RMB Funds in China
An analysis prepared
by
Edward Epstein and William Liu
Troutman Sanders LLP
Shanghai
November 2009
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Despite the global financial crisis, China remains one of the favorite investment destinations
for global investors. According to China’s National Bureau of Statistics (NBS), China's
economic growth accelerated to 8.9 percent year on year in the third quarter of 2009, and 7.7
percent year on year in the first nine months. Moreover, while the global market is suffering
a lack of liquidity, China RMB investors are both liquid and hungry to make investments.
●
Source: Zero2IPO Research Center 2009.10 www.zero2ipo.com.cn
Chart 2 Distribution of Newly-raised
Funds by Currency of Q3'09
(By No. of New Funds)
RMB,94.4%
USD, 5.6%
Chart 3 Distribution of Newly-raised Funds by
Currency of Q3’09
(By Amount Raised, US$M)
RMB, 1,061.00,
84.1%
USD, 200.00,
15.9%
Source: Zoro2IPO Research Center 2009.10 www.zeroipo.com.cn
Source: Zero2IPO Research Center 2009.10 www.zero2ipo.com
Amt. Raised (US$ M) No. of New Funds
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RMB funds are not new in China. In 2003, China’s Ministry of Commerce (MOFCOM)
issued the first regulation regarding Foreign Invested Venture Capital Enterprises (FIVCE),
which created the preliminary framework for RMB funds. The first RMB industrial
investment fund approved by the National Development and Reform Commission (NDRC)
was established in 2005. In late 2008, the State Council of China issued the Several Opinions
on Providing Financial Support for Economic Development, which paved the way for a
codification of the private equity (PE) industry in China and the regulation of PE investment
funds. In June 2009, the NDRC confirmed that the draft of the Administrative Rules of
Private Equity Investment Funds has been completed, and submitted to the State Council for
approval. Moreover, since 2008, Beijing, Shanghai and Tianjin have all promulgated local
policies to promote the development of RMB funds business.
China’s economic growth and the development of RMB funds in China, combined with the
global economic situation, have resulted in many foreign fund managers reviewing the
possibility of setting up RMB funds in China, which can raise funds from China local
investors and facilitate investments in the Chinese market. However, since laws and
practices in this area are developing rapidly and largely ad hoc, many fund managers have
been confused by the types and structures of RMB funds and the requirements to access to
them.
The current framework for RMB funds in China has developed piecemeal based on various
regulations issued at different times, which has resulted in structures and practices that lack
logical consistency. There are four main forms of RMB funds currently used in practice,
which form the subject of this analysis.
1. Industrial investment funds (IIF) which are subject to special approval from the
NDRC and the State Council
IIFs are usually established by government-back investors (combined with private
investors) or based on multi-lateral treaties and mainly use a corporate structure. Since
the Bohai IIF established in 2005, there have been dozens of IIFs approved but most of
these IIFs were not successful. In October 2009, the NDRC and the Ministry of
Finance (MOF) newly approved 20 new IIFs focusing on high-tech industries. The
total investment in these IIFs is RMB9.2 billion, in which central and local
governments contributed RMB2.2 billion, and the balance will be raised from private
investors.
2. Venture capital enterprises (VCE) which are subject to specific administrative
rules applicable to domestic VCEs and FIVCEs
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VCEs and FIVCEs are established under special regulations and can take the form of
either pure RMB funds or sino-foreign RMB funds under a corporate or partnership
structure (for FIVCEs, the regulation establishes a quasi-limited-partnership structure).
By using VCEs, fund managers can raise funds from both offshore and onshore
investors and establish onshore RMB-denominated funds. Some qualified VCEs and
FIVCEs can also enjoy certain incentive policies including tax benefits. The
limitations of VCEs and FIVCEs are that, the legal structures of these funds are limited
by the regulations, which are very inflexible, and that FIVCEs can, in principle, only
invest into high-tech or new-tech companies.
3. Equity investment funds (EIF) which are currently formed under local policies
using a corporate or partnership structure
National rules on PE funds are still under discussion but local governments, such as in
Beijing, Shanghai and Tianjin, have begun to explore practical ways to develop PE
funds in their jurisdictions.
For example, since August 2008, the Shanghai government has allowed PE fund
enterprises, which can be structured in the form of limited companies, limited
partnerships or foreign invested enterprises. These PE funds must have a registered
capital of at least RMB 100 million, all of which shall be contributed in cash. Under the
limited partnership structure, the partners of the PE funds enjoy pass-through taxation,
among which the general partners bear unlimited liability and are subject to corporate
income tax of 25% or a progressive individual income tax of up to 35%. The limited
partners enjoy limited liability and are subject to corporate income tax at a rate of 25%
or the individual income tax at a rate of 20%.
PE fund enterprises are now allowed to be established in several cities in China and
those PE funds are also allowed to make investments in many industries, but investors
still face many practical problems.
According to the current regulations, these PE fund enterprises can only make equity
investments, which means they can only hold equity interests of portfolio companies
but cannot provide debt financing or directly hold assets by themselves.
With respect to the legal and tax structure, corporate structure is not tax-efficient
because the dividends distributed by the portfolio companies are subject to 25%
enterprise income tax at the PE fund level. The form of a limited partnership also has
its own limitations. First, since the rules for foreign invested limited partnerships are
still under discussion, foreign investors still cannot become partners of domestic
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partnerships. Second, even if the foreign investors intend to use a foreign-owned
enterprise (a Chinese legal entity) to act as partner of these PE funds, there are
additional hurdles. According to the rules of the State Administration of Foreign
Exchange (SAFE), such a foreign-owned enterprise may not be able to make
investments into these PE funds by using its registered capital since the investments are
beyond its business scope. PE funds which have investments from a foreign-owned
enterprise may also face foreign investment restrictions when making investments.
