Venture Capital Update: What Is Really Going On?

Given the clear failure of the MOFTEC Rules to achieve their objective, an intensive effort has been underway since the end of last year to redraft the rules. It is hoped by those close to the discussions that are being conducted by the various ministry-level agencies that new rules will be published in the next few months. Legal and investment communities will be most interested to see how the taxation issue is treated in the anticipated new rules.

Opportunities for Fund Management Do Exist

What is really of interest to fund managers, at least to fund managers in Hong Kong and Taiwan, would be the chance to manage the huge pools of domestic money available for investment in China by local governments funds and companies. What are the options? Below are some possibilities and comments on their feasibility.

Employment by the Fund

If an individual fund manager is willing to receive payment in renminbi it would be an option to be directly employed by the fund. With the approval of the local labor bureau, the manager could convert his or her renminbi income into foreign currency and remit it outside China. However, in the event that such approval is not obtained, receiving only unconvertible renminbi would not be a very attractive prospect for a highly paid overseas professional.

Management by an Offshore Company

Contract management has a long history in China. Hotels, for example, have long been operated under management contracts, and one of my clients once ran a semiconductor plant under this arrangement. While a management contract requires approval of the local authorities, with the right connections, approval from the local authorities is possible.

Offshore Funds

One option is to see if the Chinese fund can obtain hard currency to establish funds in Hong Kong using PRC money. Government-related entities, in particular, may have access to foreign exchange, and be willing to deposit them in Hong Kong in funds that can attract matching contributions from foreign investors for investment in their localities. At least two funds backed by local governments in China are in the process of being formed using this model. The funds are to be managed by management companies registered in Hong Kong and owned jointly by the PRC party and the offshore party. There are plans to list the funds on the Hong Kong Stock Exchange, thus hopefully attracting additional offshore investment. The goal of the funds is to use the proceeds for investment in state-owned companies (SOEs), to effect turnarounds and make the SOEs profitable businesses able to stand on their own and compete effectively in a developing market. If such funds are able to acquire controlling stakes in relatively healthy companies and to have a comparatively free hand in directing management personnel and policies, these funds have some chance of success, although foreign investors may not find them the most interesting of investment possibilities. As long as state policy remains one of reducing support to state-owned companies, funds used for this purpose under this model are likely to be tolerated by the central government.

It might be, however, that the PRC fund is not a SOE-turnaround fund, does not have close relations with local government, or simply does not have foreign exchange available to move into the offshore fund. In this case, the best strategy would be to form an on-shore management company under which the foreign party receives management and performance fees from the PRC fund that can be distributed as dividends, to the extent they constitute profits, in foreign exchange.

MOFTEC Rules

Before looking at what the better alternatives may be, let us take another look at the MOFTEC Rules as they currently stand. These rules clearly contemplate a partnership-type structure in which one of the offshore investors is a manager that contributes only a small amount of capital. Article 5.1 of the MOFTEC Rules enumerates the criteria that must be met by foreign investors to a foreign-funded venture investment enterprise. Among other criteria, Article 5.1 states that at least one foreign investor in a fund must have managed at least US$100 million over the previous three years, but may contribute only 3% to the capital of the fund, which is an amount typically invested by the general partner of a US-style fund.

This is a good start, until Article 5.2 is considered. It is stated here that at least one foreign investor must invest at least US$20 million in the fund, and if there is only one foreign investor, it must satisfy the criteria in both Article 5.1 and 5.2. Therefore, the minimum contribution by a foreign fund manager seeking to manage an onshore fund is US$20 million, unless it can find a co-investor to put up such amount. This is a very high entry fee and makes the MOFTEC Rules an unattractive option for most offshore funds to use them as a vehicle for fund management.

