The walls are coming down

The rules governing foreign private equity investment into China are notoriously strict. However, the arrival in June of the Shanghai Pudong New Area policy indicates some barriers are coming down. Hubert Tse reviews the new policy and the improving prospects for foreign private equity firms in China.

In June this year, the Shanghai government issued the Trial Measure for the Establishment of Foreign-invested Equity Investment Management Enterprises, which allows foreign private equity and venture capital firms operating in the Shanghai Pudong New Area to register as equity investment management enterprises. The Chinese government aims to attract more foreign capital and expertise to the country with this new policy.

Currently, foreign private equity and venture capital firms have to set up a consulting company in China (which cannot provide investment management-related consulting services under Chinese law), and/or a representative office (which cannot carry on business/profit-making activities and can only carry out liaison work for its parent company). The consulting companies and rep offices are typically used to source deals and carry out investment appraisal/research in China, while deals would be done and funds invested into Chinese targets from the GPs’ offshore vehicles – approval by the Chinese Ministry of Commerce (MOFCOM) is required for such investments.

Under the new policy, foreign private equity and venture capital firms are required to have registered capital of at least $2 million to set up the onshore private equity management entity. The $2 million has to be paid up within two years, with at least 20 percent of the amount to be paid up within three months of the enterprise receiving a license. The entity must be set up in the form of a company and not a limited partnership.

To control financial risk, the policy stipulates that such enterprises must have at least one shareholder who has private equity investment experience. Each enterprise needs to have at least two executives with more than two years of experience in private equity investment or private equity investment management. These executives should also have more than two years of experience in a senior managerial role.

The new equity investment management enterprises can carry on investment-related consulting businesses in China. Having a Chinese entity participate in the domestic market could enable foreign firms to raise their profiles in the country and gives them more opportunities to work with their domestic counterparts. Given the $2 million registered capital requirement, it is expected that larger private equity and venture capital firms will have a deeper interest in this new policy.

Shanghai is the first Chinese city to implement such a policy and it will be valid for 12 months. It follows a guideline issued by China’s State Council in March, aimed at developing Shanghai into a global financial and shipping centre by 2020. The guideline gave the city priority to carry out financial innovation as well as other preferential policies.

Via this new policy, the Shanghai government hopes to further attract private equity capital and talent to Shanghai Pudong to achieve its goal of positioning itself as the private equity hub of China. In doing so, it is competing with Beijing, Tianjin, Shenzhen and Hangzhou. Media reports since June would indicate the policy is finding some success: a number of foreign private equity firms have set up RMB-denominated funds in Shanghai since implementation, although it is not clear whether such set ups are equity investment management enterprises or other wholly-Chinese owned entities.

What the new onshore management entity can do

The new policy is encouraging news for foreign GPs looking to further tap the Chinese private equity market, although currently the new entity is only permitted to engage in equity investment management services under the new rules. In other words, foreign private equity firms are not yet allowed under the new policy to set up a RMB fund and raise funds from onshore Chinese LPs via this entity, nor can they use this entity to make investment in Chinese targets outside the application of Chinese foreign investment laws which require MOFCOM approval for all foreign investment in China including private equity investment in Chinese companies.

Even though the one-page policy does not expressly permit foreign private equity firms to raise funds from domestic LPs and/or to invest in Chinese targets, Shanghai officials have indicated that it may be possible for equity investment management enterprises to qualify as domestic GPs, enabling them to form onshore RMB funds by raising money from Chinese LPs in the future, although further guidelines on this are still to come. This is positive. However, the jury is still out on when the rules will actually come out (it could take months or years) and whether all the talk and expectations will eventuate in the form of official laws and regulations in the end which would finally allow foreign private equitys to invest in China with more convenience and flexibility. Challenges include foreign exchange, tax and foreign investment law issues and obstacles needing to be resolved by the Shanghai government, MOFCOM, SAFE and the tax authorities.

What foreign private equity firms are doing now in China

Long and uncertain approval processes and restrictions on investments in certain industries are one hurdle facing foreign private equity firms. Another has been limitations on their onshore presence and their inability to raise funds in Chinese RMB. The pilot scheme to allow foreign firms to establish a proper onshore presence has been taken as a sign the Chinese government is now warming to the idea of opening up its private equity industry.

