Making it official

Risk of fraud in China’s private equity industry has caught the government’s attention. China’s National Development and Reform Commission (NDRC) has even publicly said that the industry’s rapid growth has resulted in “illegal fundraising and undisciplined operational behaviour”.

One example is suspected fraud at a fund in Tianjin, which had raised about RMB1.6 billion (€189 million; $251 million) from more than 5,000 people across the country, according to local reports.

Funds could collapse, leading to social unrest. To protect investors, the NDRC issued a landmark notice in December.

Known as “The Notice on Promoting the Disciplined Development of Equity Investment Enterprises” it extended rules nationally that previously only applied to six jurisdictions, becoming China’s first nationwide private equity law.

The notice requires all private equity funds in China (regardless of size) to register with the government. It also set new guidelines on private equity fundraising and the operation of funds.

A major takeaway of the notice is the adoption of the “look-through” principle.

Private equity funds are legally obligated to keep the number of investors below fifty. According to the new rule, when an investor is a pooled fund trust, a partnership enterprise or other non-legal person institutions, the “look-though” principle will be applied to check whether the natural persons or legal person institutions investing through such entities are qualified investors, and then to make sure the fifty-investor limit has not been exceeded (fund of funds investors are excluded from this principle).

The notice also defines a qualified investor as someone who is capable of identifying and tolerating the risks involved in fund investing.

“The general idea is to [protect] those unqualified people who do not have much money or who pour all of their savings into this high-risk industry [which can potentially trigger] social problems,” says Jia Yan, a Shanghai-based partner at law firm Paul Hastings. “That’s something the NDRC and central government are really concerned about.”

Because the “look-through” principle requires examining and calculating the ultimate investors, it would actually preclude a lot of individual investors making commitments through trust, according to Helen Jiang, a Shanghai-based counsel at law firm Weil, Gotshal & Manges.   

Another facet of the notice is the emergence of the NDRC as the country’s top regulator of private equity with the ability to promulgate national rules.

“Until now, the Chinese private equity industry has depended on self-regulation, and it hasn’t been clear to investors where to take their complaints or even who the regulator is,” Jiang says. 

“This notice is important partly because it makes it crystal clear that the NDRC is that regulator and will be going forward.”

But in reality, the notice may not live up to intentions. Industry insiders told PE Manager that in practice not many firms have made necessary recordals to the NDRC since the previous notice (which applied to six provinces) was issued in January 2011. And it’s hard to see whether this time would be different, as the “penalty” for funds that fail to do so only means their names will be published on NDRC’s website.

“The effects of the rule may be muted because the regulatory framework needs to develop further to foster a stronger compliance culture among Chinese fund sponsors,” says John Fadely, partner and head of funds practice for Asia at Weil.

Many private equity firms are taking a wait-and-see attitude due to the lack of clarity and slow implementation. After all, the government moves far slower than the booming private equity industry. 

A few high profile domestic fraud cases could change that.