatory requirements and local policy reasons. For example, FIVCIEs are required by relevant regulations to primarily invest in high-tech industries; some RMB funds may have to focus on investment in certain industries or invest certain amounts in the area where the fund is located in order to enjoy certain tax benefits or subsidies. This is more often seen when a local guidance fund is a major LP in the relevant RMB fund.

 

Key persons/suspension of investment period

In an offshore fund, LPs typically require that key persons devote a certain amount of time to the fund and key person events trigger suspension or termination of the fund’s investment period. In the RMB fund market, this has been a less focused area and so far the fund agreements seem to be more GP friendly. For example, most FIVCIEs have no key person event provisions and some have chosen to simply agree in a side letter that a key person will devote a certain amount of time to the FIVCIE without adverse consequences in the event of a breach. In addition, most FIVCIEs do not allow LPs to terminate the investment period without cause. That said, we have seen some partnership funds (especially those managed by foreign-brand GPs) adopt key person event provisions typically seen in offshore funds.

 

GP removal

Most FIVCIEs do not allow LPs to remove the GP with or without cause. In pure RMB funds, the practice varies from fund to fund and no market norms have developed. Some funds permit LPs to remove GPs for cause but only with a high voting threshold (in some cases, 100% consent). Few funds provide that LPs may remove GP without cause.

 

Reinvestment

In offshore funds, reinvestment of certain proceeds representing capital recovered during the investment period (such as one year) is often permitted. Practice in the RMB fund market varies in this area. RMB funds managed by foreign-brand GPs tend to allow reinvestment. Among such funds, some fund agreements contain mechanisms and/or restrictions similar to those found in an offshore fund agreement; other agreements include only general provisions without specifying any mechanism. In practice, if foreign exchange issues are involved (e.g., in a FIVCIE structure or a foreign-invested partnership structure), recalling distributions for reinvestment may not be practical. Some agreements provide that funds can retain proceeds for reinvestment as an alternative.

Investor advisory committee

As in the case of offshore funds, RMB funds often have an investor advisory committee; although in some RMB funds the functions and powers of that committee are not defined in detail or are more limited. Unlike offshore funds, where members of the advisory committee are typically appointed by GPs, some RMB funds leave the decision to the LPs or provide in the agreement that the seat will be granted based solely on the size of an LP’s commitment. Such arrangements may impact the composition of an advisory committee. Although the size of an LP’s commitment is a factor often considered by an offshore GP, it is rarely the determining factor. An advisory committee representing different LP classes will likely be more efficient and effective.

As discussed above, key commercial terms of the RMB fund market are still developing. Numerous factors can affect the key economic terms of a particular fund, including the fund structure, its location, the nature of the GP, its LP base, and the fund counsel. However, as more and more international investors participate in RMB funds while domestic LPs become more sophisticated, we can expect more convergence of the terms for RMB funds and offshore funds in the near future. Fund lawyers who are knowledgeable in both onshore and offshore funds will play a crucial role in bridging the gaps between GPs and LPs. Indeed, in addition to our work for GPs, we are acting for a number of Chinese LPs for their fund investments.

 

So you want to fund raise?  Be practical (again)

Most of the attention provided to date in the RMB funds area has focused on fund sponsors. But what about the LPs investing in these funds and their corresponding rise as a disciplined investor base? Which limited partners apart from NSSF are or will soon be preeminent? How do the make-up and experience of these investors affect fund-raising for GPs? Is it true that “onshore LPs want to act as their own GPs?”

Although the Chinese LP base has become more diversified (to include pension funds, insurance companies, state-owned enterprises, government guidance funds, private companies, high-net-worth feeder funds, etc.), the number of Chinese institutional LPs is still relatively small. In addition, many LPs either lack experience with investing in traditional private equity funds or are not yet comfortable with traditional terms used for such blind pool investments where managers are given substantial discretion. Moreover, Chinese LPs are subject to entity-specific regulatory requirements that make it more difficult to have different LP groups in the same fund.10 Funds often end up closing on initial anchor LPs without further fund-raises. As a result, fund-raising in China has proved complicated despite the vast amounts of capital coming online. Below is a brief summary of recent developments concerning Chinese LPs:

 