However, in keeping with its customary caution, China appears to be leaving everything open to discussion and it will be sometime before the full implications of the policy are known. For now, what is clear is that foreign firms have a window of opportunity to the end of June 2010 in which they will be allowed to establish “equity investment management enterprises” in the Shanghai Pudong New Area to manage equity investments.

Furthermore, taxation and repatriation issues will need to be addressed and dealt with together with other details in future policy/regulations in order for foreign firms to assess how to/whether to set up such an onshore private equity entity to tap the Chinese market.

Looking ahead

Until more details further to the pilot policy are issued by the Shanghai government in the near future, foreign private equity firms will continue their China private equity investment using their offshore vehicles, which require MOFCOM approval, and must also wait – and hope – for SAFE approval before funds can be injected into the Chinese target subject. Some private equity firms have onshore joint venture set ups with Chinese partners and some have in place a Foreign-invested Venture Capital Investment Enterprises (FIVCIE).

The FIVCIE is currently the only legally-prescribed wholly-foreign owned entity which foreign GPs can use to invest in Chinese companies without MOFCOM and SAFE/foreign exchange approvals after the FIVCIE is approved to be set up. New rules were issued earlier this year to enable FIVCIEs with registered capital under $100 million to only seek approval from provincial and local governments – Beijing MOFCOM approval will no longer be required.


FIVCIEs can be set up in the form of a non-legal person (partnerships) or incorporated as a company (limited liability) under the 2003 FIVCIE regulations. The minimum registered capital for a corporate FIVCIE is $5 million while it’s $10 million for a non-legal person FIVCIE. The primary investor in a corporate FIVCIE is required to contribute at least 30 percent  of the total registered capital while the non-legal person FIVCIE only requires the primary investor to contribute 1 percent  of the registered capital.

FIVCIEs can be wholly-foreign owned or a JV FIVCIE (Sino-foreign FIVCIE) can be set up together with a Chinese partner. Often the Chinese partner in such an FIVCIE is government-backed and the result would be good deal flow and co-investment opportunities from the Chinese partner. Furthermore, if the FIVCIE is established here in Shanghai, a branch can also be set up by this FIVCIE in Beijing/Shenzhen or elsewhere in China – this entity can be used to carry out deal sourcing, due diligence, investment appraisal and other activities given China is a vast country.

It is also worth mentioning that the FIVCIE is a unique private equity entity in that it is the only entity in China which can accommodate both onshore and offshore GPs and LPs, although FIVCIEs should only invest in high-tech and high growth unlisted companies – such definitions (set out in the FIVCIE’s constitutional documents) and to what extent they can invest in other companies are subject to the discretionary interpretation of the relevant approval authorities.

Conversion of FX into RMB by foreign GPs relaxed

At the time of writing this article, there’s talk that the Shanghai Pudong government and SAFE have reached an agreement to permit GPs formed in Shanghai Pudong to automatically convert foreign currency into Chinese currency for investment in their own RMB funds.  Up until now, the ability of foreign GPs to make financial commitments to an RMB fund has been prevented by SAFE’s Circular 142. 

The waiver would apply to up to one percent of total capital commitments to a fund.  The GP commitment to a fund – viewed as a vital aspect of GP/LP alignment – is generally in the range of 1 to 2 percent of the total capital raised.

If and when this proposed policy takes effect, it remains to be seen how and to what extent this new rule will be implemented to allow foreign GPs to compete more effectively against their Chinese counterparts in China’s private equity market in the years ahead.

Promising future for foreign GPs

As China continues to open up and internationalise its financial markets and as the government looks to further strengthen the domestic private equity market, foreign GPs can expect more favorable rules to come in the foreseeable future. With the launch of the ChiNext (China’s Nasdaq) on 30 October and SMEs continuing to need substantial funding to expand in the domestic market and abroad, the future looks promising for foreign GPs here in China – soon-to-be the world’s second largest economy.

* Hubert Tse is the managing director and head of international business at Yuan Tai, a Shanghai-based law firm. He advises global private equity firms on their RMB fund formation and investment in China.