Structuring RMB Fund in China

Steven Wei [email protected]

Structuring RMB-denominated Private Equity Funds in China and Recent Regulatory Development

Hong Kong May 2011

Guo Lian PRC Lawyers国联律师事务所

mailto:[email protected]

What is a RMB-denominated Private Equity Fund?

• A RMB-denominated private equity fund (RMB Fund) is an onshore fund raised in RMB for private equity investment in China. This is a concept as opposed to the China-focused fund established overseas and denominated in a foreign currency.

• In general, a RMB fund can be a pure domestic fund without participation of foreign investment, or such a fund with foreign investment.

• This seminar focuses on the RMB fund with foreign investment.


Increasing Interest in RMB Fund

• Attracted by rapidly growing economy, global PE firms view China as their primary market. According to EMPEA, US$38.1 b have been raised globally by PE firms targeting China investment from 2005 to 2010. In 2010, China-targeted PE firms raised about US$7.1 b globally for China investment, an increase of over 16.1% on 2009, recovering to almost half of the peak level in 2008. The figure in India is only US$ 2.4 b, down 30% from 2009.

• Before 2008, raising of China-targeted fund was dominated by international firms with dollar-denominated funds. China-targeted transactions involving international funds were done mainly through offshore deals. Typically, offshore funds acquire directly China assets through complicated structures and exit mainly through offshore listing or sale.

• From 2006, the interest in RMB funds rises fast. In the recent two-three years, the fundraising market has witnessed a drastic shift from global US$ fund to onshore RMB fund.

• Currently, many international PE firms are setting up onshore entities and raising local capital to invest in China.


Increasing Interest in RMB Fund (Cont)

• In China, the number of RMB fundraising cases has been climbing up fast since 2006, contrasting the down trend of the number of US$ fundraising. In 2010, for example, 217 RMB funds have completed fundraising, whilst only 23 foreign currency funds raised fund.

• In terms of the volumes, the VC fund in RMB grows fast, overtaking foreign currency fund in 2009. The PE funds fluctuate, but the RMB fund (VC and PE funds) recovers quicker from the global financial crisis than the foreign currency fund does and it is catching up.

• The trend continues in Q1 2011 and the dominant position of RMB fund is further enhanced. 29 funds completed fundraising in Q1 2011, of which 26 or 89.7% are RMB funds. RMB funds totally raised US$3.99 b which is 92.3% of the total raised fund.




Source: Zero2IPO

VC Fundraising in RMB and US$ for 2006 - 2010

1092.18

2341.22

3567.26

6867

4392.8

4968.85

2288.6

4302

773.77

3199.35

12

29

88 84

146

29 28

10 12

27

2006 2007 2008 2009 2010

RMB(US$ M) USD(US$ M) RMB Numbers USD Numbers

Nnmber ofNew lyraised US$Funds

Number ofNew ly raisedRMB Funds


Guo Lian PRC Lawyers国联律师事务所Source: Zero2IPO

PE Fundraising in RMB and US$ for 2006 - 2010



1720.77

4487.18

23669.22

12295.26

1754516449.35

36575.8

44793.85

6608.6

21245

2006 2007 2008 2009 2010

RMB (US$ M) USD (US$ M)

PE/VC Fundraising in RMB and US$ for 2006-2010



RMB, US$3.35.b,92.3%

Foreign Currency,US$0.26 b, 7.7%

RMB, 26, 89.7%

Foreign Currency, 3,10.3%

2011Q1 PE/VC Fundraising Cases and Volumes in RMB and Foreign Currency



China: 2008Q1-2011Q1 PE/VC Fundraising Cases and Volumes

3,038.45

592.21

1407.9

985.5

1386.211664.13

1820.022059.25

2341.99

2014.89

3359.02

4752.86

2,271.50

42

21

2932

45

31

50

33

26

1916

24

29

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

08'Q1 08'Q2 08'Q3 08'Q4 09'Q1 09'Q2 09'Q3 09'Q4 10'Q1 10'Q2 10'Q3 10'Q4 11'Q1

0

10

20

30

40

50

Amount (US$M) Number of new fundrasing cases



2008Q1-2011Q1 Investment Cases and Volumes

1,308.82

973.49

819.9

1,587.18

749.92804.07 830.57

989.08

1483.59

1928.41

1254.95

1,108.26

1659.33

132

221221

152146

119

60

153

232

182

140

209

166

0

400

800

1,200

1,600

2,000

08'Q1 08'Q2 08'Q3 08'Q4 09'Q1 09'Q2 09'Q3 09'Q4 10'Q1 10'Q2 10'Q3 10'Q4 11'Q1

0

50

100

150

200

250

Amount (US$M) Cases

Why RMB Fund?

