Private funds are being subjected to more stringent regulation, but policy revisions are also providing more investment opportunities. Frankie Wang reports
Just as new rules around private equity and venture capital (PE/VC) investment appear to be tightening, so opportunities for expansion and reward are opening as China’s capital reform process takes shape.
With a view to further guarding against systemic financial risks and encouraging capital “to forego the virtual and head for the real”, the regulation to which the PE/VC market is subject continues to intensify in 2018.
On 27 April, the People’s Bank of China, the China Banking and Insurance Regulatory Commission, the China Securities Regulatory Commission (CSRC) and the State Administration of Foreign Exchange (SAFE) issued the Guiding Opinions on Regulating the Asset Management Business of Financial Institutions, commonly known as the new asset management rules in industry circles.
The new rules, the objectives of which are to shatter rigid payments, prohibit fund pools, stop channel business and eliminate risks such as multi-layer nesting, are having a major impact on the entire “offer, invest, manage and divest” process of domestic PE/VC, pushing uniformity in regulation.
The new rules extend the transition period in the earlier draft for comment by one year and a half, until the end of 2020, but how to affect the adjustments within the allotted time is still a challenge that investment firms will face.
There are also rules on the management of private fund investor suitability, issued by the CSRC and the Asset Management Association of China (AMAC). The CSRC issued the Several Provisions on Shareholding Reductions by the Shareholders, Directors, Supervisors and Senior Officers of Listed Companies, while the AMAC has strengthened reviews for the registration of private fund managers and the recordal of private fund products. All of these have a significant impact on the PE/VC industry.
Sherry Ma, the managing partner of Co-effort Law Firm in Shanghai, says the regulation of the CSRC and the AMAC in the past 12 months has continuously intensified. “It is my understanding that a major portion of these new regulatory policies will be a blow to the current private fund business model, but, over the longer term, they will be effective medicine for promoting the sound development of PE/VC funds,” says Ma.
Zhou Lin, a partner at Han Kun Law Offices in Beijing, says the most important recent trend has been tighter requirements in respect of the professional operating capabilities and genuine business development of PE/VC managers. “The regulatory policies conform with the state’s macro policy of eliminating gearing, requiring the finance industry to serve the real economy, and emphasizing that private funds are to return to the original essence of the asset management business, differentiating themselves from the lending business and not guaranteeing principal or returns.”
While relevant regulatory systems are being further improved, the advantages for large PE/VC firms are becoming more marked. Wang Lei, a partner at Haiwen & Partners in Beijing, says the top-ranked PE/VC firms “are starting to develop comprehensively in such sectors as project investment, renminbi funds/US dollar funds, etc., and are beginning to demonstrate their systemic advantages in terms of post-investment management and resource protection. We foresee that the leading advantages of the top-ranked PE/VC firms in the market will grow progressively larger in the coming years.”
On the other hand, the variety of participants in the private offering industry has become more diverse. “Investment firms that often took the form of LPs [limited partnerships] in the past are flush with funds, and may now set up new entities and themselves establish private funds to charge management fees, rather than passively handing their funds over to funds sponsored by other GPs [general partnerships] as in the past,” says Wang. Persons and firms with extensive knowledge of specific industries and investment projects may also exploit their advantages to establish funds and expand their teams. “The foregoing two circumstances are showing a growing trend in the market at present.”
Jeremy Dai, a partner at AnJie Law Firm in Beijing, observes that investment orientations are moving more towards real economy industries such as advanced manufacturing, while under the influence of policy, previously hot sectors such as the game and film/TV industries, have started to lose some of their lustre.
Dai contends that the major change that the launch of the pilot project for the “full tradability of H-shares” represents is also presenting new investment opportunities for PE/VC funds. “The review of applications for A-share IPOs has become extremely stringent recently, with the exception of unicorn enterprises, due to the impact of the alleged fraud by Le.com in its listing last year,” he says. “Against such a backdrop, many companies, particularly New Third Board companies, may actively withdraw their applications for A-share IPOs and shift their sights to H-shares.
“Many PE/VC funds are now interested in these domestic companies that are withdrawing their A-share listing materials, because the full tradability of H-shares signifies that PE/VC funds investing in these companies will be able to exit on the H-share market.”
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LEGISLATIVE TRENDS
The new rules particularly spell out their scope of application: laws and regulations specifically for private investment funds govern private investment funds, but where the laws and regulations specifically for private investment funds are silent on a matter, the new rules apply. However, the regulations for venture capital funds and for industry investment funds to which the government contributes will be formulated separately.
