Client Alert: Be Ready for RMB Funds Although international sponsors and PE houses will still invest in Chinese portfolios through offshore structures, the future of private equity in China is onshore renminbi funds. by Jonathan Reardon and Stephen Ye, Shanghai, December 2009 structures: the good old days China's venture capital (VC) and private equity (PE) industry has developed rapidly and improved steadily in recent years. Historically global PE investors invested in Chinese portfolios through offshore structures. There have typically been two possible types of investment routes. Direct Investments from The first route is buying equities in domestic Chinese portfolios directly through overseas fund vehicles (Direct Investment). As illustrated in Chart I (A), foreign PE houses and fund sponsors may set up China/Asia-orientated investment fund vehicles (typically, in the form of a limited partnership) in overseas jurisdictions ( Funds). These Funds may invest in each Chinese target through various offshore single purpose investment vehicles (Investment SPVs) and subsequently convert those domestic targets into joint ventures (JVs) or other forms of foreign invested enterprises (FIEs) under Chinese law. Significant shortcomings of the Direct Investment structure include:- each direct investment requires onerous government approvals which can be slow and uncertain. exit through IPO is very difficult. This is because an IPO of a FIE is highly restricted under the current Chinese regulatory regime. Only a small number of FIEs have successfully obtained the required approvals from the Ministry of Commerce (MOFCOM) and the China Securities Regulatory Committee (CSRC) to list on either a domestic or overseas stock exchange. Although there are signs that MOFCOM and the CSRC may further liberalise IPOs of FIEs on the domestic exchanges (A-share Listing) in the near future, until that happens global investors have to look at private sale as their main option for exit under a Direct Investment structure. Chart I (A) Fund: Direct Investment GP Chart I (B) Fund: Round-trip GP 1 Owners Round-trip SPV1 Portfolio1 Fund Investment SPVs Fund LP LP Round-trip SPV2 Portfolio 2 JV1 JV2 JV3 2 Owners 1
Investments in Round-trip SPVs The second widely used structure for PE-backed deals in China is offshore investment through the so called "round-trip" offshore structure of the Chinese target (Round-trip Investment) -see Chart I (B). Since the early 1990's, a large number of Chinese domestic entrepreneurs established or controlled shell companies in offshore jurisdictions such as Hong Kong, the BVI or Cayman Islands (Roundtrip SPVs) and then used such vehicles to reinvest in China, by way of setting up greenfield FIEs or acquiring their originally owned operating business. This was initially used for domestic Chinese owners to get tax incentives which FIEs are entitled to. However, such offshore structuring has also been used to facilitate offshore PE and VC investment and to prepare such companies for an offshore listing (e.g. in Hong Kong, Singapore, London or NASDAQ). The benefits of this structure include:- a more flexible transaction structure not available under Chinese law, eg. more diverse classes of shares, convertible loans, warrants, ratchets and other alternative equity investment instruments and arrangements; foreign investors may avoid conversion of foreign currency and RMB and minimize the exposure to China's foreign exchange regulatory restrictions on capital account transactions; it is possible for investors to exit through IPOs of the Round-trip SPVs in overseas capital markets - which historically have been more transparent, had greater liquidity and the listing procedures of which are more predictable compared to the local exchanges in China. However, the Chinese government became increasingly uncomfortable with the Round-trip Investment structuring because of the concern that large numbers of Chinese companies would opt for overseas capital markets and be outside the scope of Chinese taxation and foreign exchange control. As a result, the government issued a series of regulations in the last three years making it very difficult for Chinese businesses to complete an offshore restructuring. For example, the Merger and Acquisition Regulations (also known as "Circular 10") issued in 2006 require an overseas listing to be approved by MOFCOM and CSRC. Notices 75 and 106 issued by the State Foreign Exchange Administration (SAFE) in 2005 and 2006 created onerous filing requirements for overseas restructurings. As the number of Chinese candidates with a proper offshore structure has dried up it has become very difficult for VCs and PEs to structure a deal through Round-trip Investment structures. In addition, SAFE also issued general rules (SAFE Notice 142) that prohibited FIEs from converting foreign capital into renminbi (RMB) for the purpose of equity investment in other domestic entities, except for onshore equity investment vehicles like FIVCIE vehicles (as discussed below). These rules further limit foreign PE/VC Funds options in structuring their investments in Chinese companies. RMB Fund: FIVCIE Foreign PE/VC investors have increasingly been considering the option of investment through vehicles that are formed in China whose capital commitments and contributions are denominated in RMB (RMB Funds). Chart II FIVCIE (Non-legal Person CJV) Affiliate Mgt. Company Advisor (GP) Management Agreement Formation of FIVCIE X% Commitment 1% Commitment Portfolio1 Investors (LP) Y% Commitment FIVCIE (CJV Structure) Chinese Investors (LP) Portfolio 2 For foreign investors and PE houses wishing to set up an RMB Fund the most straightforward vehicle to use under the current regulatory regime is a foreign invested venture capital investment enterprise (FIVCIE) established under the Administrative Measures on Foreign Invested Venture Capital Investment Enterprise (FIVCIE Rules) issued in 2003. 2
