31 May, 2012
Legal News & Analysis – Asia Pacific – China – Investment Funds
Foreign sponsors who want to establish domestic RMB funds in the People's Republic of China may be compelled to re-evaluate their strategies following a recentruling by the National Development and Reform Commission (NDRC) in relation to The Blackstone Group.
Background
When Shanghai enacted measures implementing the first pilot programme for Qualified Foreign Limited Partners in February 2011 (QFLP Programme), commentators welcomed the development as a further step towards opening China's nascent private equity industry to foreign investors to access Chinese private equity opportunities using RMB investment fund structures. Please see Ashurst's February 2011 RMB fund update.
One of the questions posed by the measuresimplementing the QFLP Programme was whether RMB funds which raised domestic capital exclusively from PRC investors and which were managed by foreign sponsors approved under the QFLP Programme would be treated by the Chinese regulators as "domestic" or "foreign" funds.
The answer to this question has significant ramifications. Foreign funds are subject to the Industrial Catalogue governing Foreign Direct Investment in the PRC (Catalogue) and foreign exchange restrictions, meaning they are subject to investment restrictions and approval processes which can limit their ability to invest and divest in the PRC. Foreign funds are, therefore, at a serious competitive disadvantage in the dynamic and fast-paced deal-making environment that exists in the PRC when compared with domestic funds which are not subject to such restrictions and approvals processes
NDRC's ruling on foreign GPs' "skin-in-the-game" a significant set-back
The NDRC recently answered this question in a rulingon an RMB fund which we understand raised domestic capital exclusively from PRC investors and which was managed by a foreign investor (The Blackstone Group).
The NDRC held that the fund should be treated as aforeign fund, meaning it is subject to the Catalogue and foreign exchange restrictions and, accordingly, is at a competitive disadvantage when compared with domestic funds in the PRC.
The factual basis for the NDRC'sruling?
A typical feature of private equity funds with terms that are consistent with international market practice is that the fund's sponsor will be required to make an investment in the fund (typically via the general partner or an associated entity of the sponsors). The purpose of this commitment from an investor's point of view is of course to align the interests of the sponsor with the success of the fund and, therefore,with the investors' interests.
As noted in Ashurst's February 2011 briefing, this need for an alignment of interests was acknowledged in theQFLP Programme. One of the most significant features of the QFLP Programme is that Article 24 permits a qualified foreign-invested manager to invest foreign capital in an onshore RMB fund up to a maximum amount of 5 per cent of the total amount of capital raised by the fund, thus facilitating this fundament alalignment of interests. It was thought that reference in the measures implementing the QFLP Programme to the "5% investment not affecting the 'original nature' of the fund" meant that such a fund would still be treated as a domestic fund notwithstanding this sponsor investment.
It now seems clear, however, that an investment of this type by a foreign sponsor will taint what could otherwise be a domestic fund and transform it into a foreign fund. There appears to be no safe harbour from this tainting even if the foreign sponsor invests the maximum 5 per cent permitted under the QFLP Programme.
Implications for foreign sponsors
The ruling by the NDRC is noteworthy because of the high profile of The Blackstone Group and the significant implications it has for existing and future funds raised by foreign sponsors under the QFLPProgramme in the PRC.
Foreign sponsors may previously have sought to establish onshore RMB funds raised solely from PRC investors under the QFLP Programme in the hope or expectation that the fund would be treated as a domestic fund and, therefore, not be subject to the terms of the Catalogue and the investment restrictions and approval processes which limit its ability to invest and divest in the PRC. This ruling removes this hope or expectation by seeming to confirm such funds – and particularly those in which a foreign sponsor has made an investment to create an alignment of interests with the investors – will be treated by the Chinese regulators in the same way as any other foreign fund.
Comment
The NDRC's decision seems to reinforce the view that knowledge transfer is the key driver and policy goal underlying programmes such as the QFLP Programme. Viewed in this light, the NDRC's ruling is consistent with the objective of developing indigenous private equity specialists in the PRC. Foreign stakeholders in PRC private equity may do well to consider future private equity reforms in the PRC from this perspective.