• Driving forces behind the interest in RMB Fund: - The difficulties in implementing company inversion transactions caused by PRC regulatory

restrictions. This is a common structure that enables offshore funds to acquire offshore entities established by the company founders for holding and operating domestic assets. From 8 September 2006, the Chinese regulators tightened control on roundtrip investment, which made it difficult to implement the company inversion transaction. The difficulties have put the structure under great uncertainties, and make some offshore funds move onshore.

- Intensive competition from domestic funds. A large number of domestic funds and government-sponsored funds have been established by well-trained local PE professionals. These funds enjoy significant advantages over the “offshore funds”, because of their legal status, culture closeness, connection, etc. They have become strong competitors to the international funds in the China market.

- Access to domestic LPs. One of the most important reasons for establishing a RMB Fund is that it can raise local capital. Currently, NSSF, insurance fund, government guidance funds, fund of funds, enterprise funds, high-net value individuals and industrial funds are the main LP groups, creating huge pool of capital seeking high-return investment. Potentially, local social security funds, commercial banks, security companies and enterprise annuity funds will join. NSSF has over RMB800 b to invest in PE. Regulators approved allocations of as much as 5% of insurance companies’ assets to PE investments, creating a potential pool of US$30b capital.


Why RMB Fund? (Cont)

- Closer to deal sources. China hosts attractive deal flow. In 2010, 817 PE investments of the total value of US$ 5.4 b were reported in China. Q1 2011 sees 232 PE investment cases with the total value of US$1.93 b, making the 8th consecutive growth quarter since 2009. Amid the strong performance of the domestic IPO market and the competition from domestic funds, high quality enterprises gain strength in selecting investors. They prefer onshore funds and local teams as it makes domestic listing relatively easier, if they plan to list in China. In practice, a domestic exit plan often gives onshore fund a better chance to invest, and those planning to exit overseas tend to seek offshore fund investment. In Q1 2011, for instance, 20 PE exits through NYSE and NASDAQ listings are all offshore funds, and the rest 90 PE exits from domestic markets are all onshore funds.

- Development of domestic capital markets In 2010, among the total 476 Chinese enterprise IPOs which raised US$105.4 b,

221IPOs or 46.1% were backed by PE/VC investors. Among the 221 IPOs, 72 were listed overseas and 149 were listed in China. ChiNext, launched in late 2009, and SMEB together hosted 54% of the 221 PE/VC- backed IPOs in 2010. ChiNext led the ROI list in 2010, making an average ROI of 12.13X. The higher P/E ratios traded in domestic markets also offer the onshore PE investors higher return;

- Government encouragement policies, etc.


Why RMB Funds? (Cont)


PE/VC-backed Chinese Enterprises IPOs (2006-2010)

Source: Zero2IPO

Why RMB Funds? (Cont)

Average ROI of VC/PE-backed Chinese Enterprises in 2010

by Listing Markets ________________________________________________________________________

Markets Listing Markets ROI (X) ________________________________________________________________________

Domestic Markets Shanghai Stock Exchange 7.08

ChiNext 12.13

Shenzhen SMEB 9.38

Average 10.40

________________________________________________________________________

Overseas Markets HK Main Board 1.64

NASDAQ 2.81

NYSE 5.17

Average 3.50

Note: ROI= (Number of Pre-IPO shareholding*IPO price-amount of total investment)/amount of total investment

Source: CVSources


Who Have Established RMB Funds in 2010?

Some RMB Funds Launched by International PE/VC Firms in 2010

___________________________________________________ Foreign Investors Fund Name Date Scale Location

(RMB100M)

______________________________________________________________________________

Carlyle Carlyle-Fosun RMB Fund 2010.2 6.60 Shanghai

IDG Capital Harmony Edge 2010.4 35.00 Beijing

Investment Centre

DT Capital DT Venture Capital 2010.4 2.50 Chongqing

Centre

Sequoia China Sequoia Venture 2010.4 1.00 Zhuhai

Capital Centre

Prax Capital Prax Tianjin RMB Fund 2010.5 6.00 Tianjin

TBG TBG Growth Fund 2010.6 5.00 Dalian

Carlyle Beijing RMB Fund 2010.7 24 Beijing

TPG TPG China Partner 2010.8 50 Shanghai

TPG TPG China West Development 2010.8 50 Chongqing

CLSA CLSA Guosheng RMB Fund 2010.6 100 Shanghai

First Eastern China-UK Fund 2010.11 33 Beijing

Source: Zero2IPO


Evolving Regulatory Landscape

• China is lack of a national-level legal framework governing PE fund, which have slowed down the development of regulations, making it the top market barrier to international investors.

