New roads open for PE – but still a bumpy ride

Historically, offshore foreign currency funds were used by foreign private equity investors in China. For various reasons, including policies that discouraged the “round-trip” structure of Chinese ownership in foreign investing companies, offshore funds became less attractive.

Beginning in 2003, foreign investors could establish Foreign-Invested Venture Capital Enterprises (FIVCEs) to invest in unlisted high-tech enterprises in China. However, establishing a FIVCE involves initial regulatory hurdles and FIVCE investments remain restricted to the high-tech sector.

From 2009, Shanghai, Beijing, Tianjin and Chongqing permitted foreign investors to set up renminbi (Rmb)-denominated funds in these cities under local rules that specified establishment requirements and offered tax and other incentives. A number of Rmb funds were established in these cities following the introduction of these rules.

Administrative measures issued by the State Council in March 2010 explicitly permitted foreign-invested partnership enterprises (FIPEs) and provided for a simplified approvals process, requiring registration with the State Administration for Industry and Commerce (SAIC) and no approval from Mofcom. Following these administrative measures, foreign-invested Rmb funds proliferated.

Convertibility concerns

A concern for private equity investors is that the money invested by Rmb funds cannot be converted from foreign currency. Circular 142 issued by the State Administration for Foreign Exchange (Safe) in August 2008 stipulates that Safe approval is required for the conversion of any foreign currency invested by an equity investment enterprise. This particular Safe approval is not easy to obtain. This effectively restricts the funds that can be raised by foreign private equity investors to onshore sources, in the form of domestic partners.

The Measures seek to address this concern by establishing a process for approval of Foreign-Invested Equity Investment Management Enterprises (FIEMEs) and Foreign-Invested Equity Investment Enterprises (FIEIEs), and by permitting FIEMEs and FIEIEs who fulfil certain criteria to become “Pilot Enterprises” under the QFLP project.

The Measures provide for the convening of eighteen Shanghai-level government departments including the Shanghai Municipal Government, Shanghai FSO and Shanghai Safe, to oversee the project in a forum called the Joint Commission.

Approval conditions and procedures for FIEMEs and FIEIEs are set out in the Measures. FIEMEs are essentially foreign-invested private equity fund managers and may take the form of companies or partnerships. FIEIEs are foreign-invested private equity funds and may be partnerships.

The Measures prescribe the enterprise names, minimum registered capital (US$2 million for FIEMEs and US$15 million for FIEIEs), capital contribution schedules, permitted businesses and, with respect to FIEMEs, senior management and investor qualifications. The Shanghai Mofcom is responsible for approving FIEMEs in company form and the Shanghai AIC is responsible for approving FIEIEs and FIEMEs in partnership form. The Shanghai FSO must be consulted in all cases and is the competent authority for FIEMEs and FIEIEs.

Pilot Enterprises

To become Pilot Enterprises, FIEMEs and FIEIEs must be approved by the Joint Commission and fulfil the following criteria: minimum self-owned assets of US$500 million or assets under management of US$1 billion, sound governance structure and internal controls, no penalties imposed by judicial or other administrative authorities in the previous two years, at least five years' investment experience and any other conditions required by the Joint Commission. Additionally, the executive partner of a Pilot Enterprise must have at least three years' experience in direct or indirect investments in domestic enterprises in China.

According to the Measures, foreign investors of Pilot Enterprises will comprise mainly institutional investors such as foreign sovereign funds, pension funds, charitable funds, fund of funds, insurance companies, banks and securities companies.

Pilot Enterprises will be granted a quota of Rmb within which they can convert their foreign currency and utilise the Rmb for investments in China. The capital of the Pilot Enterprise will be maintained in a capital account with a custodian bank, which must be a domestic bank qualified to act as a custodian bank. Usage of the capital will be governed by regulations.

Impact of QFLP

According to media reports, an aggregate quota of US$3 billion has been earmarked for allocation to Pilot Enterprises in Shanghai. Applications for Pilot Enterprise status are expected after the Lunar New Year (February 3-8). A similar pilot scheme with reportedly the same aggregate quota is anticipated for Beijing.

By expressly permitting Pilot Enterprises to use foreign currency for domestic investments, the Measures provide a channel for foreign private equity to invest domestically without resorting to domestic limited partners such as China's national pension fund and local governments.

