Private equity (PE) funds formed to make investments in the People’s Republic of China (PRC) come within three main types of structures. This post identifies and analyzes the characteristics, advantages and disadvantages of each structure, and highlights recent legal developments pertaining to how international investors can build or sponsor an onshore RMB funds.
PRC’s economic growth has created a steady flow of investment opportunities. Especially after the global financial crisis, more and more global PE funds seek to deploy capital in this region. The financial crisis turns out to be a starting point for PRC to usher in a completely new phase for its opening-up and become one of the favorite investment destinations. To date, PE industry enjoyed a steady growth as can be seen in the chart below.
Chart 1 Annual Fundraising Amount by PE Funds focusing on Greater China between 2002 and 2011 Source: Preqin as of 2012
PE funds could be formed in PRC in one of the three structures:
- Offshore US Dollar-denominated funds;
- Onshore domestic-invested RMB-denominated funds;
- Onshore foreign-invested RMB-denominated funds.
Offshore US Dollar-denominated Funds
Offshore US Dollar-denominated funds are formed in non-PRC jurisdictions, most commonly in the Cayman Islands or British Virgin Islands.
· As offshore funds are typically organized as limited partnership, investors enjoy two typical advantages of partnership compared to corporations: greater flexibility of commercial terms and the availability of pass-through tax treatment, i.e. it avoids dividend tax and double taxation because only owners or investors are taxed on the revenue.
· As offshore funds are organized under laws of Cayman Islands or British Virgin Islands, there are greater certainty and predictability pertaining to the legal enforceability of contracts and limited liability protection of limited partners than entities governed by PRC law.
Offshore funds are not governed by PRC law, but their investments made in PRC will be. As they are registered in non-PRC jurisdictions and funded by foreign investors, offshore funds are classified as foreign investors under PRC’s regulatory regime pertaining to foreign investment, and thus are subject to many special restrictions.
According to Foreign Investment Industrial Guidance Catalogue enacted by PRC’s State Council, many sectors and industries are closed to foreign investment. Even for accessible industries, every investment needs government approval. While not difficult to obtain, the great latitude of administrative authorities has generated huge space for rent-seeking. Moreover, the application process can be time-consuming since it involves extensive negotiations with various approval authorities. For example, a large factory may have serious land use or environmental issues. Thus, the exact time frame for approval is never certain. It depends on the type of project and the location. Foreign investors must be prepared for this uncertainty from the outset.
· Since offshore funds are denominated in USD yet invest in RMB, government approvals are also required for the conversion of USD into RMB and associated repatriation.
· As there are no PRC tax rules specifically ensuring pass-through tax treatment for offshore funds, investors must be very cautious to make sure that a “permanent establishment” is not created in PRC as the tax exposure of both general partners and limited partners could be adversely affected.
It should be noted that offshore funds used to be able to circumvent the restrictions stated above through “round-trip investment”: typically a PRC national established or controlled an offshore holding company to control a Chinese domestic company by captive contractual arrangement. The Chinese domestic company makes investment in China as a domestic investor while the international investors invest at the offshore level. However, the “round-trip investment” is no longer an easy shortcut as PRC had made significant policy changes in recent years to close related regulatory loopholes.
Since then, more and more PE funds prioritize setting up RMB funds. As can be seen in the graph below, most of the newly-raised funds are denominated in RMB.
Chart 2 PRC Private Equity Fundraising. USD Funds vs. RMB Funds, denominated in $US Billons Source: Preqin as of 2012
Onshore Domestic-Invested RMB-Denominated Funds
Onshore domestic-invested RMB-Denominated funds are registered in PRC, comprising exclusively of domestic source of capital. The vast increase in its popularity in recent years could be partially attributed to the corresponding growth of Chinese sources of capital available to onshore RMB funds, including, among others, 1) PRC’s National Social Security Foundation; 2) local government funds held by several provincial and municipal authorities, such as Beijing, Shanghai, Tianjin and Jiangsu; 3) an increasing number of wealthy Chinese entrepreneurs.
It is crucial to note that onshore domestic-invested RMB-Denominated funds are closed to foreign capital, but not to foreign investors. In other words, international investors could sponsor an onshore domestic-invested RMB-Denominated fund as its general partner. First, they should register a management entity in PRC to raise and manage the RMB fund as its general partner. Then, they would raise limited partner capital from domestic Chinese investors. Specific regulations pertaining to such type of transaction vary across provinces and municipalities, as there is not yet a unified set of rules governing investor solicitation and private offering on a national level.
· As onshore funds are typically organized as limited partnership under PRC’s Partnership Enterprise Law, investors enjoy two typical advantages of partnership compared to corporations: greater flexibility of commercial terms and the exemption from double taxation.
· As onshore funds are classified as “domestic investors” under PRC law, government approval for investment and currency conversion could be avoided, so as the associated lag-time and rent-seeking, resulting in greater efficiency and lower cost.
· As domestic investors, onshore funds can invest in industries restricted to foreigners like television stations and publishing, thus have access to more deals in a broader share of PRC’s economy.
· Onshore domestic-invested RMB-Denominated funds are by its nature inaccessible to foreign sources of capital, and thus very difficult to scale their business. As of now, most of them are relatively small in size, with whole funding below US$100 Million.
· Compared to Cayman Island and BritishVirginIsland, there are less certainty and predictability in PRC’s legal matrix, especially pertaining to enforcing contracts in PRC courts. PRC has a lot of capital, but not a large group of seasoned investors. It could be tricky when dispute arise between foreign sponsors and domestic investors, who are unfamiliar with private equity, regarding terms such as capital calls and years-long commitment.
