China's Revised Venture Capital Rules: Limited Partnerships with Chinese Characteristics?

February 28, 2003 | BY

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Rules on foreign-invested venture capital enterprises were promulgated in 2001, but fell considerably short of expectations. New rules in this important area have recently been issued. Have they overcome the limitations of the prior rules?

In August 2001, China released foreign investment rules intended to encourage foreign sponsors to form China-based venture capital funds. These rules (the 2001 Rules) imposed many non-market restrictions on fund formation and operation and were not successful in attracting investors to China.1 China revised those rules recently. We assisted in drafting the revised rules, entitled Rules on Administration of Foreign-invested Venture Capital Enterprises (the 2003 Rules), which overcome many of the prior barriers to onshore fund formation.

The 2003 Rules are officially targeted at "venture capital" sponsors and investors. However, because permitted investments are not limited to pure venture capital start-up situations, we believe the 2003 Rules can also be used by most private equity sponsors.

The 2003 Rules were published on February 18 2003 and bring the structure and operations of a Chinese private equity fund (referred to as Foreign-invested Venture Capital Enterprises) far closer to international norms. If the anticipated tax clarifications described below are issued, we believe that there are practical solutions for most of the issues that remain. Sponsors and investors will, however, have to accept that the Chinese government requires more disclosure about fund organization and maintains more control over the investment process than is the case in most other jurisdictions.

Summary of Improvements

Major improvements made by the 2003 Rules are summarized below. Although we describe the changes in international terms that are the functional equivalents of the concepts used in the 2003 Rules, readers should bear in mind that neither the 2001 Rules nor the 2003 Rules speak in terms of general or limited partners or partnership agreements.

  • The 2003 Rules clarify that a fund requires only one general partner. (The 2001 Rules seemed to require both a Chinese general partner and an offshore general partner.)
  • The 2003 Rules make it clear that the experience-related qualifications for a fund general partner may be satisfied by the general partner or its affiliates. (The 2001 Rules did not offer this flexibility.)
  • The 2003 Rules clearly recognize that a fund may be managed on a day-to-day basis by a fund manager under separate contract. (The 2001 Rules did not recognize the role of a separate fund manager.)
  • The 2003 Rules appear to provide total flexibility to call capital on an "as-needed" basis over an investment period that may be as long as five years, and to permit unused commitments to be released at the end of the investment period. (The 2001 Rules required all committed capital to be contributed over a three-year period.)
  • The 2003 Rules reduced the general partner contribution requirement from 3% to 1%.
  • The only capital requirement for a limited partner under the 2003 Rules is a capital commitment to the fund of at least US$1 million. (The 2001 Rules required all foreign investors to commit at least US$10 million and to have one or more foreign investors who would commit at least US$20 million.)
  • The 2003 Rules eliminate the requirement that each investor submit its audited financials as part of the approval application package.
  • The 2003 Rules permit a fund to return capital to its investors as investments are liquidated. (Under the 2001 Rules, express regulatory approval was required for any return of capital.)
  • The 2003 Rules only require reports to Chinese regulatory authorities as to "fund raising and fund utilization". (The 2001 Rules seemed to require broad performance-based reports.)
  • The 2003 Rules permit the admission of new limited partners and transfer of limited partnership interests without further governmental approvals if the original approved fund agreement provides for such actions. (Neither was provided for under the 2001 Rules.)
  • Under the 2003 Rules, the minimum aggregate committed capital for a fund is only US$10 million. (The 2001 Rules imposed a minimum requirement of US$25 million.)
  • The 2003 Rules do not establish a minimum foreign investment level in a portfolio company and require only notification of MOFTEC for investments in the "encouraged" and "permitted" industry classification. (The 2001 Rules required prior MOFTEC approval for all fund investments and implied that a fund had to provide at least 25% of the total equity of a portfolio company in the absence of other foreign investors.)

The foregoing summary (and the remainder of this article), applies only to funds organized as "Non-legal Person Cooperative Joint Ventures"

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