QFLP enables foreign-invested funds that qualify as Pilot Enterprises to invest in domestic enterprises by applying to the custodian bank for conversion of foreign currency within their quota for investment, although SAFE may yet issue separate regulations mandating its approval.

The Measures permit fund managers to invest in funds; specifically, FIEMEs that are Pilot Enterprises may use foreign currency to pay for subscribed capital in an equity investment enterprise provided the subscription does not exceed 5% of the total subscribed capital of the equity investment enterprise. This will not affect the original status of the equity investment enterprise, apparently permitting foreign-invested domestic funds.

Additionally, foreign-invested private equity fund managers can be established without the need to set up a fund in China immediately, yet eventually set up funds under the same Measures.

The pilot project is commonly compared to the Qualified Foreign Institutional Investor (QFII) scheme which permitted foreign investors to trade in domestic securities. It remains to be seen whether there will be a minimum and maximum quota that a QFLP may subscribe for under the scheme, as with QFII, or whether SAFE will impose additional conditions.

QFLP will generate more efficiency in the market for capital in China by providing private equity investors greater flexibility to deploy foreign currency for onshore investments. In this sense, QFLP is a breakthrough as it reduces fund managers' reliance on domestic limited partners while potentially speeding up the investment process.

Restrictions remain

Although apparently permitting investments in domestic funds, QFLP does not wholly overcome another major concern of foreign private equity investors, namely restrictions on particular industry sectors.

The Measures expressly state that investments by FIEIEs are subject to industry policies on foreign investment and FIEIEs specifically cannot invest in industries prohibited to foreign investors, stocks and bonds traded in secondary markets (except for shares listed in the FIEIE's portfolio), derivatives such as futures and non-proprietary real estate. They are also expressly prevented from investing using non-proprietary funds or providing loans or security. Accordingly, QFLP does not address a major problem facing private equity investors in China, which is a shortage of suitable investment targets.

It appears that, with each investment, a Pilot Enterprise must still go through the usual foreign investment approval and filing procedures, such as Development and Reform Commission (DRC) and Mofcom approval. The Measures provide that the equity investments of FIEIEs will be subject to the relevant laws, regulations and rules governing foreign investment and specify that the documents submitted by a Pilot Enterprise when reporting a domestic investment transaction to the Joint Commission must include documents issued by the local Mofcom at the location of the target.

Difficult exits

QFLP also does not resolve a perennial issue for private equity investors in China which is to secure a satisfactory exit. Well-timed and profitable exits are crucial to private equity investors because of their impact on the internal rate of return of a fund.

So far the most popular route for private equity investors is an initial public offering (IPO) of the investments of the fund, as opposed to obtaining a secondary buyer for the investments.

The Hong Kong Stock Exchange (HKSE) is the obvious choice; however listing on the HKSE involves a pre-process of restructuring and due diligence that some mainland Chinese companies may find daunting. The establishment of the ChiNext board in Shenzhen in November 2009 was intended to create a further option for public listing. To encourage ChiNext listings, requirements were made less stringent than those of the main board in Shenzhen and the Shanghai Stock Exchange. The performance of stocks on ChiNext has however been criticised. Price-to-earnings ratios on ChiNext are extremely high compared to Shenzhen's main board and its small-to-medium enterprises board, yet financial performance of entrants following listing has been patchy. Some commentators remain doubtful as to the longer-term ability for ChiNext stocks to generate returns. Since a 12 month lock-up applies to a pre-IPO investor, a private equity investor could face a year-long period of uncertainty following the IPO.

Platform for secondary trading

Recently, an interesting exit alternative presented itself in the form of a potential secondary trading platform.

In November 2010, China Securities Regulatory Commission introduced regulations permitting the trade of private equity funds on the Beijing Financial Assets Exchange (BFAE). The BFAE was established in June 2010 chiefly to create a market for the trade of non-performing State-owned assets.

The recent regulations made the BFAE the first and only market for trading in private equity funds. The regulations are not publicly available and are issued only to BFAE members and trading participants, but it is believed that the regulations focus on the trade of direct interests in investments as opposed to interests in funds.

Transfers of equity interests will still be subject to any relevant contractual restrictions in the fund's investment documents, but as an exit strategy, this could be less time-consuming than an IPO. As the BFAE is a relatively new exchange, it remains to be seen how successful it will be in facilitating trade of private equity investments and whether any other exchanges will follow suit.

Geraldine Johns-Putra, Minter Ellison, Hong Kong