Why PE funds need to file

At present, most established domestic PE funds are not subject to any supervision by PRC authorities. As a result, regulating and monitoring these operations becomes critical. The new Circular aims to enforce and strengthen the regulation of PE funds after their establishment. This includes fundraising activities, asset custodians and continuous information disclosure and reporting.

In China, the establishment and operation of PE funds involves various authorities, including the NDRC and the Administration for Industry and Commerce (AIC). If the funds have a foreign investment element the Ministry of Commerce, the State Administration of Foreign Exchange and possibly relevant local financial offices also come into play. The new Circular may be an indication that the NDRC is attempting to be the leading regulator (if not the sole regulator) for the PE industry in China.

Mandatory filing

Historically, filing with the NDRC was voluntary until Circular 253 required the PE funds established in six pilot areas to file with the Commission. However, funds can only receive investment from the National Social Security Fund (NSSF) when they have filed with the NDRC. Despite this incentive, very few PE funds have done the filing. It is reported that only 23 funds have filed with the NDRC before the issue of the new Circular. Since early 2010, the NDRC even suspended filing in practice.

All PE funds have to now be filed with the NDRC or the local authorities designated by the provincial governments (normally the local counterpart of the NDRC) within one month of completion of the AIC registration. No PE fund is exempted from the filing unless: the fund is registered as a venture capital investment enterprise; or the fund is established by one entity or individual, or by one entity and its wholly-owned subsidiary, or by two or more entities that are wholly-owned subsidiaries of one entity.

The new Circular also requires that previously established PE funds or fund management enterprises (FME) must apply for filing within three months of the issue of the new rules. Depending on capital size (including the actual paid-in capital and the subscribed capital), the fund must file with the NDRC if its capital reaches or exceeds Rmb500 million, or file with the relevant local authority if its capital is below Rmb500 million.

Self-managed funds should carry out the filing procedures in their own name. If the fund is entrusted to an FME, then the FME should carry out the filing. FMEs are also obliged to make an additional filing with the NDRC for themselves. According to the checklist provided in the new Circular, FMEs have to file fewer application documents than funds.

Number of investors

The new Circular summarises that a PE fund may be set up in the form of a limited partnership enterprise, a limited liability company or a joint stock company, and reaffirms that the maximum numbers of investors for these three forms should be consistent with the relevant laws, namely 50, 50 and 200, respectively.

PE funds can only raise funds from qualified investors who have risk identification and tolerance capacity. Solicitation to the public through the media or other methods is strictly forbidden. Investors can only use legally acquired cash to make capital contributions to the fund. Fund-raisers must fully disclose the investment risks to the investors, and are prohibited from guaranteeing repayment of principal and/or payment of return.

Circular 253 and the new Circular both fail to define qualified investors or set out any specific threshold for investors. A guideline issued by the NDRC suggests that each investor should contribute no less than Rmb10 million to the fund. An investor contributing less than Rmb10 million may be deemed unqualified. The NDRC Guideline has no mandatory legal effect. However, the funds that do not fully comply with the NDRC Guideline run the risk of failing to file with the NDRC.

To ensure compliance with the investor qualification requirement, the new Circular unprecedentedly imposes a look-through mechanism for counting the number of investors. This means that, if the investors are unincorporated institutions (such as trusts and partnership enterprises), the ultimate investors above such unincorporated institutions should also be examined and counted as investors to the relevant fund. In other words, the qualification requirement for investors of a PE fund would also apply to all such ultimate investors (even though they do not directly invest in the fund).

However, the look-through requirement has an exception. If the unincorporated investor is a fund of funds (FOF), the look-through examination is not applicable. The Circular is also silent on what fund can be deemed as an FOF. The NDRC Guideline does say that an FOF may be held to be one investor if the FOF is set up and managed by professional management institutions; the FOF's investors meet the investors' qualification and number requirements as provided in the new Circular; and the FOF has completed the filing in accordance with the new Circular.

Risk control

Several restrictions in the new rules minimise the risks that PE funds may encounter after establishment, including:

(1) the capital of the fund cannot be used to provide security for any other entity unless it is a portfolio company invested by the fund;

(2) the fund may only invest in non-listed equity. Spare cash is only permitted to be deposited with banks or used to purchase treasury bond or other fixed-return investment products;

(3) the fund shall adopt a related-party abstention system for its investment decision-making, and such a system should be provided in the fund's constitutional documents;

(4) constitutional documents of a fund or FME should include the performance incentive plan and risk control mechanisms; and

(5) unless all the investors have unanimously waived it, the fund must entrust an independent custodian institution to safeguard the fund's assets. If the FME of a fund is a foreign invested enterprise, the assets of such a fund must be entrusted to an independent custodian institution with the status of an independent legal person in China.