• PRC Securities Law (2005) - The law prohibits public offering of securities unless approved by CSRC;

- “Public offering” is defined as (i) offering to non-specific offerees; (ii) issuance to over 200 specific persons; (iii) any other issuance as specified by laws or regulations.

• PRC Partnership Enterprise Law (2006) - The law applies to foreign-invested partnerships. Together with the special

regulations on foreign-invested partnerships, it offers the basic legal framework for limited liability partnerships (LLP), a popular form to organize a fund;

- Enterprises or individuals are permitted to set up LLP with partners between 2 and 50 with at least 1 GP.


Evolving Regulatory Landscape (Cont)

• Provisional Measures on Administration of Foreign-invested Venture Capital Investment Enterprises (MOFCOM and 4 other regulators 2003)

- Foreign investors are allowed to set up venture capital investment enterprises (FIVCIE) in the form of non-legal person cooperative joint venture or limited liability company, and investment management enterprises in the form of limited liability company or LLP;

• Provisional Measures on Administration of Venture Capital Investment Enterprises (NDRC and 9 other regulators, 2005)

- The Measures apply to venture capital investment enterprises in China. Qualified VC firms are required to file for recordation on a voluntary basis with the NDRC after the establishment.

• Administrative Measures for Foreign Enterprises and Individuals to Establish Partnership Enterprises(the State Council, December 2009)



- foreign investors are allowed to directly establish foreign-invested limited liability partnerships (FILP);

• Administrative Provisions of Registration of Foreign-Invested Partnership Enterprises (the SAIC, January 2010)

- rules on how to establish, change and deregister a FILP;

• Local regulations in Beijing, Shanghai, Tianjin, Chongqing and other cities

- local legislations or policies on establishment of equity investment fund (EIF) and equity investment management enterprises (EIME), and encouraging policies;

• Details on Implementing the Pilot Program of Foreign-invested Equity Investment Enterprises (Shanghai Financial Service Office, 2010)



- requirements and procedures for setting up private equity investment enterprises and private equity investment management enterprises, and provisions related to a qualified pilot program in Shanghai;

• Tax clarification for FIVCIE (SAT 2011 Announcement 2)

- flow-through tax treatment previously granted under Guoshuifa[2003] No.61 to non-legal person FIVCIE seems no longer available;

• Rules Punishing Illegal Public Fundraising Activities (SPC, 2010)

- certain activities of illegally raising capital targeting non-specific members of public are criminalized and punitive;



• Circular on Further Regulating the Development and Filings of Equity Investment Enterprises in Pilot Regions (NDRC, 2011)

- the Circular, among other issues, requires qualified equity investment enterprises (EIE) and some equity investment management enterprises (EIME) in six pilot regions be filed with the NDRC or a locally designated authority. On 21 March 2011, the NDRC issued 11 guidelines to guide the filing.


Options for RMB Fund - FIVCIE

• Foreign-invested Venture Capital Investment Enterprises (FIVCIE)

- It is the earliest form of onshore foreign-invested private equity fund;

- A FIVCIE is allowed to invest in the equity of unlisted high-or-new-tech enterprises established in China.

- A FIVCIE can be organized in either incorporated or unincorporated form. The unincorporated FIVCIE is of no legal-person status. It is often an onshore Sino-foreign cooperative joint venture (CJV) set up by foreign GP/LP and domestic LPs based on contractual arrangements. CJV is generally considered as a preferred form of FIVCIE as it offers greater flexibilities for arrangements among investors comparing to the incorporated form.



Options for RMB Fund – FIVCIE (Cont)

Offshore

Onshore

FIVCIE Management

Co/Partnership

PortCo A

Investment in ForEx

Typical FIVCIE Structure

GP

PortCo N

SPVs

LPs

RMB Fund (CJV)

PortCo B …...