NSSF

NSSF has invested in numerous onshore RMB funds. These include Tianjin CDH Fund I, Tianjin Hony Industrial Investment Fund I, CITIC Mianyang PE Fund, Harmony Growth Fund, and others. NSSF is known for its extensive due diligence process through which it assesses potential GPs. Previously, garnering NSSF investment was closed to a small circle of GPs due to NDRC recordal procedures. As of October 2010, only 22 private equity managers successfully completed recordal procedures with the NDRC and this served a prerequisite to allow an NSSF investment in a fund to move forward. This will soon change with the issuance of the new NDRC circular discussed above, which alleviates such recordals. Pursuant to the NDRC new circular, any equity investment fund established in one of the pilot areas with total commitments of RMB500 million is required to be recorded with the NDRC. This new recordal guidance is expected to change the fund-raising procedure for funds seeking LP commitments from NSSF. On the one hand, this will open the door to other funds whose GPs could not record with the NDRC previously. On the other hand, since NDRC recordal will take place only after a fund has closed with at least RMB500 million, a GP will likely have to build a larger base of LPs before closing on any NSSF money.

 

Government guidance funds

Government guidance funds (政府引导基金) are government-funded fund-of-funds. They are typically sponsored by local governments and state-owned enterprises to promote the development of venture capital or private equity investments in specific municipalities or provinces. To date, about 40 cities/districts/provinces in China have set up their own guidance funds, and new ones are regularly being announced. Some guidance funds have lofty fund-raising targets of as much as RMB10 billion (equivalent to US$1.5 billion) while others may be as small as RMB100 million (equivalent to US$15 million). Many of these fund-of-funds have a single LP.

Making headlines of late is the Suzhou Industrial Park guidance fund in Jiangsu province. Suzhou Industrial Park previously established a guidance fund in 2007 with RMB1 billion and is known to have supported a dozen portfolio funds with such capital. The deployment of the early Suzhou Industrial Park guidance fund, and the reportedly clear evaluation process of the managers of such guidance fund, has helped Suzhou Industrial Park become a gathering place for venture capital organizations. In September 2010, Suzhou Industrial Park announced that it will be the location for an RMB60 billion fund-of-funds focusing on both private equity and venture capital. This fund is reported to be managed by Suzhou Industrial Park and CDB Capital. In addition, NSSF, China Life (a major Chinese insurer) and the Chinese Development Bank are reported to be among the investors of this guidance fund. Many consider this new fund-of-funds to be China’s first true national fund-of-funds and cite its launch as evidence of a new trend in the market regarding the scope of downstream fund investments.

 

High-net-worth individuals

More intermediaries are now available to successfully raise significant amounts from Chinese high-net-worth individuals. These intermediaries include privately owned wealth management companies and private banking departments of large banking institutions. Some even establish “feeder” vehicles through which high-net-worth individual LPs may invest and address partial GP functions with respect to that feeder. We have seen a rising number of GPs (including well-known international brands) complete their fund-raising at remarkable speed with the help of such placement agents.

 

Insurance companies

As of August 31, 2010, the CIRC (中国保险监督管理委员会) published regulations that allow Chinese insurance companies to make private equity investments in funds managed by third parties. Based on conservative market estimates, approximately RMB200 billion (equivalent to US$29.8 billion) will be available for private equity investments (including through private equity funds). Unlike the previous CIRC pilot programs, which permitted insurance companies to make direct investments only into certain industries, there is, with few exceptions, little industry restriction on the portfolio companies of the private equity funds in which such insurance companies have invested. However, we would note that some first-time GPs may be excluded from the investment pool of insurance companies because insurance companies can invest only in funds set up by fund sponsors that have met relatively rigid standards. For example, the sponsors must have a minimum registered capital of RMB100 million, have a team of at least ten investment professionals with certain track records of experience, have assets under management of at least RMB3 billion, have established risk reserves, and have completed at least three exits. In addition, insurance companies may not invest in more than 20% of a given fund.  China Life was the first insurance company to become an LP of an authentic RMB fund earlier this year.

