Guidelines for Trust Companies to Operate a Private Equity Investment Business in China

(iii)trust company.

Limited Liability Company

The “limited partners” of a private equity fund that is structured as a limited liability company become the equity holders of the limited liability company. The limited liability company engages a “management company” to manage the limited liability company's assets by investments in private companies. The primary disadvantage of the limited liability company is double taxation.

Partnership

A partnership generally consists of a general partner and a number of limited partners. The general partner assumes unlimited liability for the fund's debts and obligations whereas the limited partners assume limited liability. The advantage of a partnership is that it is treated as a pass-through entity for tax purposes. The disadvantage of a partnership is that a general partner shall assume unlimited liability should the partnership goes bankrupt. Although the Partnership Enterprise Law was recently amended to allow for the establishment of limited partnerships in China, we do not know yet whether the market will widely adopt a limited partnership as the preferred legal structure.

Trust Companies

A trust company manages a trust and investors who invest in the trust become beneficiaries of the trust. The trust plans are generally treated as pass-through entities for tax purposes with respect to profits. A trust company's operations are under the supervision of the CBRC. In order to address some insolvency concerns, assets of the trust are kept separate from the assets of the trust company.

Definition of “Trust Private Equity Investment”

The Guidelines define a “Trust Private Equity Investment” as a trust business whereby a trust company invests capital in:

(i) the equity securities of a private company,

(ii) the restricted shares of a listed company or

(iii)any other equity security approved by the CBRC.

The Guidelines clarify for the first time that, subject to government approval, trust capital may also be invested in the equity securities of overseas private companies.

Capital Requirement

Under the Measures for the Administration of Trust Companies, the principal capital of a trust company may only be invested in financial companies, financial products and fixed assets that will be used by the trust company. The Guidelines now clarify that the principal capital of a trust company may also be invested in the trust that is managed by the trust company. This change provides greater incentive for a trust company to maximise profits for the trust.

There are certain limits to principal capital investments. For example, the trust company's principal capital invested in trust plans cannot be more than:

(i) 20% of all assets under such trust plans or

(ii) 20% of the trust company's net assets.

Management Obligations

The Guidelines highlight the management obligations of trust companies by:

(i) requiring a trust company to exercise its equity holder's rights in its portfolio companies and

(ii) prohibiting the trust company's investment adviser from making investment decisions on behalf of the trust company.

Previously, the Measures for the Administration of Trust Companies allowed a trust company to completely entrust an investment adviser to handle the trust company's investment decisions. As a result, existing trust companies typically operate under two models. Some trust companies completely entrust its investment decisions and portfolio company management obligations to investment advisers. Other trust companies not only make their own investment decisions, but also appoint senior managers of portfolio companies and participate in the management of the portfolio company. We believe that the Guidelines encourage trust companies to take more responsibility in portfolio management. To such end, the Guidelines require each trust company to have a management team, with at least five people in charge of investments and at least three of whom must have at least two years experience in equity investments or a related field.

Investment Advisors

The Guidelines also set forth certain qualifications for investment advisers. An investment adviser must own at least 10% of the trust units of the trust and investment adviser must have at least Rmb20 million in paid-in capital. We believe the government hopes to motivate investment advisers to act as fiduciaries through such a requirement, while at the same time ensuring that the right and interests of the investors are protected. We believe that the Rmb20 million paid-in capital threshold is aimed at keeping smaller and perhaps less sophisticated investment advisers out of the market.

Lower Cost

The Guidelines also decrease operating costs. According to the Guidelines, a trust company may charge management fees and performance rewards for managing trusts. The draft version of the Guidelines that was circulated in March 2008 stated that the management fees must be no less than 1% of the total amount of capital in the trust. But the final version of the Guidelines does not contain this provision and instead allows trust company and its investors to negotiate the management fees.

Investments

The Guidelines set broad criteria for trust investments, including:

(i) the principal business and development strategy of the target company must conform to the government's industrial and environmental protection policies;

(ii) the target company must own a core technology or an innovative business model and have substantial growth potential; and

(iii)the target company must have no direct or indirect affiliation with any trust company or any affiliated party thereof, except for those who reported to the CBRC and made prior disclosures regarding such affiliation.

Conclusion

We believe that the Guidelines provide additional guidance on the operations of the trust companies engaged in the private equity investment business, which result in additional transparency for the domestic private equity industry in China. However, whether the trust company structure becomes the preferred legal structure for the domestic private equity industry is yet to be seen. For example, the China Securities Regulatory Commission does not currently allow a trust company to be a stockholder in a public listing candidate. As a result, a trust company would be required to restructure its investment prior to a portfolio company's proposed public listing, which would result in additional costs to the trust company.