Onshore Foreign-Invested RMB-Denominated Funds
Onshore foreign-invested RMB-Denominated funds are registered in PRC, comprising at least partially of foreign source of capital. They could be organized either as foreign-invested venture capital enterprises (FIVCEs) or foreign-invested limited partnerships (FILPs).
With respect to regulatory framework, of particular importance are the passage of Waishang Touzi Chuanye Touzi Qiye Guanli Guiding (外商投资创业投资企业管理规定) [Administrative Rules on Foreign-Invested Venture Capital Enterprises] (the “FIVCE Rules”) on March 1, 2003,  and the Waishang Touzi Hehuo Qiye Dengji Guanli Guiding (外商投资合伙企业登记管理规定) [Administrative Measures on Establishment of Partnership Enterprises by Foreign Enterprises or Individuals in China] (the “FILP Measures”) on March 1, 2010. 
According to FIVCE Rules, the scope of investment of FIVCEs is limited to high-tech or new-tech industries. Additionally, FIVCEs are forbidden to make investment by borrowed funds. Thus FIVCE can be a very ineffective model for making PE investment in PRC.
FILPs, as a new investment avenue opened in 2010, offers another promising option for international investors to engage in PE investments in the foreseeable future. The Carlyle-Fosun RMB fund, registered in March 3, 2010, is the first reported FILP. With initial investment of US$100 million, the co-branded fund is a 50/50 joint venture between Carlyle and Fosun, both of which are general partners . Afterwards, Blackstone formed the Shanghai Blackstone Equity Investment Partnership, while TPG launched the TPG Shanghai RMB Fund and the TPG Western China Growth Partners I. Goldman Sachs and Morgan Stanley also reportedly have RMB funds in the pipeline.
· As onshore RMB funds are typically organized as limited partnership under PRC’s Partnership Enterprise Law, investors enjoy two typical advantages of partnership compared to corporations: greater flexibility of commercial terms and the exemption from double taxation.
· Capital contribution could be made in cash or in kind, subject to valuation and filing requirements.
· Previously, PE investments by foreign investments are subject to approval of Ministry of Commerce (MOFCOM), which could be very intrusive, paper-intensive and time-consuming. But according to FILP Measures, FILPs could be set up by registration with State Administration of Industry and Commerce only, thus bypassing the burdensome process of MOFCOM approval.
· It could use RMB to invest more easily in domestic companies in PRC, thus help take them public in PRC, on the Shanghai or Shenzhen stock markets. By contrast, offshore USD funds typically made investment into companies that were structured for a public listing outside PRC. Since IPO valuations are at least twice as high in PRC as they are in Hong Kong or USA, investment through RMB funds leading to a Chinese IPO can earn foreign investors a much higher return, likely over 300% higher, than otherwise.
· When organized as offshore funds governed by Cayman law, the general partner and the fund manager are typically exempted from taxation. But as the general partner and the fund manager of FILP are treated as PRC tax resident, the carried interest and management fee payments are taxed at the PRC corporate income tax rate at 25%.
· FILPs are still subject to the previously mentioned Foreign Investment Industry Guidance Catalogue, thus could not invest in industries restricted to foreigners like television stations and publishing.
· The local limited partners may not be as sophisticated as the international investors. Their lack of experience and unrealistic expectation of high yields may possibly damage the business cooperation.
Recent Regulatory Developments
In 2011, the four direct-controlled municipalities of PRC: Beijing , Shanghai , Tianjin  and Chongqing , initiated significant pilot programs as to RMB funds organized as FILP. Under these programs, certain FILP could avoid more regulatory hurdles. For example, foreign capital contribution by foreign general partners and qualified limited partners may not be subject tot foreign currency conversion approval.
Indeed PRC is taking cautious steps to further open up its PE market. On November 23, 2011, PRC’s National Development and Reform Committee (NDRC) promulgated the first nationwide regulation of PE industry: Guojia Fazhan Gaigewei Bangongting Guanyu Cujin Guquan Touzi Qiye Guifan Fazhan De Tongzhi (国家发展改革委办公厅关于促进股权投资企业规范发展的通知) [The Notice on Promoting the Standardized Development of Equity Investment Enterprises].  On one hand, it tightens regulation of PE funds by requiring that all the PE funds shall register with NDRC or its counterparts at provincial level. On the other hand, the notice further opens PRC’s PE market to international participation as it does not reverse or limit any of the pilot programs’ initiatives to circumvent the foreign current regulations. In other words, this state-level regulation’s “hands-off” approach implicitly encourages local authorities to offer new incentives to attract international capital, and implicitly encourages international investors to continue forum shopping among these competing programs.
To sum up, the PE industry in PRC is blessed, as nowhere else is, with abundant capital, stellar investment opportunities and favorable IPO markets. With respect to investment avenues, the advantages of onshore RMB funds are clear: they can make investment without foreign exchange controls, they face much less red tape and they can raise funds from PRC’s local sources. Carlyle, TPG and Blackstone, as the earliest market entrants in this regard, have each launched their own RMB funds in partnership with leading PRC private company, and point the way forward for many of its peers in US. As PRC authorities gradually opens up its PE market to foreign capital, an increasing number of PRC’s strong private enterprises will get growth capital from international PE investors with the know-how and pools of RMB to build great public companies.
*Chenhao Zhu received a JSM (Master of Science of Law) from Stanford University in 2011, where he was the recipient of Franklin Family Fellowship and an editor of Stanford Journal of International Law. He is now an associate in the Palo Alto office of K&L Gates LLP, focusing on US-China business transactions, especially venture capital and private equity investments.
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