Fund Manager Formed under Local Rules

The MOFTEC Rules are not the only regulations in China relevant to venture capitalists. In October 2000, a year before MOFTEC came out with its provisions, Shenzhen issued the Interim Provisions of the Shenzhen Municipality on Venture Capital Investment in the High and New Technology Industry (the Shenzhen Rules). The Shenzhen Rules specifically permit the establishment of wholly owned or joint venture management companies by foreign funds. The barriers to entry are not very high. The minimum registered capital is Rmb1 million, the fund manager must have a good reputation and employment record, and the professionals should possess a venture capital investment qualification that is approved by the venture capital investment professional association (the Shenzhen Rules are unclear if this means in China or in their home jurisdiction, but in either case it would not be a big problem for legitimate fund managers). While, as the title suggests, venture funds formed under the Shenzhen Rules may only invest in the high-tech area, there is no explicit limitation on what funds may be managed by management companies formed under the Shenzhen Rules.

Although still uncommon, at least one Shenzhen joint venture fund manager has been established by a foreign fund and a fund in Shenzhen. In addition, leaders of the Shenzhen venture capital community have indicated that a few other management companies have been formed by offshore funds, including some from the US and Taiwan.

A joint venture fund management company formed under the Shenzhen regulations is not limited to making investments within Shenzhen. Domestic venture capital companies in Shenzhen are investing all over China, and there is no regulation that says a joint venture or wholly foreign-owned fund management company in Shenzhen cannot do the same thing. Indeed, Shanghai lawyers have informed me that there would even be no impediment to forming a Shanghai branch office of the fund and operating there, or anywhere else in China.

In the unlikely event that investment outside the local area becomes an issue with the authorities, an investor or fund manager could expand their horizons outside of Shenzhen to a certain extent by forming a fund and investing in Zhuhai and Guangzhou, relying on venture capital regulations that were issued by those local authorities in June and September 2001, respectively, and that contain similiar provisions on management companies as the Shenzhen Rules. Given the trend, other localities may come up with similar rules in the future.

Another set of local legislation, Regulations on the Administration of Registration of Companies in the Zhongguancun Science and Technology District (the Beijing Rules) were issued by Beijing Municipality in March 2001. They do not mention fund management companies, and even though venture capital companies set up under these rules can manage other funds, the registered capital must be at least Rmb10 million. While radical in their explicit mention of the use of limited partnerships as investment vehicles, the Beijing Rules have also failed to achieve their goals and have rarely, if ever, been used.

Shanghai has had new venture capital rules in the works for many months, but still there is no sign of their promulgation. With new MOFTEC regulations imminent, the Shanghai authorities are probably playing a wait and see game to see what is actually contained in the national regulations.

Parallel Funds

One of the possibilities opened up by the new local venture capital rules is a parallel fund structure. Under this arrangement, the joint venture fund manages a domestic renminbi fund, and the foreign partner manages an offshore fund. By a contractual arrangement between them, the PRC and offshore parties agree to pool the profits from the two funds. If the offshore fund is more profitable than the domestic fund, the PRC party is paid its portion of the profits in foreign exchange. If the PRC fund earns more, then the profits are reinvested in China until the renminbi becomes convertible (unless the PRC fund has access to foreign exchange or another conversion method can be activated). The PRC party gets the opportunity to invest offshore without having to use difficult-to-obtain foreign exchange, and can train its staff in international investment practices by working closely with the experienced foreign professionals.

Even before the promulgation of the new local venture capital rules, it would have been possible for a domestic fund and a foreign fund to contract to share profits as described above. However, with a joint venture fund management company, and therefore the funds under management, controlled by the foreign party, the foreign fund can rest more easily with the knowledge that the contracts will indeed be honoured. The PRC party, on the other hand, always has recourse to suit outside China if the foreign party breaches the agreement.

Parallel fund structures are not just figments of the imagination of creative lawyers and bankers, but have in fact been set up by some PRC funds and their overseas partners.

Joint Venture Consultancy Companies

Contrary to the position of the central government, local authorities have been willing to approve applications for companies that engage in fund management if they are called "consulting companies". In some cases, local approval has even been obtained for companies called fund management companies even though under the old investment guidelines fund management was on the restricted list of industries and should therefore have required approval from the central government.

