A New Era for Private Funds in China?
Several years ago, alternative asset managers were enthusiastically regarding China as a new frontier for fundraising. Indeed, in 2011, Chinese private equity and venture capital firms raised substantially more money from local renminbi investors than from foreign investors1. This was in part based on the premise that investment firms could access deals that were hitherto unavailable to them – for example, by sidestepping industry investment restrictions applicable to foreign capital. However, there was also a sense that raising money in mainland China – often from newly minted high net worth individuals and cash rich state-owned enterprises – was easier than raising capital in what was at the time a rather moribund fundraising market elsewhere. For these and other reasons, raising renminbi-denominated funds (commonly known as RMB Funds), traditionally the preserve of very local investment firms, was briefly at the forefront of the China strategy of a whole host of private equity firms, with global heavyweights such as Carlyle, Blackstone Group, KKR and TPG all launching renminbi-denominated products.
Since this 2011 peak, there has been a steady decline in the amounts raised for RMB Funds, whereas international fundraisings focused on China have remained relatively constant. A backdrop to this has been a large amount of uncertainty regarding the regulation of the private funds industry in China. Underpinning this uncertainty has been an interesting battle for supremacy over the regulation of the PE/VC industry by two important regulatory bodies in China – the China Securities Regulatory Commission (CSRC, the body that is principally responsible for supervising the securities industry in China) and the National Development and Reform Commission (NDRC, which is principally involved in formulating and implementing policies for economic and social development in China).
This battle appears to have been decisively determined, resulting in a number of legal developments during the course of this calendar year. However, it is perhaps helpful to outline in brief the historical backdrop to such recent legal developments.
A Brief History Lesson
On 28 October 2003, the PRC Securities Investment Funds Law (2004 PRC Fund Law) was promulgated, effective as of 1 June 2004. However, the 2004 PRC Fund Law regulated only publicly-offered funds, leaving private funds in regulatory limbo. Nine years later, on 8 December 2012, new amendments were finally adopted to the 2004 PRC Fund Law (Amended Fund Law, effective as of 1 June 2013), and this time private funds were brought into the regulatory regime thereunder. Unfortunately, the Amended Fund Law was designed in such a way that private equity funds and venture capital funds were excluded from its scope of application, perhaps for the reason described below.
Historically, NDRC took charge of supervising the PE/VC industry in China. In 2005, the Administrative Policy for Venture Capital Investment Enterprise was promulgated by several ministries of China (including NDRC itself), requiring funds targeting start-up companies to be registered with the NDRC. Later, as the industry developed to encompass later-stage investments, NDRC attempted in 2009 to extend its regulatory power to any RMB Funds investing in non-listed equities of Chinese companies (commonly known as PE funds). Such attempt, however, encountered strong resistance from CSRC and failed.
Subsequently, CSRC actively pushed for amendments to the 2004 PRC Fund Law, trying to expand its scope to include private funds – in particular, PE/VC funds. However, the proposed amendments regarding PE/VC funds failed to pass, and NDRC issued two successive notices in 2011, requiring PE funds set up in China to be registered with NDRC. But the battle was far from over. Instead, it resulted in what was perhaps the most brazen exhibition of this conflict between CSRC and NDRC – in the form of a notice released by CSRC on February 18, 2013, permitting PE firms to invest in public securities or operate public funds, followed shortly thereafter by NDRC issuing a notice on March 25, 2013, explicitly prohibiting PE firms from such activities.
Ultimately, the State Commission Office for Public Sector Reform (SCOPSR, the main coordinator for public sector reform, led by the PRC State Council and Communist Party) decided to step in. A notice on Division of Duties in Private Equity Fund Administration was issued thereby on June 27, 2013. By this notice, NDRC was empowered to compile policies for the development of the PE/VC industry, but its regulatory power over the same was transferred to CSRC, which then delegated such power to Asset Management Association of China (AMAC, a self-regulatory organization for funds in China).
The New Regulatory Framework
On 17 January 2014, AMAC issued the Measures for the Registration of Private Investment Fund Managers and Filing of Private Investment Funds (for Trial Implementation), taking effect on 7 February 2014 (AMAC Measures). A little over six months later, on 21 August 2014, CSRC released its Interim Measures for Supervision and Administration of Private Investment Funds (CSRC Interim Measures). The AMAC Measures and the CSRC Interim Measures are intended to implement and supplement the Amended Fund Law, which only provided certain general principles with respect to the regulation of private funds, such as registration of fund managers and filing of the private funds with AMAC. The AMAC Measures and the CSRC Interim Measures constitute, together with the Amended Fund Law, the new regulatory framework for private funds in China.
As mentioned above, the Amended Fund Law focuses on PRC domestic private funds investing in publicly traded securities in China, and does not provide for specific rules regulating private equity funds and venture capital funds. As a notable improvement, however, the AMAC Measures and the CSRC Interim Measures expanded the scope of private funds under the Amended Fund Law to include any investment funds raised in the PRC through a non-public offering or a private placement.2 Accordingly, all private funds are now under the scrutiny of CSRC and AMAC.