Domestic LPs

Offshore Fund

Management Agreement

Investment in RMB

Investment in RMB

Dividends in RMB

Dividend in ForEx

Fund Manager

Investment in ForEx

Return + Carried interest in ForEx

Return in RMB

SPVs

Investment in ForEx

Return in ForEx

Options for RMB Fund - FIVCIE (Cont)

• Key requirements

- Main business is to invest in equity of unlisted “high or new tech enterprises” and provision of related services;

- To form a FIVCIE, investors must apply for approval from MOFCOM (who will consult with MOST) before registering the FIVCIE with SAIC;

- Minimum capital requirements are US$5 m for incorporated and US$10 m for unincorporated;

- FIVCIE must have at least 1 qualified mandatory investor undertaking to contribute no less than 1% of the capital of an unincorporated FIVCIE and assuming joint liabilities with the FIVCIE, or at least 30% of the registered capital of an incorporated FIVCIE;

- At least 3 professionals each with at least 3 years experience in venture capital investment, unless the FIVCIE engages a management enterprise for its management;

- Business operation term for FIVCIE: maximal12 years in principle.



• Qualifications for the mandatory investor

- Main business must be venture capital investment;

- Managing assets of the value of at least US$100 m and US$50 m already invested in the most recent 3 years;

- Having no less than 3 professionals with at least 3 years experience related to venture capital investment;

- No history of suspension from venture capital investment or being punished for fraud;

- No less than 1% capital contribution to an unincorporated FIVCIE or 30% contribution to an incorporated FIVCIE;



• FIVCIE Management Enterprise

- Foreign investors are also permitted to set up a FIVCIE Management Enterprise in the form of a company or a limited partnership; Key requirements for a FIVCIE Management Enterprise include:

△ at least 3 professionals with minimum 3 years experience in venture capital investment business;

△ having capital of no less than RMB1 m or in equivalent foreign exchange;

△ having adopted a sound internal control system;

△ main business of a FIVCIE Management Enterprise is managing a FIVCIE and providing consulting services.



• A FIVCIE can

- invest with its own fund;

- raise both domestic and foreign fund;

- provide management or consultancy services to portfolio companies; and

- provide investment consultancy services to other funds.

• A FIVCIE cannot

- lend fund or guarantee any lending (except investing in bond or convertible loan issued by the portfolio companies);

- invest in the business prohibited for foreign investment;

- invest in listed corporate stocks or bonds; and

- invest in real estate not for self-use.



• Issues commonly seen as pros and cons of a FIVCIE

Pros

- relatively established regulatory framework;

- an onshore entity that can raise both domestic and foreign fund;

- conversion of foreign exchange capital into RMB for equity investment is permitted;

- injection of capital into FIVCIE may be made in accordance with the progress of the investment plan within 5 years from the registration date, longer than other types of FIEs;

- MOFCOM approval power is delegated to its provincial counterparts for establishing FIVCIE with total capital under US$300 m;

- investment by FIVCIE needs to file only with MOFCOM office at the location of the portfolio company, provided the investment projects fall into the “encouraged” or “permitted” industry categories. Otherwise, portfolio investment has to be approved by provincial-level MOFCOM. Processing of the filing will be shorter than direct inbound investment.



- FIVCIE may be qualified for deduction against its taxable income at 70% of its equity investment amount on the third year after holding the equity of qualified portfolio companies;

- FIVCIE Management Enterprises are allowed to establish either in the form of a LLP or a company to manage multiple FIVCIEs, which may help foreign investors to diversify revenue streams;

- FIVCIE Management Enterprises organized as a LLP may still be tax transparent, etc.



Cons

- FIVCIE’s portfolio investments are limited to high or new tech enterprises;

- establishing FIVCIE needs approvals from both MOFCOM and MOST;

- to be qualified as the mandatory investor of FIVCIE, a number of minimum thresholds must be met;

- portfolio investments are subject to investment restrictions generally applied to foreign investment;

- unable to provide debt financing (except legally issued corporate bond) or hold other non-self-use assets in its own name;

- pass-through taxation may no longer be available for unincorporated FIVCIE;

- compared to offshore deals, some well-developed incentive measures for company founders are unclear under PRC laws (earn-out, share options etc.)


Options for RMB Funds – Equity Investment Fund

• International PE funds may also establish or invest in EIMEs and EIFs in the regions where local regulations permit so.

• Many regions, such as Beijing, Shanghai, Tianjin, Chongqing, Suzhou, Shenzhen have issued local policies or regulations to facilitate setting up EIFs or EIMEs.