Under the new Foreign Investment Industrial Guidance Catalogue (外商投资产业指导目录) (the Catalogue) that became effective on April 1 2002, the establishment of foreign fund management companies under the joint venture laws has been eased is several ways. First, the wording of the relevant restricted industry category has been refined to read "securities investment fund management companies" (zhengquan touzi jijin guanli gongsi), as opposed to "fund management companies" (jijin guanli gongsi). Arguably, the restriction is limited to funds managing investments of listed securities only. Furthermore, the annex to the Catalogue,² following the WTO Protocol, permits even securities investment fund management companies to be 33% foreign owned after December 11 2001, and 49% foreign owned by December 11 2004. In addition, in the new Catalogue, authority for approving restricted industry investments has now been delegated to provincial level authorities as long as the proposed amount of investment is within the amount that can be approved at the provincial level.

As a result of these changes, it has now become easier for local authorities to approve a joint venture fund management company formed under the joint venture laws, without reference to the venture capital regulations. Just as in the case of management contracts with renminbi funds and offshore funds using PRC money, this is more likely to happen where the local government is itself putting up the funds and is looking to the foreign party for management expertise. If the foreign party is also willing to invest some matching funds, the chances for approval will be even greater.

At least one PRC local authority is working with a Hong Kong party to form a joint fund and a joint venture fund manager in the PRC. Both of these entities are being formed under the equity joint venture laws. As with the offshore funds discussed above, the goal is to support struggling state-owned enterprises, and if this is the case, approval of the local authority is likely to be obtained and the central government should tolerate the arrangement. However, the possibility that other funds with the right connections could use this approach also exists.

Conclusion

While all onshore fund management company strategies set out above are currently being pursued by various groups, it must be borne in mind that none of them are free from risk. Following the usual way of doing things in the PRC, as long as the government is willing to tolerate or even encourage these activities, they will be allowed to continue. However, if national rules conflict with local rules, the national rules win out. As such, there is always the possibility that the central government could decide that the Shenzhen Rules and other local rules permitting fund management companies are contrary to the MOFTEC Rules as long as the MOFTEC Rules remain in their current form. If this were to happen, fund management companies established under the local rules could be closed down by the central government.

Similarly, fund management companies that violate, or are declared by the PRC authorities to violate, current rules are at risk of being sanctioned by MOFTEC and SAFE with the result that dividends and other flows of capital back to the foreign party could be blocked. There are clearly many grey areas in the above discussion, such as whether a management company set up under the Shenzhen Rules can operate in Shanghai as a branch, whether a consulting company can manage a fund, and whether parallel fund contracts violate national policy. Any fund contemplating using these structures to manage PRC money must weigh the potential gain against the risk. But as long as the fund is not putting up much of its own money, the risk may be bearable.

So what are the best options? Of course, it depends on the circumstances.

Is the fund manager a small player willing to take a risk? If so, then a branch of a company formed under the Shenzhen, Guangzhou or Zhuhai rules, or a joint venture consulting company would be appropriate. Both of these routes will require approvals to form the company, and the branch, and what is possible in practice and what can be done in theory will rapidly become apparent as approvals are obtained or denied. But of course, getting the company formed would only be the beginning.

Is the fund willing to put up US$20 million of its own money for the chance of managing a larger pot of renminbi funds? If so, maybe the MOFTEC Rules make sense; at least one fund is pursuing this course of action, although approval has not yet been obtained.

How about a large fund? As was said above, revisions or clarifications to the MOFTEC Rules should be out soon and the outlook for large funds could change completely as a result. So, stay tuned.

Endnotes

1 The rules were promulgated by the Ministry of Foreign Trade and Economic Cooperation (MOFTEC), along with the Ministry of Science and Technology and the State Administration for Industry and Commerce.

2 The annex has information on 10 encouraged and 12 restricted industries in China. The annex borrows heavily from the Protocol of Accession, which formed one of the key documents governing China's membership in the WTO. Thus many of China's commitments to the world trade body regarding the opening of domestic industries and services to foreign investment, including geographical limits, quantitative restrictions, business scope, shareholding percentages and progressive access schedules, are all included in the Catalogue. The inclusion of fund management companies in the annex, and the timeline for access to the industry with ownership percentages, is generally seen as a progressive step showing the government's commitment to opening key services to foreign participation.