 

PPM disclosure

In late March 2011, the NDRC published on its website a series of standard forms and guidance on the preparation of various documents for recordal by certain RMB funds pursuant to its recent circular,11 including guidance on the PPM (资本招募说明书) of equity investment enterprises. This is the first published nationwide guidance regarding the preparation of a PPM, eliminating the long absence of standards for fund-raising and marketing materials in China. This guidance sets forth a list of must-haves, such as the format and content of the cover page and items to be included in the main body, including:

•    basic information concerning an RMB fund;

•    the maximum number of LPs in an RMB fund (which varies depending on the fund structure);

•    commitment requirements for LPs;

•    governance and management of the fund;

•    fund investment (including investment areas, strategies, restrictions, investment process and exit, among others);

•    fund assets;

•    fund expenses and profit distribution;

•    tax;

•    termination and liquidation;

•    risk factors;

•    reporting and disclosure requirements; and

•    any other information that is not explicitly provided under the guidance but would be material to the investment decisions of investors.

As a best practice, fund sponsors should refer to this guidance when preparing their marketing materials regardless of whether a particular fund is required to record with the NDRC.

 

How to reach the onshore exit

Current market information suggests that both onshore IPOs and onshore trade sales continue to gain momentum. The following chart shows the breakdown of capital market exits preferred by VC/PE firms participating in a recent survey by the CVCA (中华股权投资协会). (See pie charts on page 19 of the PDF.)

 

At present, there are two main stock markets in China (i.e., Shanghai Stock Exchange and Shenzhen Stock Exchange), which are divided into the Main Board, Small and Medium Sized Enterprises Board, and ChiNext. A portfolio owned by an RMB fund, whether foreign invested or not, may list on each of these exchanges following proper approval procedures.

 

In general, the listing of a “foreign-invested” portfolio is more difficult than listing a purely domestically invested portfolio. This is mainly because of the three-year requirement of continuous profits for the listing vehicle to convert from a foreign-invested joint venture into a company limited by shares and the prolonged associated MOFCOM approval mechanics of same. However, there is more evidence now to support a significant amount of onshore public market exits by companies that have RMB funds (pure and foreign invested) as their investor base. We count roughly 10% of Chinese IPOs in 2009 and 2010 had foreign PE/VC investment and of course a much greater percentage had local PE/VC investment.

 

In addition, the runup to the CSRC clearance process for IPO of private equity fund–backed companies has not always been consistent. Take Xinjiang Western (西部牧业), a VC-backed company successfully listed on ChiNext in August 2010 (Code 300106). Xinjiang Western not only had private equity fund investors but also a FIVCIE investor, which remained one of its investors during and after the listing process. Instead of requiring a conversion of Xinjiang Western into a foreign-invested company, limited by shares and subject to central MOFCOM approval, a domestic procedure was sanctioned. In other words, the company was treated the same as a domestically invested portfolio. This is in sharp contrast to Hiconics (合康变频), another FIVCIE-backed company, which successfully listed on ChiNext in January 2010 (Code 300048). In the runup to that IPO, the listing vehicle was forced into a centrally MOFCOM-approved conversion process for a foreign-invested company limited by shares.

 

Similar sensitivities around structuring the onshore IPO are present for purely domestic private equity funds given the discretionary nature of what is often a difficult process. Some examples include the restructuring of the target company into a company limited by shares well in advance of the listing process. For example, Anhui Shengyun (盛运股份) converted into such status in June 2004, and not until 2008–2009 did it obtain substantial pre-IPO financing from four onshore RMB funds, which collectively took close to a 40% stake in the company. Anhui Shengyun was successfully listed on ChiNext in June 2010 (Code 300090).

 

That is not to say that offshore private equity funds are not also managing to participate in these lucrative onshore public exits on a cross-border basis. Offshore private equity funds have begun to invest directly into onshore target companies without the use of Cayman Islands holding companies given the current ban on red-chip (红筹) restructurings. Similar techniques are used by these offshore private equity funds for these onshore deals in respect of causing the conversion of the target company into a company limited by shares early in the process to control risks related to central MOFCOM approval. For example, Sunsea Telecom (日海通讯) arranged for its conversion in May 2007 well after offshore private equity financing in and well before the successful main board listing took place on the Shenzhen Exchange (Code 002313). Interestingly, some offshore funds have also been involved in deals where the founders hold the target company shares, which are held by founders from offshore as well. For example, Zhanjiang Guolian (国联水产), a company backed with offshore financial investors that listed on ChiNext in June 2010 (Code 300094), obtained clearance for such a unique structure. In that deal the conversion of the target company took place in April 2008 and included a significant ownership stake by a Hong Kong holding company controlled by the founder. That deal was allowed as a proper SAFE-registered round-trip investment (返程投资) into the target company.