“Because venture capital funds, as a special form of private equity fund, serve to incubate small and medium-sized enterprises, they are exempted from the restrictions of the new rules,” says Zou Jing, a partner with Grandall Law Firm in Shanghai. “Pursuant to relevant regulations, venture capital funds that meet certain conditions are eligible for preferential policies relating to taxation, shareholding reduction and lock-up periods. Additionally, government-invested industry funds usually take the form of PPP [public-private partnership] funds, private equity funds, etc., which likewise confers upon them a special nature. These can all be deemed advantages bestowed on private equity funds by the new rules.”
One of the major reforms of the new rules is the shattering of minimum guarantees/guaranteed returns, or “rigid payment”. “The new rules impose more stringent regulation on minimum guarantees/guaranteed returns,” says David Yu, a partner at Llinks Law Offices in Shanghai. “At the investment stage in the past, many PE/VC funds carried out ‘equity in name, debt in reality’ investments, for example requiring in the investment documents that the investee company give a buyback undertaking, requiring the investee company to guarantee its returns at the investment stage, etc.”
Dai, from AnJie, summarizes the “equity in name, debt in reality” model as follows: (1) the distribution of returns ignores the investee enterprise’s future business position; (2) an undertaking to the effect that, at maturity, the principal will be repaid and fixed returns paid is given to investors; and (3) the investee enterprise, or an affiliate, is compelled to redeem the equity or pay back the principal and interest.
“With the issuance of the new rules, whether these types of investments will require rectification awaits the issuance of relevant implementing rules for clarification,” says Yu. “If rectification is required, accomplishing the same by the end of 2020, as specified in the new rules, will pose a major challenge for fund managers, given the relatively long periods usually required for equity investment projects.”
In terms of the structure and management of PE/VC products, the new rules set upper limits on class leverage and liability leverage, and set out new compliance requirements for PE/VC fund managers in terms of net value management and information disclosure. “There is a difference between net value management and the usual practice of private equity funds of using the cost method of valuation,” says Zou, from Grandall. “When using the cost method of valuation, the net value of the private fund remains unchanged throughout its life. Under such a circumstance, investors’ sensitivity to investment risks is dulled.
“As the new rules require net value management and a market method of valuating asset management products, the net value of a private fund will vary during its life, which will aid investors in clearly seeing the risks,” says Zou. “To a certain extent, net value management signifies that, when there are no returns, asset management investors will not be able to take or receive returns, thus eliminating rigid payment from another perspective.”
One month prior to the issuance of the new rules, the AMAC issued the Guidelines for Valuating the Investments of Private Investment Funds in the Equity of Unlisted Companies (for Trial Implementation), which will be implemented from 1 July 2018. Yu, from Llinks, contends that the guidelines improve the valuation criteria in the asset management industry, and will play a major boosting role at the investment stage of domestic PE/VC funds.
“The guidelines emphasize the principle of valuation at fair value to maintain consistency in the valuation method, and, with respect to unlisted equity, they set out specific valuation methods, applicable scenarios and application guidelines, which will be of great significance in improving the valuation system for the investment stage of domestic PE/VC funds,” says Yu. “Additionally, they mark the further improvement and development of the entire private fund system.”
The new rules emphasize the halting of channel business used to circumvent leverage restraints and other such regulatory requirements, and the elimination of multi-layer nesting. “The new rules permit an asset management product to invest in another single-layer asset management product, provided that the investee product does not further invest in a product other than a public securities investment fund,” says Richard Xu, founding partner of Han Yi Law Offices in Shanghai. “The multi-layer nesting model seen previously in practice, where a bank wealth management fund would subscribe for the equity of a PE fund through trust and securities brokerage asset management products, will no longer be viable.”
In terms of requirements in respect of investors, the new rules set out a provision on “net household financial assets” for the first time. Zou says that, compared with previous regulation, the new rules require, in respect of investor qualifications, “net household financial assets” of not less than RMB3 million (US$460,000) or gross household assets of not less than RMB5 million, demolishing the minimum investment threshold of RMB1 million required by current private offering rules.
At the same time, the investment threshold for qualified investors is lowered. “The limits on the net household financial assets of investors, and on the investment of others’ funds, will reduce the number of investors that satisfy regulatory requirements, thereby affecting the source of the offering proceeds of private funds,” says Zou. “However, the minimum investment threshold for fixed-return type products is lowered to RMB300,000, and that of mixed-type products to RMB400,000. This will not prevent certain equity-type investment funds from employing the portfolio investment model in future to design products as mixed products and smoothly lower the investment threshold.”
In December 2017, the AMAC issued an updated version of the Instructions for the Registration of Private Fund Managers, expressly specifying circumstances under which registration will be denied, including: alleged illegal raising of funds; engagement in direct lending; private lending; P2P; crowdfunding investment; and real estate speculation.