• The local regulations normally provide for various encouragement policies, and certain specific requirements and procedures guiding the establishment of EIFs and EIMEs. A few of them, however, address specifically how a foreign investor can participate in a RMB Fund.

• At some cities, such as Beijing, Tianjin, Shanghai, Chongqing, regulations expressly permit foreign investors to set up foreign-invested EIMEs;

• International funds often set up an EIME at a preferred region to raise capital from local LPs to set up an EIF. The EIME acts as an onshore GP, and to offer management services to the EIF. In some regions, an offshore GP may not be prohibited from sponsoring an onshore EIF.


Options for RMB Fund – Equity Investment Fund (Cont)

• From March 2010, foreign investors can organize an onshore EIF or EIME in the form of FILP (where the local regulation permits FILP as a corporate form). FILP offers foreign investors a platform to arrange onshore fund structure and profit distribution similar to other major jurisdictions, in particular FILP affords investors the flexibility to structure their interest-sharing arrangements without any linkage to their capital contribution share;

• Establishing a FILP does not need approval from MOFCOM, but it remains lack of unified rules as to whether establishing an investment FILP would need approvals from other governmental authorities, especially on local levels;

• Main drawbacks with FILP: (i) foreign exchange conversion (no rules have been issued regarding FILP’s settlement of foreign exchange under its capital account.) This has raised concerns under Huifa [2008]142 and Huizongfa [2008]125); (ii) national treatment of portfolio investment from RMB Funds (MOFCOM Shangzihan [2011] 72 clarified the investment of FILP whose primary business is “investment” must comply with laws and regulations governing foreign investment and be subject to MOFCOM’s approvals); (iii) No regulation addresses how a foreign corporate limited partner be taxed in China. 10% or lower withholding tax rate may apply to non-resident corporate taxpayer on income.



Offshore

Onshore

GP LPLPs

EIME Co/Partnership

PortCo A

Investment in ForEx


SPVs

RMBFund

PortCo B PortCo N…...

Domestic LPs

Management Agreement Investment

in RMB

Investment in RMB

Investment in ForEx

Dividends in RMB

Return in ForEx + Carried interest

SPVs

EIF Structures

Return in RMB

Dividends in ForEx

Investment in ForEx

Offshore Fund

Services, Fee and Return


• Incentive Measures from Local Governments

- To attract PE investors, various incentive measures have been issued in a few regions in China. The local rules and policies prescribe some incentive measures for EIFs and EIMEs as well as the qualifications for enjoying the incentives. Common incentive measures include financial subsidies, office purchase or renal subsidies, paid tax refund for both corporate and individual income tax, incentive reward linked to fundraising, etc.

- The EIFs and EIMEs must meet the qualifications set out under respective local regulations to qualify for these incentive measures.



EIF Qualifications for Incentives under Some Local Regulations (RMB m)_______________________________________________________________ Beijing Tianjin Shanghai Chongqing (Haidian Dist.)______________________________________________________________ Minimum committed 100 100 100 100capital

Minimum initial 20%+5ys 20% 20% 50%payment 15%+3yr(FIEs)

Minimum per investor n/a 1 5 n/a

Filing FSO/NDRC NDRC/ FSO/NDRC FSO/NDRC local filing office_________________________________________________________________Some other requirements may also apply, such as the EIF must have made the first investment in the region before applying for the incentive treatments; the sponsor of the EIF must be primarily engaged in PE business; the EIF must have established a sound internal management system; its registered capital has been paid up; etc.



Key EIME Qualifications for Incentives under Local Regulations (m) _______________________________________________________________ Beijing Tianjin Shanghai Chongqing (Haidian Dist.)_______________________________________________________________

Minimum reg. RMB10 (Dom.) RMB1(LLC) RMB1(LLC) RMB1(LLC) cap US$ 2 (FIE) or RMB5(JSC) or RMB5(JSC) or RMB5(JSC) or US$2(FIE)Minimum initial 20%(dom.) 100% 20% 20%payment 5% (FIE)_________________________________________________________________



• Below are some representative examples of the incentive measures:

- Tianjin: business tax (2yr exemption and 3yr half), corporate/individual income tax refunds; office purchase of rental subsidies; EIF is entitled to 60% of the locally-retained portion of the income tax paid on the profit of exit from a Tianjin investment.