 

Suffice to say the onshore capital market exit can be complex and various sensitivities arise with founders in regard to ensuring a fund investor does not add complexity to the listing process. These concerns are heightened when a foreign-invested RMB fund is involved and this places a premium on structuring the RMB fund in a way to ensure the exit can proceed efficiently.

 

Tax structuring

Typically, an RMB fund will be structured as a partnership enterprise for PRC tax purposes. According to the circular of the Ministry of Finance and the State Administration of Taxation regarding the Issues of Income Tax of Partners of Partnerships, or Circular 159, this form of entity adopts a special system of taxation termed in Chinese as “first allocate, then tax” (现分后税). In addition, the PRC Enterprise Income Tax Law carves out partnership enterprises from the scope of the enterprise income tax. In practice, this treatment is similar but not identical to the pass-through treatment known in other jurisdictions. The fund is not subject to Chinese tax on its income and instead the owners of interests in the fund include, in computing their taxable income, their share of the income of the fund. While this avoids the problem of double taxation for individual fund investors (whether LPs or GPs), many issues are still not addressed in the current guidance and much is left to the administrative practice of tax authorities in charge of the RMB fund. In particular, no guidance exists with respect to partnership tax accounting. As a result, additional structuring is required to avoid pitfalls and odd results. For example, each partner’s tax basis in the RMB fund is not automatically adjusted upward or downward to reflect a share of gains or losses of the fund. Without additional structuring, a secondary transfer of fund interests by an LP or a GP can trigger double tax in China. Similarly, losses of a fund are not attributed to investors for tax purposes and additional structuring would be required to monetize the value of certain tax losses.

 

Foreign LPs in an RMB fund face other tax issues. These include obtaining clearance that the LP does not constitute a permanent establishment in China and local agreement as to the amount and timing of withholding taxes imposed with respect to distributions made to foreign LPs.

 

GPs also have a separate set of issues to protect their carry from taxation. These include the structuring of carry to avoid the Chinese business tax (营业税) and getting clearance as to the proper character of carry as being taxed at lower rates for capital gains. More advanced structuring for GPs includes various deferral techniques and certain types of financial subsidies, which can be obtained in certain preferred jurisdictions.

 

Conclusion

For international private equity fund sponsors and LPs, the landscape we have described above is intricate and, at times, perplexing. Sponsors committed to long-term expansion in China will need to make many difficult choices, and the best decisions will depend on a combination of factors and will change over time as the Chinese regulatory regime evolves. LPs will need to decide where they stand in terms of giving their GPs flexibility to make greater inroads into China, which may place pressure on full alignment of interests. LPs will also need to consider how they may be more involved in the various opportunities and developments for RMB funds. The trend is quite clear that GPs will need to strive for preserving the maximum optionality in raising funds, making investments, and achieving exits. This will usually mean establishing both offshore and onshore vehicles and learning how to structure deals in a manner adapted to the peculiarities of Chinese law. As control over RMB conversion is further liberalized, yet another evolution of RMB fund structures will emerge, and the experience gained during the current stage likely will be essential, if not a prerequisite, to effective participation.

Endnotes:

1.    Notice of General Office of National Development and Reform Commission regarding Further Regulation on Development and Recordal Administration of Equity Investment Enterprises in Pilot Areas (《国家发展改革委办公厅关于进一步规范试点地区股权投资企业发展和备案管理工作的通知》) issued on January 31, 2011.

2.    Source: http://www.carlyle.com/Media%20Room/News%20Archive/2010/item11054.html.

3.   These Tianjin regulations include, among others, (i) Opinions Regarding Industrial and Commercial Registration of Private Equity Investment Funds and Private Equity Investment Fund Management Companies (Enterprises) (关于私募股权投资基金、私募股权投资基金管理公司(企业)进行工商登记的意见) issued by Tianjin Administration for Industry and Commerce on November 16, 2007; (ii) Provisional Measures for the Administration of Registration and Filing by Equity Investment Funds and Equity Investment Fund Management Companies (Enterprises) in Tianjin (天津股权投资基金和股权投资基金管理公司(企业)登记备案管理试行办法) issued by the Tianjin Municipal Development and Reform Commission, Tianjin Municipal Financial Service Office, Tianjin Municipal Administration for Industry and Commerce, Tianjin Municipal Commission of Commerce, Tianjin Municipal Finance Bureau, and Tianjin Municipal Local Taxation Bureau on November 5, 2008; and (iii) Measures on Facilitating the Development of Equity Investment Fund Industry of Tianjin (天津市促进股权投资基金业发展办法) issued by the same six departments set forth in  item (ii) above on October 16, 2009.