It is clear that a great deal of thought has gone into the new rules, which are described below, taking on board approaches similar to those in more developed jurisdictions, including the United States. In brief, the focus is on regulating the fund manager rather than the fund itself, although there are a number of notification requirements relating to the fund that need to be made subsequent to the completion of the raising of funds.
The Qualified Investors and the “Look-Through” Rule
Private funds in China should be raised only from qualified investors. Each individual investor is required to invest at least RMB1 million (equivalent to approximately USD160,000)3 in a private fund. To be a qualified investor, the individuals or entities should have the capability to identify and undertake investment risks, and must meet the following net worth or income requirements:
- If the investor is a legal entity, it should have net assets of at least RMB10 million (equivalent to approximately USD1.63 million).
- If the investor is an individual, he or she should hold at least RMB3 million (equivalent to approximately USD0.5 million) in financial assets, or have a personal average annual income of no less than RMB500,000 (equivalent to approximately USD81,000) for the last three years.
In addition, the new regulatory framework imposes a limit on the number of qualified investors in a private fund, as set forth below:
- If the private fund is set up in the form of a limited liability company or limited partnership, the number of investors may not exceed 50.
- In the case of a joint stock limited company or general partnership, the number of investors must be in excess of two but less than 200.
For non-corporate entities such as a limited partnership, the private fund manager or placement agent must look through to the ultimate owners of these entities to confirm that they are qualified investors. All of these ultimate owners need to be counted to determine whether limits on the number of investors have been reached.
Investors falling into the following categories will be deemed as qualified investors: (i) social security funds, pension funds and social charitable funds; (ii) investment plans registered with AMAC; (iii) private fund managers and their employees who invest in private funds under their own management; and (iv) any other investors specified by CSRC. Investors in the (i), (ii) and (iv) categories will not be subject to a “look-through”.
As the look-through rule applies only to non-corporate entities, some commentators have suggested that ineligible investors would still be able to invest in private funds by forming a company. For example, a limited liability company may have up to 50 shareholders and each shareholder only needs to contribute RMB0.4 million (equivalent to approximately USD65,000) in order to satisfy the required net worth of RMB10 million (equivalent to approximately USD1.63 million). However, this approach would require further analysis, as a company established solely for the purpose of investing in a fund may in itself be treated as a fund by the regulators, and thus its shareholders would be subject to the net worth requirements described above.
Restrictions on Private Fund Raising
A private fund manager and any placement agent are not allowed to market private funds through public media such as newspapers, radio, television and the internet, or promote private funds to non-specific prospective investors via lectures, seminars, flyers, text messages and emails. Nor can they give investors a no-principal-loss or minimum return guarantee.
Fund managers must rate (or appoint a third party to rate) the risks of their private funds. Interests in the private funds may be sold only to investors whose ability to identify and undertake risks are aligned with the risk rating of the funds. To achieve this end, private fund managers and placement agents need to use questionnaires or other available means to assess and evaluate the risk profiles of prospective investors.
Registration and Filing Requirements
Private Fund Managers
Managers of all domestic PRC private funds, including PE/VC funds, are required to register with AMAC and apply for AMAC membership through an online system. If they have not been registered, fund managers would not be allowed to engage in any business related to the management of private funds. The penalties for failure to comply are severe, involving confiscation of any revenues acquired in the course of such fund management business activities, as well as a fine of up to five times the illegal revenue.
When registering, fund managers are required to submit the following information: (i) industrial and commercial registration information and business license; (ii) articles of association or partnership agreement; (iii) list of major shareholders or partners; (iv) basic information as to the fund manager’s senior executives; (v) basic information as to the team members; and (vi) basic information regarding the funds under management. Fund managers are required to disclose details of their compliance and credibility over the past three years, including whether they received any criminal or administrative sanctions. Fund managers also must fully disclose any legal proceedings in which they were involved during the past three years. In addition, fund managers need to furnish an undertaking to AMAC, affirming that the documents and information provided by them are true, accurate and complete.
AMAC will not conduct a substantive review of a fund manager’s registration application, although AMAC may interview the senior executives of the fund manager or carry out on-site inspections. AMAC must conclude the registration procedures within 20 business days following receipt of the complete registration documents, as well as make a public announcement on AMAC’s website regarding the private fund managers and their basic information. This deadline is subject to further extensions if managers submit incomplete or non-compliant documents. AMAC will be able to deregister a manager if the latter is dissolved, terminated or declared bankrupt.
Within 20 business days following completion of a private fund raising, the fund manager must file the private fund with AMAC through its online system. The filing of the fund is conditioned upon two premises. First, only fund managers who have completed the registration procedures can proceed to file a fund with AMAC. Second, the only private funds that may be filed with AMAC are funds that are actually managed by the fund manager.
