Study: RMB funds 'less flexible'

RMB-denominated funds are following an evolutionary path different from their USD counterparts, one with fund terms more reflective of China’s nascent private equity industry, according to a new study.

The limited partnership agreements of RMB-denominated funds are “less flexible and diversified” in certain areas than those of USD funds, according to a new study from the China Venture Capital and Private Equity Association (CVCA).

Local rules and regulations, as well as China’s relatively nascent private equity industry, largely account for the differences, said Larry Sussman of law firm O'Melveny & Myers, which worked in partnership with the CVCA in studying RMB- and USD-denominated funds closed between 2007 to 2011. 

For example, only one-fifth of RMB funds studied offered investors any type of side-agreement, which typically provides large LPs preferential terms or treatment. In contrast 61 percent of USD funds carried such arrangements. 

Other differences relate to ‘key-man’ clauses – which offer LPs suspension rights upon the exit of certain senior GPs – with almost half  (47 percent) of RMB funds omitting this type of provision. In comparison all USD funds studied included a key-man clause as part of its limited partnership agreement. 

“Some of the RMB funds have experienced frequent staff turnover this year, which has sounded the alarm for the arrangement of a key-person provision,” the study noted. 

A third difference discovered is fewer RMB funds require a preferred investor return before the payout of carried interest. Only one-fifth of RMB funds require this hurdle rate whereas 68 percent of USD funds did so. 

China’s private equity industry is still playing catch-up to international best practices, said Sussman. “Fund agreements are extremely complicated in the international space, having evolved over so many years”, he said, adding the limited partnership vehicle itself was only introduced in China a few years back.  

Domestic regulations have also shaped differences between the two fund types. More RMB funds require investors to pay capital up-front, as opposed to as investments are made (as is standard practice in USD funds) on account of certain local rules which make immediate capital drawdowns difficult for some LPs. Sussman explains certain state-owned enterprises would need to “go through cumbersome procedures to meet an immediate capital call”.

Despite these differences, the study discovered a number of similarities between USD and RMB funds. GPs’ own capital contributions, long seen by investors as a way of aligning interest, was for both fund types typically in the 1 to 1.5 percent range of total capital commitments. A large majority of both fund types also provided GPs with carried interest in the 15 to 20 percent range of fund profits. 

Late last year the CVCA released a code of conduct calling for member firms to “abide by the best practices of international VC/PE industry”.