4.   Notice on Industrial and Commercial Registration and other Matters by Equity Investment Enterprises in Shanghai (关于本市股权投资企业工商登记等事项的通知) issued by Shanghai Financial Services Office, Shanghai Administration for Industry and Commerce, Shanghai State Tax Bureau and Shanghai Local Tax Bureau on August 11, 2008.

5.   These regulations include, among others: (i) Trial Measures of Shanghai Pudong New Area on the Establishment of Foreign-invested Equity Investment Management Enterprises (上海市浦东新区设立外商投资股权投资管理企业试行办法) issued by the People’s Government of Pudong New Area on June 2, 2009; (ii)  Implementing Measures of Shanghai Pudong New Area on Promoting the Development of Equity Investment Enterprises and Equity Investment Management Enterprises (浦东新区促进股权投资企业和股权投资管理企业发展的实施办法) issued by the People’s Government of Pudong New Area on June 2, 2009; and (iii)  Implementation Measures on Pilot Program of Foreign-invested Equity Investment Enterprises in Shanghai
(关于本市开展外商投资股权投资企业试点工作的实施办法) issued by Shanghai Financial Services Office, Shanghai Commission of Commerce and Shanghai Administration for Industry and Commerce on December 24, 2010.

6.   The Beijing circulars include (i) Opinions on Facilitating the Development of the Equity Investment Fund Industry (关于促进股权投资基金业发展的意见) issued by Beijing Municipal General Office of Leading Group for Financial Service, Beijing Finance Bureau, Beijing State Taxation Bureau, Beijing Local Taxation Bureau and Beijing Administration for Industry and Commerce on January 19, 2009 and (ii) Provisional Measures on Establishment of Foreign-invested Equity Investment Fund Management Enterprises in Beijing (在京设立外商投资股权投资基金管理企业暂行办法) issued on January 1, 2010 by Beijing Finance Bureau, Beijing Commission of Commerce, Beijing Administration for Industry and Commerce, and Beijing Municipal Commission of Development and Reform.

7.   Notice of the General Affairs Department of the State Administration of Foreign Exchange on Relevant Operating Issues concerning the Improvement of the Administration of Payment and Settlement of Foreign Exchange Capital of Foreign-invested Enterprises (国家外汇管理局综合司关于完善外商投资企业外汇资本金支付结汇管理有关业务操作问题的通知) (No. 142 [2008]) issued by SAFE on August 29, 2008, which prohibits the conversion of foreign exchange capital for equity investment by FIEs.

8.   《关于本市开展外商投资股权投资企业试点工作的实施办法》 issued by Shanghai Financial Services Office, Shanghai Commission of Commerce and Shanghai Administration for Industry and Commerce.

9.   See http://www.omm.com/circ-grants-insurance-companies-full-authority-to-make-alternative-investments-next-wave-of-institutional-limited-partners-for-rmb-funds-is-unleashed-08-19-2010/

10.  For example, NSSF is known to require that its portfolio funds be registered with the NDRC, while insurance companies do not have such requirement but can only invest in funds sponsored by having a minimum registered capital of RMB100 million.  In addition, insurance companies are prohibited from venture capital investment, while NSSF is not subject to such explicit restrictions.

11.   See footnote 1.

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This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. O'Melveny professionals contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

O'Melveny & Myers LLP is a foreign law firm registered with the Ministry of Justice of the People's Republic of China. Under current Chinese regulations, we are allowed to provide information concerning the effects of the Chinese legal environment, but we are not authorized to practice Chinese law or to render legal opinions in respect of Chinese law. We work in cooperation with a number of Chinese law firms. Should you require a legal opinion in respect of any Chinese law matter, we would be happy to assist you in obtaining one from a Chinese firm.