When filing a fund with AMAC, the fund manager needs to specify the type of the fund, its management mode and its scope of investments. The fund manager is also required to disclose basic information in relation to the fund, such as its size and its date and jurisdiction of incorporation. Fund-related documents, including the fund contract or partnership agreement or articles of association, must be provided as well.
After receiving the complete filing documents, AMAC must conclude the filing procedures within 20 business days and make a public announcement of the fund on AMAC’s website. Information disclosed on the website includes the fund’s name, date of incorporation, date of filing, investment objective, fund manager and custodian.
Fund managers who fail to file the details within 20 business days after the completion of a fund raising may face a fine of up to RMB300,000 (equivalent to approximately USD48,900). Fund managers providing false materials and information, or concealing materials facts, will be exposed to penalties, including suspension of the fund’s filing and disqualification of its AMAC membership. AMAC may also publicly censure the key executives and the employees of the fund managers or revoke their certificate of practice for violation of the relevant rules and laws.
Continuous Reporting of Fund Information
The new regulatory framework requires on-going and regular reports and updates on the information of both the fund managers and the private funds. However, different types of funds are subject to different reporting requirements. Private funds investing in publicly traded securities are subject to a monthly report of the relevant information, including, but not limited to: size; net asset value per unit; and number of investors. Private equity funds, on the other hand, are subject to quarterly updates. Fund managers are required to report, on an annual basis, information regarding the fund managers, their shareholders or partners, senior executives and other employees. An audited annual financial report must also be provided by the fund managers.
Implementation of the New Regulatory Framework
Based on data published by AMAC, as of 7 February 2015, 7,358 fund managers with an aggregate AUM of RMB2.38 trillion (equivalent to USD390.2 billion) and 9,156 private funds (including 2,562 new private funds formed after their fund managers’ registration with AMAC) have been registered. To give an interesting sense for the scale of the industry, and therefore the challenges of implementing regulatory oversight, as at 1 February 2015 there were only 1,612 registered investment advisers in the United States (and this number includes advisers to funds other than private funds, such as mutual funds).
Five fund managers have been disciplined by AMAC, among which, one was deregistered and the other four received public censure and were added to the “blacklist” published on AMAC’s websites. In addition, six key executives of fund managers received public censure and/or were added to the “blacklist”. Once added to the “blacklist”, such fund managers would be prohibited from conducting any investment management business and such key executives would be prohibited from working in any fund managers registered with AMAC. The main causes for such actions have included (i) failure to provide true, accurate and complete information, (ii) failure to report material events, (iii) non-cooperation in the investigation procedures, and (iv) fraud. In addition, five fund managers have voluntarily applied for deregistration on the basis that they would not continue to conduct the business of investment management.
AMAC continues to take measures to improve the registration and filing process, including simplification of the online registration and filing system, categorization of private fund managers based on their AUM and types of funds under management, etc.
Our discussion with clients and other well-known Chinese private fund managers is that they have generally been comfortable dealing with the registration and filing process.
The AMAC Measures recently “celebrated” their first anniversary, and it is encouraging to note just how efficient and successful the registration process has been in terms of the number of fund managers and funds being registered. Clearly, a process which does not involve a substantive review by the regulator is considerably more efficient than registration processes in other jurisdictions which require substantial regulatory input and approvals. That said, given the sheer mass of fund managers and funds in existence, an approach akin to (but more streamlined than) investment adviser registration in the United States (where there is an approximately 45 day process) as opposed to the three month plus processes in Hong Kong and Singapore, is clearly the most appropriate approach for the Chinese market. Indeed, less than 6 months since being decisively granted the regulatory power over the industry, AMAC has already started disciplining fund managers, indicating that the new framework has enabled it to exercise some genuine oversight over the newly regulated industry. This clearly marks an important step in the professionalizing of the industry. As to whether these changes will bring about a return of investor confidence in RMB funds, it is clearly too early to comment, but time will tell.
An interesting side point is whether this increased regulatory oversight will eventually be extended into other areas that could be of interest to international fund managers. For example, it is not inconceivable that the CSRC might seek to create similar rules for offshore fund managers who are either raising capital from international investors for investment into China or from Chinese investors for investment outside of China.
1) USD 31.8 billion was raised for RMB funds whereas USD 21.8 billion was raised for US dollar funds, according to a short report published by China Money Network on 14 March 2014.
2) AMAC lists a variety of types of funds that the new rules cover. Specifically, they describe “funds investing in publicly traded securities” as including hedge funds, multi-asset funds, securitized asset funds and fund of funds, and “private equity funds” as including growth funds, real estate funds, infrastructure funds and mezzanine funds.
3) An exchange rate of USD 1/RMB 6.1 is used in this article to convert RMB into USD, as published by the China Foreign Exchange Trade System's website on 12 September 2014.