Under the FIVCIE Rules, a RMB Fund can be structured in either a corporate form (Incorporated FIVCIE) or in the form of a Sinoforeign cooperative joint venture (FIVCIE CJV). The FIVCIE CJV structure is a legal form that is similar to a limited partnership. A typical example of a FIVCIE Structure is shown in Chart II. A FIVCIE CJV may be formed by 2-50 investors including one investor who has unlimited liability (the equivalent of a General (GP)). The GP or its affiliate has to meet various qualification requirements, including that it must mainly be engaged in the business of venture capital investment and the capital under its management shall not be less than US$100 million during the last 3 years, of which US$50 million was invested in PE or VC deals involving qualified high technology companies. The other investors of the FIVCIE CJV can have limited liability to the extent of their committed capital investment. Global fund managers (which often are affiliates of the offshore investor) can also establish an onshore fund management company under the FIVCIE Rules (Management Company) to manage the FIVCIE in China. The minimum fund size of a FIVCIE CJV is US$ 10 million and US$ 5 million for an Incorporated FIVCIE. All the capital contributions to the FIVCIE must be made in cash of which the minimum commitment by the GP is 1% of the committed capital in the case of a FIVCIE CJV or 30% in the case of an Incorporated FIVCIE. The minimum investment of other investors is US$1 million each. A FIVCIE is allowed to make equity investments in unlisted domestic companies without having to obtain government approval, as long as the target companies are in the encouraged or permitted categories of foreign investment. In addition, unlike other types of FIEs, FIVCIEs are allowed to repatriate initial contributed capital as well as all profits back to their investors as and when the FIVCIE disposes of its portfolio investments. Under current tax rules, FIVCIE CJVs can achieve tax pass through treatment as they are exempted from enterprise income tax (EIT). As FIVCIE CJVs have more favourable tax treatment than Incorporated FIVCIEs they are the more frequently used of the 2 structures. The formation of a FIVCIE raising more than US$ 100 million requires approval by MOFCOM at central level. Since March 2009, the establishment of FIVCIEs raising less than US$100 million only needs approval at local level. This makes establishing smaller FIVCIEs quicker and easier. It has been reported that over 40 FIVCIEs had been set up in China by May 2009, raising in aggregate over US$1.5 billion equivalent in RMB funds. Pros & Cons of FIVCIE Structures The FIVCIE structure has a number of benefits for foreign investors: it enables foreign investors to convert foreign exchange faster and retain and redeploy capital onshore in RMB. This avoids the difficulty arising from inconvertibility of the RMB and the onerous regulatory constraints attached to cross border investment structures; streamlined government approval process on portfolio investment enables foreign investors to complete a deal more quickly and efficiently. This gives a level playing field for global PE to compete with other purely domestic RMB funds and Chinese investors which can invest without the need to go through those onerous approvals normally required for offshore investors; removes the need for an onerous offshore restructuring of portfolio companies with a view to an offshore exit. As a result, foreign investors are able to get access to greater deal flow in China; possible exit by way of A-share Listing in Chinese domestic markets which have become increasingly liquid and transparent in the past three years. There has been a strong rebound in share prices and revived IPOs after the global financial crisis. Additionally, the Growth Enterprise Market (GEM), the Chinese equivalent of NASDAQ, opened in Shenzhen in September 2009. The new junior board makes it possible for foreign investors to exit from small-cap investments by listing on GEM following a lock-up period ranging from one to three years. Earlier entry can mean shorter lock-ups and better multiples; Incorporated (Co-operative) FIVCIEs and FIVCIE CJVs have flexibility to include "carried interest" or performance related allocation of profits and gains/losses; offers foreign fund sponsors and managers a legal structure to raise RMB capital onshore. A significant number of Chinese institutions such as securities firms, insurance companies and government industrial guidance funds have been approved to invest in private equity funds. It is reported that RMB Funds raised RMB264 billion in 2008, climbing 347% from 2007. The National Social Security fund is reportedly seeking approval to invest up to US$8 billion in domestic and foreign PE funds. The growth of onshore money constitutes an attractive capital pool for global PE houses to set up RMB Funds. However, FIVCIEs have some drawbacks for foreign investors: 3
Investments in FIVCIEs are in principle limited to companies in high/new technology industries. A prior confirmation on proposed target industry sectors from the Ministry of Science and Technology (MST) is required for the establishment of FIVCIEs. FIVCIEs with a investment mandate in more general industries are not currently contemplated under the FIVCIE Rules, although in practice such limitation is not strictly implemented by the regulatory authorities; As there has been no foreign investment partnership law until early December 2009, many statutory matters that are usual in a western law jurisdiction have to be spelt out in the fund agreement, in particular for a FIVCIE CJV. These issues include fiduciary duties, inter-partner liabilities and the assignment of fund interests. In light of the above, many global PE houses and fund sponsors have not yet set up a FIVCIE but are waiting for a clearer regulatory framework in respect of RMB Funds. RMB Equity Investment Fund (EIF) The problems with FIVCIE structures have led some investors to consider alternative structures for RMB funds. Clearer rules for the formation and operation of RMB Funds for general private equity investments (EIF) in China are emerging. Local Regulations Foreign fund sponsors are