In order to encourage the establishment of PE funds, local governments are actively
seeking incentive policies from the central government. For example, the government
of Shanghai Pudong New Area issued some pilot rules in June 2009 to allow foreign
investors to set up onshore fund management enterprises (FEIMC) as WFOEs or Sino-
foreign joint venture companies in Pudong, which have the business scope of fund
management services and can be used to manage RMB funds in China. By
contributing at least US$2 million as registered capital in these FEIMCs, foreign PEs
may set up an onshore vehicle to raise and manage RMB funds in China, which will be
used to pioneer the development of foreign-managed RMB funds. At the end of
October 2009, the government of Shanghai Pudong New Area reached an arrangement
with SAFE that, FEIMCs will receive an automatic waiver to convert foreign currency
into RMB for investment in their own RMB funds. This waiver will be for up to 1% of
aggregate capital commitments of the RMB fund as a whole.
Encouraged by local incentive policies and the trend of promoting onshore PE
development, many prestigious foreign PEs have begun to explore the possibility of
setting up RMB funds in China. This year, the Blackstone Group, First Eastern
Financial Investment Group, CLSA Asia-Pacific Markets, Prax Capital, Draper Fisher
Jurvetson, among other foreign PEs, have established FEIMCs in Pudong Shanghai and
plan to set up RMB funds.
4. Trust investment plans (TIP) formed by qualified trust investment companies
China enacted its Trust Law in 2001. Although any individual or legal person can act
as a trustee, in practice, qualified trust investment companies (TIC), as non-bank
financial institutions, are the only entities which are qualified to establish commercial
trust plans and sell to unit holders. In 2007, the central government issued several
regulations to standardize the regulation of TIC business and clarify the requirements
for establishing commercial trust plans. Since then, the TIP has become one of the
most important vehicles for RMB funds. Currently, there generally are three types of
trust plans which can be used:
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(1) The TIC establishes a TIP to raise funds from unit holders and then makes equity
investments in or loans to portfolio companies. Dividends, revenues from sales
of equity, and loan interest will be used to make distributions to unit holders;
(2) The TIC establishes a TIP to raise funds from unit holders and then acquires and
holds the pooled assets. The revenues from the sale, lease or operation of these
assets will be used to make distributions to the unit holders;
(3) The TIC establishes an assets TIP for portfolio companies focusing on specific
assets and then sells the preferred beneficiary interests of these assets to unit
holders, under which the funds raised will be used to fund the portfolio
companies, and the revenues generated by the underlying assets will be used to
make distributions to the unit holders.
These TIPs are all pure RMB funds and usually are only open to Chinese investors.
Therefore, at this time, both foreign general partners and limited partners cannot
engage in these plans. However, foreign PEs' onshore subsidiaries can provide paid
management services to these RMB funds. Foreign PEs may also establish hybrid fund
structures to raise funds from domestic and foreign investors side by side to engage
indirectly in the target projects so that foreign limited partners can also indirectly invest
in the same projects.
One of the most useful functions for TIPs is pooling funds for real estate investment.
TIPs established for real estate investment are often referred to as “Quasi-REITs”. The
central government has been drafting rules to regulate REITs. Several central
government departments including China Banking Regulatory Commission (CBRC)
and China Securities Regulatory Commission (CSRC) are drafting their own REIT
rules, which they hope to be adopted by the State Council. The CBRC's version of a
REIT is a debt financing product, under which the owner of the real estate will not
transfer title to investors and will only assign the beneficiary interests to the investor,
which is similar to the third type of TIP described above. These REIT products will not
be listed but may be traded in inter-bank market. The CSRC's proposed REIT,
however, is more like a US-style REIT under which the title of the real estate assets is
transferred and the products can be publicly traded. It has been suggested that the
central government will first adopt the CBRC's proposed REIT structure and then later
adopt the CSRC's proposed REIT structure. The CRBC's draft of the REIT rules (80
clauses) were published for comments in December 2008.
After many years of hearing footsteps on the stairs, it seems that foreign participation in
RMB funds is finally becoming a reality in the PE, VC and real estate industries. The
advantages of RMB funds are clear: they can make investments without foreign exchange
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controls, they can raise funds from local investors, including high net worth individuals,
onshore companies, government fund of funds (FOF), insurance companies and social
security funds, and they can speed up the transactions because they are not weighed down by
the baggage of foreign investment approvals. There are also disadvantages: the legal structure
is still unclear and foreign participation is still restricted, as is liquidity and exit strategies.
Moreover, the lack of mature local limited partners and their expectations of high yields are
limiting the development of RMB funds. Despite these uncertainties, the rapid development
of China’s economy and the need for increasingly diverse financing tools will ensure that
RMB funds will play an increasing role in the near future.
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Edward J. Epstein
Managing Partner - Shanghai Office
Tel: + 86.21.6133.8998
Fax: + 86.21.6137.8188
Email: edward.epstein@troutmansanders.com
Olivia Lee
Partner and Head of Greater China Practice
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Fax: +852.2533.7898
Email: olivia.lee@troutmansanders.com
William Liu
Associate - Shanghai Office
Tel: + 86.21.6133.8919
Fax: + 86.21.6137.8188
Email: william.liu@troutmansanders.com
Kim Tung
Associate - Shanghai Office
Tel: + 86.21.6133.8918
Fax: + 86.21.6137.8188
Email: kim.tung@troutmansanders.com
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