- Shanghai Pudong: to the EIFs that purchase or lease an office property in Lujiazui or Zhangjiang, the government provides1.5% of the purchase price or RMB500/sq m/yr as financial subsidy to the purchase or rental.

- Beijing: an one-off subsidy of RMB 500k or RMB800k to the EIFs investing in Haidian District of the size over RMB100 m or above RMB500 m; a 3-year office rental subsidy available to EIFs and EIMEs ranging between 200 and 500 sq m.

- Chongqing: EIFs full exemption of business tax for the first 2 years from establishment date and 50% business tax for the subsequent 3 years. Full refund of the local-retained portion of the paid corporate income tax for the 2 years from the first profit year; 50% refund of the same tax for the subsequent 3 years; Individual income tax refund to senior management; Office rental or property purchase subsidies; partnership level tax transparency, etc. are also available.



- Shanghai Pudong: members of senior management of qualified EIFs or EIMEs are entitled to refund of 20%-40% of the local-retained portion of the paid individual income tax refund. A RMB5 m or RMB10 m one-off subsidy offered to EIME, if it raises fund over RMB1 b or RMB3 b, etc.



The Shanghai Pilot Program

• Several Shanghai municipal authorities jointly launched the foreign-invested private equity investment pilot program (Pilot Program) on 11 January 2011 by issuing Details on Implementing the Pilot Program of Foreign-invested Equity Investment Enterprises.

• Highlights of the Pilot Program:

- it sets out the requirements and procedures for setting up a Foreign-invested Equity Investment Fund (FIE EIF) and Foreign-invested Equity Investment Management Enterprises (FIE EIME) (Note: tentative rules for setting up FIE EIME in the Pudong area already expired in 2010);

- a FIE EIME is expressly permitted to sponsor a RMB Fund as a GP, and to contribute up to 5% of the fund size in free-convertible foreign currency to the fund on meeting some qualifications;

- a special status known as Pilot FIE EIF and Pilot FIE EIME is introduced to free some restrictions on foreign exchange conversion;

- a FIE EIF must engage a qualified local custodian bank to supervise its fund operation.


The Shanghai Pilot Program (Cont)

• Recent development: The Shanghai Financial Service Office has received a number of pilot EIF applications, among which Carlyle, Blackstone and DT Capital have been approved as such and Carlyle and Blackstone each obtained a foreign exchange quota of US$100 m.



Offshore

Onshore

GP LPs

FIE EIME Co/partnership

PortCo A PorCo B PortCo N…...

SPVs

RMB Fund

Domestic LPsManagement Agreement

Investment in RMB

Investment in RMB

Dividends in RMB

5% capital contribution in

RMB

A Structure under the Shanghai

Pilot Program

Return in RMB

Investment in ForEx

Dividens in ForEx

Return on investment in ForEx

Investment in ForEx

SPVs

?? ??



• FIE EIME

- FIE EIME is a management company or a partnership whose main business are:-

△ sponsoring private equity funds as a GP; △ managing the investment of private equity funds and providing related

investment services; and △ providing consulting services to private equity funds. - FIE EIME must receive capital of no less than US$2 mil; - at least 1 investor or its affiliate, as the case may be, is in the business related

to “equity investment” or “equity investment management”; - FIE EIME must have at least 2 senior management personnel of the

experience, including over 5 years in private equity investment or private equity investment management business; over 2 years in a senior management position; working on China-related private equity investments or with China’s financial institutions etc.



• FIE EIF - A FIE EIF is an enterprise established by foreign enterprises or individuals as

partnerships or other organisational forms, whose primary business is to make equity investments in non-listed companies. In specific, a FIE EIF can carry out the following business:

△ investing with its own capital in private equity to the extent permitted by laws; and

△ providing management consulting services to its portfolio companies. - FIE EIF cannot △ invest in prohibited industries for foreign investment; △ invest in public securities or corporate bonds in the secondary market; △ invest in futures or other financial derivatives; △ invest in real estate except for self-use purpose; △ invest with capital other than capital contributed by investors to the fund; or △ lend capital or provide security.



- Investors of FIE EIFs are required to contribute no less than US$15 m in cash, with the contribution of each LP being no less than US$1 m.

- Foreign investors are permitted to make their capital contributions with freely convertible foreign currency or with legitimate RMB revenues or earnings generated in China, while domestic investors may only contribute RMB.