“Based on current regulations and practice, a private fund that has not completed recordal may participate in investment on the New Third Board, provided that it commits to completing recordal by a certain date, and the [New Third Board] system will continuously monitor the performance of the commitment,” warns Xu, from Han Yi.
“If a private fund is the shareholder of a company that proposes to list A-shares, its failure to carry out recordal could affect the company’s listing schedule. Accordingly, from the perspective of participating in New Third Board listings or main board listings, private funds should pay close attention to the timely completion of recordal.”
Wang, from Haiwen, says that since October last year the AMAC has substantively suspended the work of registering “miscellaneous” private fund managers. (Miscellaneous private funds mainly refers to private funds that invest in areas other than securities and equity.) “We understand that this is related to use of this registration category by ‘miscellaneous’ managers to actually raise funds to invest in non-standard assets, or in other non-compliant, low-level investment projects,” he says.
While beefing up regulation, the government is also encouraging the investment of funds in real industries. In March this year, the CSRC issued the Special Provisions on Shareholding Reductions by Venture Capital Fund Shareholders of Listed Companies. “The special provisions offer preferential policies on shareholding reduction to small and medium-sized enterprises, and to hi-tech enterprises invested in by venture capital funds after they have listed, to make it convenient for a more rapid realization of shareholding reduction,” says Qi Huaying, a partner at Han Kun Law Offices in Beijing. “This measure can encourage venture capital funds to invest in qualified small and medium-sized enterprises and hi-tech enterprises.”
ROUTINE COMPLIANCE
With respect to the issues currently existing in private fund companies in practice, Wang says that unfamiliarity with or failure to understand the self-regulation rules issued by the AMAC, “carrying out the procedures at the qualified investor verification, manager registration, fund recordal, regular submission of disclosure information and other such stages only in a perfunctory manner, and the potential existence of defects in the truthfulness, accuracy and completeness of the materials submitted … could create latent dangers that affect the compliance of fund operations.”
Investor verification. Both the CSRC and AMAC implemented rules on the “management of investor suitability” last year, imposing a greater number of requirements on private offering firms. For example, pursuant to the requirements of the CSRC’s Administrative Measures for the Suitability of Securities and Futures Investors, firms that sell securities products to investors are under obligation to produce a suitability matching opinion based on such factors as the different risk-bearing capacities of investors and the different risk grades of products, so as to sell the appropriate products to suitable investors.
Ma, from Co-Effort, says that certain funds fail to perform or incompletely perform the requirements in respect of investor suitability in the course of their offerings. “[Some private fund managers] fail to explain to investors in person the risks involved in investing in relevant products, and basic knowledge on risk management, and fail to confirm in writing that it is the investor that proactively requests to understand and purchase the products,” says Ma. “Subsequently, if the product makes a loss, there is a strong possibility that an investor will take the private fund manager to court and demand compensation.”
Yu, from Llinks, contends that an investor verification cannot solely rely on the risk survey questionnaire filled in, and the undertakings given by the investor, but requires further verification of the investor’s relevant supporting documentation, “for example, requiring an individual investor to provide documents attesting to assets, such as proof of income for the past three years, or bank deposits, or requiring an institutional investor to provide documents attesting to assets, such as audit reports and balance sheets. Furthermore, managers should retain copies of such supporting documentation.”
Fund management. In terms of fund management, Yin Yue, a partner of Jingtian & Gongcheng in Beijing, says that, looking at things from the perspective of current regulatory trends, whether a private fund manager has performed its obligations and duties is a key point of focus. “Looking at the AMAC’s requirements during the past two years, the issues that it is particularly focusing on mainly include: buying and selling of shells; the number and qualifications of a private fund manager’s relevant employees failing to meet requirements; a private fund’s or private fund manager’s lack of basic risk controls; and the use of various means to provide minimum guarantees/guaranteed returns to investors in a disguised manner. In terms of the obligations of a private fund manager, the issues that the AMAC is particular focusing on include having the capacity to grow the business, ensuring investors’ right to know, guarding against conflicts of interest, etc.”
Zou says the AMAC has tightened its requirements in respect of the independence of fund personnel. “AMAC requires the personnel of each private offering firm to be independent,” he says. “However, the issue of concurrent service by the personnel of a significant number of firms is very obvious, particularly in firms that operate as groups and control multiple managers, some controlling multiple equity investment fund managers, and some controlling multiple types of equity, securities and miscellaneous fund managers.
“To unify management, these group-like firms will often place all of the middle ground and back-office personnel in a holding company, rather than separately under each of the managers, which conflicts with the AMAC’s requirement in respect of the independence of personnel.”
