On 24 December 2010, the Shanghai Municipal Service Office, together with other authorities, promulgated the Implementing Measures for the Launch of a Pilot Foreign-Invested Equity Investment Enterprise Project in the Municipality (the “Measures”), which became effective on 22 January 2011.
The Measures further ease the path for a specific class of overseas private equity investors to access the Chinese private equity market in Shanghai, reflecting a marked shift by China towards international private equity practices.
1. Fund structure permitted under the Measures
The Measures introduce provisions expressly allowing a foreign-invested equity investment enterprise (“PE Fund”) to be established in the form of a partnership for the first time. The new partnership structure which has been afforded to foreign-invested PE firms allows for the investors to invest as a general partner (“GP”) or a limited partner (“LP”), reflecting widely accepted private equity practice in more mature markets.
The measures also reinforce the ability for a foreign-invested equity investment management enterprise to be established in Shanghai (“Management Company”), which can now take the form of a partnership as well as a limited liability company. According to the Measures, the Management Company can act as a GP for the PE Fund or for a domestic RMB fund. The Management Company can establish, promote and manage a private equity fund.
In order to establish a PE Fund in Shanghai in the recognised form of a partnership, the PE Fund must have a registered capital of no less than USD 15 million. In addition, each LP of the PE Fund must directly contribute at least USD 1 million to the registered capital.
To establish a Management Company, the registered capital must be at least USD 2 million. In addition, the Management Company must have at least one foreign-investor that has the ability to make equity investments or engage in equity investment management activities, and shall have at least two qualified senior fund managers.
Once the PE Fund or Management Company has been established, the entity can apply to become a “Pilot Enterprise” in accordance with the Measures, allowing wider scope for investment. Such Pilot Enterprise is envisioned to test the waters created by the Measures, setting a precedent for future private equity activity.
To become a Pilot Enterprise, the foreign investors of the PE Fund must fulfil the following criteria:
(a) the investors must be institutional;
(b) directly held assets valued at a minimum of USD 500 million or managed assets of at least USD 1 billion;
(c) sound governance structure and internal controls, with no penalties imposed by any judicial or other administrative authorities during the past two years;
(d) the investor or an affiliated entity has at least five years’ investment experience; and
(e) the GP of the Pilot Enterprise must have at least three years’ experience in direct or indirect investments in domestic enterprises in China.
According to the Measures, foreign investors in Pilot Enterprises can only comprise institutional investors such as foreign sovereign funds, pension funds, charitable funds, fund of funds, insurance companies, banks and securities companies.
The capital of the Pilot Enterprise will be reserved in a capital account with a custodian bank, which must be a Chinese bank. Usage of the capital will be governed by regulations which have yet to be issued.
3. Investment Restrictions
The Measures prohibit a PE Fund, as well as a Pilot Enterprise, from investing in the following areas:
(a) trading in shares or corporate bonds on the secondary market (excluding IPOs);
(b) trading in futures or other such financial derivatives;
(c) directly or indirectly investing in immovable property not for its own use;
(d) diverting funds that are not its own for investment. This prohibits the enterprise from engaging in investments through borrowed funds;
(e) providing loans or security; and
(f) other areas, if prohibited from foreign investment according to the Foreign Investment Industrial Guidance Catalogue.
4. Issues of Conversion of Foreign Exchange
An ongoing issue which distinguishes private equity activity in China from many established markets, is Circular 142 issued by the State Administration of Foreign Exchange, which prohibits foreign-invested enterprises from investing in other companies in China by use of the foreign exchange funds of its capital account. It restricts such activity by preventing the conversion of foreign-invested capital into Renminbi.
However, the Measures provide that a Management Company that has qualified as a Pilot Enterprise may utilize its foreign invested capital to invest in the private equity fund that it promotes and establishes. The Measures also provide that such capital contributions must not exceed 5% of the total amount of the funds raised by the PE Fund.
In summary, although the Measures reflect a conscious move towards internationally recognised private equity structures and practice, the Chinese private equity market is still the same way from being readily accessible to overseas investors. Time will tell whether such Measures are widened in scope and rolled out across China but the indicators for change are starting to flash.