• Pilot FIE EIF Enterprises - A Pilot EIF Enterprise is a special status granted to some qualified FIE EIMEs

or FIE EIFs. - To qualify, following requirements must be met: △ a foreign investor of the FIE EIF or EIME must, among others, either own

US$500 m or more in assets or have US$1 b assets under its management in the fiscal year prior to application;

△ investors must meet other qualitative conditions on governance structure, internal control, compliance, experience and other conditions required by the Joint Conference, a joint administrating organ of Shanghai.



△ Main foreign investor(s) must be either of (i) offshore sovereign-wealth funds; (ii) pension funds; (iii) endowment funds; (iv) charitable funds; (v) fund of funds; (vi) insurance companies; (vii) banks; (viii) securities companies; or (ix) other foreign institutional investors recognized by the Joint Conference.

△ One of the notable clarifications under the Pilot Program is that a Pilot FIE EIME can make foreign exchange capital contributions as a GP to an RMB fund up to 5 per cent of the fund size and such a contribution will not affect the (domestic) nature of the relevant RMB fund. If the fund has foreign LPs, it may not benefit from this treatment.



• Outstanding issues

- How the FIE EIF and FIE EIME will be treated in practice outside Shanghai? If a RMB Fund established in Shanghai with the investment of a Pilot FIE EIME wishes to invest in an industry restricted or prohibited to foreign investment outside the city, does the fund be treated as pure domestic fund?

- One of the key obstacles for operating a FIE EIF has been foreign exchange restrictions, especially after the State Administration of Foreign Exchange (SAFE) Circular 142, which prohibits the conversion of foreign exchange into RMB for equity investment purpose by non-investment FIEs. SAFE has not issued rules on FILP foreign exchange issues. It remains unclear under the Pilot Program whether and how a foreign LP in a Pilot FIE EIF is able to convert capital into RMB.

- It is not clear if a foreign entity or an EIME established outside Shanghai can act as a GP to a RMB Fund in Shanghai.

- There is no details on the “qualifications” of a custodian bank nor guidance as to how to exercise the custodian functions.

Case Study – Blackstone Zhonghua Development Investment Fund


Blackstone Zhonghua

Dev. Investment

Fund

PortCo B PortCo NPortCo A

Blackstone Zhonghua Development Investment Fund GP

Blackstone Zhonghua Development Investment Fund LPs

HK Management CoHK Holding Co

Management Co

Blackstone onshore GP

Domestic LPs

Management Agreement

Advisory Services

Filing with the NDRC

• What is NDRC Filing? NDRC allows qualified VC funds to file with it or a locally-designated authority the information such as its articles of association; investors information, senior management information, information on its management firm, management agreement, etc.

• Why File? - not a compulsory requirement, but some domestic LPs such as insurance institutions,

NSSF government guidance funds etc. require the filing when committing fund. It is also a requirement for the fund to enjoy incentive measures available under some local regulations.

• Who can File? - an onshore established VC funds of the committed capital over RMB30 m; - the VC fund has less than 200 investors in total or 50 investors for a fund organized as a

limited liability company, with each investor committed no less than RMB1 m; - the VC fund has at least 3 professionals with at least 2-year experience in VC investment

appointed as its senior management. • Who must File? - PE funds or FoFs (and their EIMEs) registered in Beijing, Tianjin, Shanghai, Jiangsu

Province, Zhejiang Province and Hubei Province must file with the NDRC with committed capital over RMB500 m or its foreign exchange equivalent, and paid-up capital over RMB100 m;

- each investor to the PE fund must commit capital of no less than RMB10 m.


Filing with the NDRC (Cont)

• Exemption from the filing requirement

- the fund is a VCIE or a VCIME that are already filed in accordance with an applicable regulations with a compatible authority; or

- all its capital is contributed by one institutional or individual investor, or by two or more investors that are wholly-owned subsidiaries of the same institutional investor.


Exits

• RMB Fund achieves exits from portfolio companies mainly through IPO and secondary or trade sales. Very little reported exits are through management buyback.

• In many instances, PE/VC investments are made with an exit plan in mind. Exits from domestic or overseas markets require both investors and the investee to structure the investment carefully to facilitate the exits.

• Capital markets are the main route to exits. Strong investor interest in Chinese IPOs across the globe offers higher return and wider exit options. In 2010, 221 VC/PE backed IPO exits were announced, of which 72 were in overseas markets and149 were in domestic markets. The total number of PE/VC-backed IPOs and domestic IPO respectively raised 187% and 217% on the basis of 2009. ChiNext provides investors with an average IPO P/E rate of 69.85X and attractive ROI.