benefiting from local policy promulgated by various Chinese provincial and municipal governments such as Beijing, Tianjin, Shanghai, Chongqing and Suzhou who are in fierce competition to attract private equity funds and sophisticated international fund managers into their jurisdictions. For instance, in June 2009, Shanghai became the first city to allow foreign sponsors to establish a wholly foreign owned limited company with a minimum registered capital of US$2 million to manage domestic private equity investment funds ("EIF Management WFOE") in Pudong New District of the city. In an earlier move in January 2009, the Beijing local government offered tax exemption for dividends received from portfolio companies by private equity partnerships established in the City. Tianjin local regulations also contemplate an RMB Fund being formed in the form of a trust as well as through a company or partnership structure. According to ChinaVenture, the Chinese PE market researcher, Blackstone has set up an EIF Management WFOE to form and manage an RMB Fund expected to raise RMB5 billion (US$735 million) in Shanghai in November 2009. Earlier in August, First Eastern Financial Investment Group, a Hong Kong-based investment institution, became the first foreign PE house to be approved to establish an EIF Management WFOE in Shanghai. Notwithstanding these positive moves, China has yet to establish a nationwide framework on formation, fund raising and operation of RMB Funds for general private equity business. Expected National Rules There are three relevant pieces of legislation at central level either just published at the end of 2009 or expected to be promulgated soon: The recently issued foreign-invested partnership rules which clarify how foreign investors can set up limited partnership vehicles in China; The regulations on equity investment by foreign investors which are expected to establish a new regulatory framework for equity investment involving foreign fund sponsors and managers; and The administrative rules regulating the private equity fund sector as a whole which may introduce approval and registration requirements for RMB fund vehicle establishment and fund raising in China. Chart III Expected Parallel / Fund Structure Affiliate EIF Mgt. WFOE (GP) Management Agreement Co-investment Advisor Management Agreement Y% Commitmen 1% Commitmen Portfolio1 Fund (LP) Fund Investors X% Commitmen Co- Chinese Investors (LP) RMB Fund-EIF (Co./ship) Portfolio 2 4
An expected parallel structure It may soon become possible for foreign fund sponsors to structure a RMB Fund with parallel onshore and offshore fund vehicles for general PE investments in China as illustrated in Chart III. There are a number of different variations for EIFs depending upon what the fund sponsor is seeking to achieve. An EIF may be in the form of a company or a limited partnership. The number of investors of an EIF may not exceed 50 if it is a limited company or partnership and may not exceed 200 if it is a company limited by shares. It is expected that an EIF will be allowed to raise funds from Chinese domestic investors (LPs) subject to certain private placing restrictions, such as qualification of offerees, minimum size of the fund, minimum capital commitment of each investor and the relevant disclosure requirements. Global PE houses may be allowed to set up an EIF Management WFOE and subsequently act as initial investor or GP to establish a RMB Fund in China. It could also act as fund manager for the EIF under a management agreement. The minimum commitment of the GP is likely to be 1% of the proposed capital of the fund. The EIF may be subject to certain minimum capital requirements (not less than RMB10 million). The EIF may also be required to register with a PE industry regulatory authority so as to be qualified to raise RMB funds. It is expected that an EIF will be allowed to invest in un-listed companies, infrastructure and real estate project companies, trading of non-quoted shares of listed company and M&A related equity transactions of listed companies. Foreign investors may also be allowed to invest in a limited partnership EIF when the relevant national rules come into place. funds sponsors may set up offshore fund vehicles to raise money overseas in parallel to their investment in the EIF. Alternatively they may structure the investment by co-investing in domestic Chinese portfolios along with the EIF onshore. Investors of EIFs may exit from portfolios via trade sale or A-share Listings in China. Foreign PE fund sponsors will need to consider carefully whether to set up an RMB Fund. As onshore entities they will require more administrative maintenance than an offshore vehicle, capital committed may not be available for offshore investments and investment in listed securities may not be possible. Although it is widely recognized that the drafts of the relevant Chinese regulations have been developing along these lines the feasibility of the above structure must await the publication of the expected new national laws and regulations. A Challenging but Optimistic Future There are still a number of challenges facing foreign PE investors in China. Chinese rules are not yet in line with international norms and for example it is not as easy to structure ratchets, puts, call options and other mechanisms as in overseas jurisdictions. The Domestic LP ecosystem is improving but remains at an early stage. A 5-10 year fund life commonly seen in the western market may be too long for Chinese investors. Also there are concerns within the government that private equity houses don't provide sufficient added value to target companies. With too much money chasing too few good Chinese deals, foreign sponsors have to demonstrate their professionalism, experience and innovation so as to compete with local PE firms and to be supported by local governments or capital-rich Chinese institutions or state-owned companies. Nevertheless, the future of private equity in China will increasingly involve onshore RMB Funds. 5
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