Responsibilities

An internal management team, its general partner or a separate FME through a management agreement can manage a PE fund. In China, a general partner often entrusts an FME (either a related party to the general partner or not) to operate and manage the fund. Under the new regulations, the FME must perform its management duties in accordance with the management agreement, including managing its portfolio investment, disclosing operational information to the fund and preparing financial reports periodically.

In order to deal with conflicts of interest, the Circular requires that an FME must equally prioritise the management of assets of different funds and must open separate accounts for different funds. The investors may dismiss the FME if the FME ceases to have the management capability or has materially infringed the investors' interests.

Information disclosure and reporting

PE funds are to disclose their investment operation information to the investors in accordance with their articles of association or partnership agreements. PE funds must also submit their annual operational reports and annual audited financial reports to the filing authorities (the NDRC or local filing authorities) within four months of the end of each financial year. The FMEs and custodian institutions must also submit annual asset management reports and asset custodian reports to the filing authorities within the four-month period.

For any major events to the PE fund (such as amendments to the articles of association, partnership agreement or fund management agreement, capital increase or decrease, debt financing, merger or split, changing the FME or custodian institution, or liquidation or dissolution of the fund), the fund must report to its filing authority within ten working days of such an occurrence.

Penalties for non-compliance

If a fund or an FME fails to file as required, the relevant filing authority may order it to apply for filing within 20 working days. If it still fails to apply for filing, the authority may announce on its website that this fund or FME has circumvented filing supervision.

Similarly, if a fund or an FME fails to comply with any operational requirements as provided in the new Circular, the filing authority may order it to have the issue rectified within six months. If it still fails to do so, the authority may announce on its website that this fund or FME does not comply with operational and management requirements.

Defects and limitations

These changes clearly show that the NDRC wants to tighten the administration and supervision of the PE industry in China. However, the filing, asset custody and reporting requirements provided in the New Circular are imposed only after the establishment of the funds. Once the funds are established, their fund-raising activities should have already been completed or close to completion. If one of the NDRC's intentions is to prevent illegal fund raising by PE funds, then the post-establishment filing and other supervisions as prescribed in the New Circular may not be as effective as expected.

The look-through method may help the NDRC to examine the qualifications of all direct and indirect investors and thus prevent circumvention of the investors' number and qualification requirements. However, following the look-through investigation, funds whose participants are private banks, trusts or other financial products collecting money from a large pool of individual investors will be heavily affected, as their end investors may hardly satisfy the investors' number and qualification requirements of the PE funds. This obstacle may increase the fund raising difficulty for PE funds this year, setting aside the cooling-down of the macro-economy itself. People are particularly concerned about the impact on real estate PE funds, as their investments often come from trusts or partnerships and thus the look-through investigation may hinder their fund raising.

In practice, the absence of the definition of FOFs may give rise to uncertainty and the discretion of the authorities to grant exemptions. Without implementing rules, it may be difficult for the NDRC to enforce look-through, especially if the upstream investors involve foreign entities or individuals. It is rumoured that the implementing rules will be issued soon, which it is hoped will address all or some of these issues.

Nominal penalties?

The NDRC would only order funds or FMEs to rectify their non-compliance within a period of time and in the worst case publish their names on the NDRC's website as non-compliance entities.

In China, the Administrative Punishment Law prescribes that only laws, administrative regulations and local regulations are empowered to impose administrative penalties. Since the new Circular was issued by the General Office of the NDRC, its legal ranking is too low for it to impose any substantial sanctions. It may be difficult for the NDRC to enforce compliance. The PRC government needs to issue higher-ranked laws to regulate the PE industry.

The Circular does encourage funds to file for certain reasons. Firstly, completion of the NDRC filing will qualify the fund to be a candidate for the NSSF's investment (such investment is reported to be Rmb7 billion in five funds in 2011). Secondly, the fund may promote its reputation and brand after completing the public filing. Another practical consideration is that a filed fund will possibly confront less challenges and doubts from the local authorities. Especially during its daily operation or when it makes downstream investments.

Tight timeframes

Some localities (such as Tianjin, Beijing and Shanghai) have set up a filing system pursuant to Circular 253. However, most other localities have not. Even some local authorities themselves are not fully aware of the filing requirements and procedures. Implementation of the new Circular may take a while to be in place (particularly without the implementing rules).

Comprehensive reporting may facilitate the NDRC to closely monitor and supervise the PE funds and FMEs. However, one criticism is that the periodical reporting requirement is too burdensome and the timeframes for filing and reporting are too short.

To date, many PE funds in China have not set up a sophisticated disclosure and reporting system. It also takes time for funds to prepare financial reports. As such, preparing and submitting documents to the filing authorities may not be achievable within the prescribed timeframes. Statistics published on the website of the NDRC show that as of January 21 2012, only 14 funds have filed with the NDRC since the promulgation of the new Circular. It will be interesting to see if this number rises at the end of the year.

Ji Zou and Hua Wei, Allen & Overy, Shanghai