• China is also a leading M&A market in the world. In 2010, 4,251M&A deals of the value of US$ 200 b in China were announced, reaching record high both in both number and value. Almost 580 M&A deals involve PE funds in China. The deal flow created huge opportunities for PE funds.

• PRC listing - Issues to consider: (i) queuing for CSRC’s approval will be time consuming; (ii) the Chinese listing rules are less transparent and volatile, thus the result and process of approval are uncertain; (iii) following-up financing from the capital market may be more difficult and time-consuming; (iv) it may be difficult for a domestic issuer to conduct international M&A without seeking approval from the Chinese authorities in the future expansion; (v) a PRC listing will be subject to PRC laws and regulations, which prohibit foreign investor from entering into certain sectors; (vi) withholding tax may be applied to foreign investor on capital gains or dividends, etc.

• Exit from PRC listings - Key requirements


Exits (Cont)


Shanghai/Shenzhen Stock Exchange ChinNext

Minimum operating history

3 years 3 years, no material change with the main business and the management and no change with the control

Minimum pre-IPO capital

RMB30 m RMB30 m

Minimum post-IPO capital

RMB50 m RMB30 m

Minimum profitability of the issuer

1. Profitable for 3 continuous financial years prior to the public offering and accumulated net profits RMB30 m after deducting any non-recurring gains;

2. Accumulated net cash flow for the past 3 financial years RMB50 m or business revenue of RMB300 m; and

3. Positive earnings for the year prior to public offering.

1. Profitable for 2 continuous financial years prior to the public offering and having accumulated net profits RMB10 m after deducting any non-recurring gains; or

2. Having business revenue of RMB50 m for the 2 continuous financial years prior to the public offering, net profit of RMB5 m for the year prior to the public offering and business revenue grows at over 30% for the past two financial years.

Assets before IPO Intangible assets of the issuer constitute no more than 20% of its net assets in the most recent balance sheet and positive earnings.

Over RMB 20 m in net assets and positive earnings.

Minimum public holding after IPO

25% or 10% if the capital is RMB400 m or above. The controlling party must be unchanged for the past 3 years.

25% or 10% if the capital is RMB400 m or above.

Business continuity Core business, board and management must be with no material change during the past 3 years. The controlling party must be unchanged for the past 3 years.

Core business, board and management must be with no material change during the past 2 years. The controlling party must be unchanged for the past 2 years.

Lock up period 36 months for controlling shareholders, de factor controlling party, promoters for a FIE issuer; 12 months for other restricted minority shareholders. Pre-IPO investors(12 m before prospectus publication) are subject to 36 months lock-up period.

36 months for controlling shareholder or de factor controlling party; 12 months for other restricted shareholders. Pre-IPO investors(6 m before CSRC submission) are subject to 12 months lock-up period and no more than 50% transfer within following 24 months.

• China presents a unique set of challenges for global PE firms. Among the challenges, understanding its rapidly evolving regulatory landscape perhaps tops the list.

• The maturing local PE firms and the state-sponsored investment funds caused intensive competition on high-quality deals and increasing valuation in some industries and some regions.

• Facing increasing competition from domestic funds and higher regulatory barriers on offshore deals, China-focused funds need to consider forming onshore investment entities to meet the market need and to mitigate the challenges.

• Given lack of a national legal framework and China’s rigid control on influx of foreign capital, it is natural that international fund managers will face some grey areas when forming onshore funds and operating them, as regulation is developed slower than the market grows. It is important to stay within the legality margin before circumvent some market barriers.


Closing Remarks

• The current measures from the central government fighting the speculative money obviously are not in concert with many local governments’ efforts of welcoming foreign fund investment. The direction, however, is clear China needs the innovative power from international investors to help it to achieve transformation of its economic development model.

• Many local governments continue encouraging international funds to set up local fund and invest in their regions, and are ready to provide needed resources. Structuring the investment in line with the local rules and policies may not only entitle the local fund to incentives but also help overcome some legal barriers.

• China’s 2nd and 3rd tier cities or mid west regions may be considered by foreign fund managers to set up RMB Fund and look for investment opportunities.


Closing Remarks (Cont)

Thank you

Steven Wei SU Email: [email protected] Tel: +86 13552639569 +86 1051660506-123

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Economy & Finance

Structuring RMB Fund in China