To ensure stability of corporate governance, organizational structure and management team of newly registered private fund managers, a document issued by the AMAC in November 2017 requires, for the time being, that newly registered private fund managers not make a material change to their legal representative, controlling shareholder or actual controller, until recordal of their first fund product has been completed, or indiscriminately replacement of such senior management personnel as the general manager, compliance and risk control officers, etc. Xu, from Han Yi, advises that a private fund manager formulates internal control systems that are compatible with its own actual circumstances. Small private fund managers can opt to outsource their legal services.
As the subject matter of PE/VC investments has non-standard properties, they are special in terms of valuation, and calculation and distribution of returns. Accordingly, they easily give rise to “fund pool” risks, such as mismatches between investment and returns. In this respect, Ma says many PE/VC “fail to carry out independent management, independent account creation and independent accounting in strict accordance with regulatory requirements, and continue to carry on ‘fund pool’ business, which could leave them facing administrative penalties and civil damages.”
Ma also notes the issue of private products being made public. “Pursuant to the Administrative Measures for the Offering Acts of Private Investment Funds, an offering institution may not promote a private product on such online media as the offering institution’s official website and WeChat posts, in which the procedure for identifying the specific target investors has not been established.
“However, in practice, there are still private products the offering of which is openly promoted in WeChat posts, WeChat official accounts and on Weibo by certain private offering firms.”
RELAXATION OF OUTWARD INVESTMENT
Although there has been tightening in the regulation of the finance industry this year, a series of financial opening measures will be of direct benefit to PE/VC funds “going global” and “bringing in”. The central government announced measures to open the finance industry at the Boao Forum for Asia in April. These measures will have an impact on all types of financial institutions including banks, securities companies, fund management companies, futures companies and insurance companies.
Previously, PE/VC funds faced certain operational difficulties when carrying out outward direct investment (ODI) due to foreign exchange regulation, resulting in many renminbi funds being non-compliant when investing in enterprises proposing to list abroad. Zou, from Grandall, contends that there are three common non-compliance issues: (1) non-compliant investment orientation. These funds often realize their outward investments by investing in other projects, many of which have no connection with the enterprises that are proposing to list; (2) relative prevalence of intermediated holding. As approval of ODI is relatively difficult, intermediated holding is often accomplished through the fund’s individual partners or the SPVs held by them; and (3) a relative abundance of exchange control violations.
However, there is a large practical demand for sending domestic PE/VC funds offshore. “On the one hand, outstanding domestic startups may have designed a red-chip structure early on in preparation for a future offshore listing,” says Wang, from Haiwen. “Once erection of the red-chip structure is completed, the finance seeking entity may become an offshore company, e.g., a company established in the Cayman Islands, not an operating entity in China. Accordingly, when domestic PE/VC firms consider investing in such a project, they will be subject to foreign exchange regulation of the outbound funds [unless they simultaneously manage renminbi funds and US dollar funds].”
On the other hand, emerging economies present new investment opportunities. “For example, manufacturing enterprises along China’s southeast coast relocate their plants to Southeast Asian countries like Vietnam, or Indian scientific and technical talent imitates China’s internet companies, setting up similar Indian startups,” says Wang. “The emerging economies present numerous investment opportunities, which are of great value to domestic PE/VC and domestic investors.”
With a view to promoting bidirectional opening of the finance market and advancing convertibility on the capital account, the National Development and Reform Commission issued the Administrative Measures for the Outward Investment of Enterprises at the end of 2017, and implemented them from March this year. With a view to meeting the demand of market entities for the cross-border allocation of assets, the SAFE has further advanced the work associated with the QDLP (qualified domestic limited partnerships) and QDIE (qualified domestic investment enterprise) pilot projects, recently increasing the pilot limits of Shanghai and Shenzhen to US$5 billion each.
Ma says the Shanghai and Shenzhen pilot projects, and the increase in their limits, represent a major move in the bidirectional opening of China’s finance market, providing domestic investors with feasible channels and options to realize asset allocation in global markets. “The pilot QDLP project in Shanghai facilitates the entry of domestic investors into international secondary markets by way of private offerings,” she says. “On the other hand, the pilot QDIE project in Shenzhen opens up a wider scope of investment, providing other types of investment, real estate and primary markets, in addition to the secondary markets.
“The foregoing methods represent new experiments in comprehensive capital relaxation models under the restrictions imposed by the limits. Through orderly opening, domestic organizations and individuals can, on the one hand, secure additional channels for the preservation and increase of value. On the other hand, these opening mechanisms are beneficial for the balancing of international receipts and payments by the state, effectively utilizing exchange reserves and leveraging the utility of pilot projects.”
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https://law.asia/impact-of-new-rules-on-pe-vam/
