On March 1, 2018, the Administrative Measures for Outbound Investments by Enterprises (企业境外投资管理办法) (“Circular 11”) issued by the National Development and Reform Commission (the “NDRC”) went into effect. In addition to regulating direct outbound investments by Chinese companies in general, Circular 11 introduces a new regulatory framework administered by the NDRC governing Chinese companies’ sponsorship of, and investment in, offshore private equity investment funds.
In summary, Circular 11 requires a Chinese company that is sponsoring or investing in:
- An offshore private equity investment fund with pre-identified portfolio investments that are not “sensitive projects”1 to submit regulatory filings or reports to the NDRC or its local counterparts, unless such sponsorship or investment is made through a Controlled Entity (as defined below) and the aggregate amount of investments from Chinese companies, directly or through Controlled Entities, in the relevant fund is less than US$300 million; and
- An offshore private equity investment fund either (i) with pre-identified portfolio investments that are “sensitive projects” or (ii) without any pre-identified portfolio investments, regardless of the industry or project in which it intends to invest (each of (i) and (ii), a “Regulated Fund”) to obtain prior approval from the NDRC.
A. Casting a wider net
Domestic Chinese companies, as well as any offshore entities controlled2 by such companies or by Chinese individuals3 are subject to Circular 11’s regulatory regime. Circular 11 applies to two important groups of Chinese investors that have been active in the private equity investment funds space but were not previously covered:
- Chinese insurance companies, which were previously required to comply only with regulations issued by the China Insurance Regulatory Commission; and
- Offshore entities controlled by Chinese companies or individuals making outbound investments (each, a “Controlled Entity”), which were generally outside the scope of prior regulations.
B. Seal of approval
Circular 11 has significant implications for the sponsorship of and investment in Regulated Funds, either by a Chinese company directly or by an offshore entity controlled by a Chinese company or individual:
- Sponsoring a Regulated Fund requires NDRC approval. Prior to Circular 11, the sponsorship of an offshore private equity investment fund was generally not subject to regulatory approval, and the major regulatory hurdle that Chinese sponsors were facing was the exchange and remittance of funds outside China to fulfill the sponsors’ commitment.
- Investing in a Regulated Fund is also expected to require NDRC approval, regardless of the size of the proposed investment.
C. Great uncertainties
Because Circular 11 just went into effect on March 1, 2018, there remains great uncertainty regarding its interpretation, application and impact on market participants:
- The expected timeline and mechanics of the approval process administered by the NDRC remain uncertain.
- It remains unclear whether a Chinese investor must obtain approval prior to the execution of any fund documentation with respect to an investment in a Regulated Fund or prior to making any capital contributions.
Because of these uncertainties, Chinese investors are asking fund sponsors to provide solutions in anticipation of their admission into Regulated Funds:
- Closing conditioned upon regulatory approval: Some Chinese investors are agreeing to submit signed fund documentation to be held in escrow by a Regulated Fund, but the effectiveness of such documentation and its admission to such Regulated Fund is conditioned upon NDRC approval. An even more conservative approach taken by some Chinese investors is to avoid submitting any signed fund documentation until all regulatory hurdles are cleared.
- Withdrawal from participation: Some Chinese investors are agreeing to be admitted into a Regulated Fund prior to the completion of regulatory review, on the condition that if such investment does not receive approval, the investor may withdraw from such Regulated Fund using the withdrawal mechanism typically reserved for other regulated investors (e.g., ERISA investors). This approach could potentially be significantly more disruptive for a Regulated Fund, given the commercial and legal difficulties that can arise from processing a withdrawal from a closed-end fund.
- Exceptions to confidentiality restrictions: Chinese investors are requiring fund sponsors to allow them to disclose certain fund related information, such as the investment objective, geographic focus and target size, to the NDRC to obtain regulatory approval. Circular 11 states that such information will be kept confidential by the NDRC.
Until the NDRC issues further guidance on the interpretation and application of Circular 11, or until market participants have had more experience dealing with the NDRC, both fund sponsors and investors will be “crossing the river by feeling the stones” as they consider their approach to outbound investments in offshore private equity investment funds and, in particular, Regulated Funds.
Kuang (Serena) Tan is a funds partner in Morrison & Foerster’s Hong Kong office. Ms. Tan has extensive experience in forming and investing in private investment funds (including offshore funds, RMB funds, and dual-currency funds), as well as advising on funds structuring (including complex structures involving preferred/subordinated investors and other finance arrangements). A native Mandarin speaker with significant international experience, she has represented many of the most prestigious sponsors that are active in this region and Asia institutional investors that invest globally.
Kenneth W. Muller serves as co-chair of Morrison & Foerster’s Private Equity Funds Group. He represents private equity funds, venture capital funds, leveraged buyout funds, debt funds, secondary funds, real estate funds and emerging growth companies in all aspects of their enterprises. Mr. Muller’s practice emphasizes the formation, organization and operation of limited partnerships, limited liability companies and corporations, as well as venture capital and strategic finance, mergers, acquisitions, divestitures, public and private offerings, joint ventures, cross-border transactions and other types of business transactions. He has represented some of the largest and well-known sponsors of private equity, venture capital, secondary funds and real estate funds.
Stephanie Thomas is co-chair of the firm’s Private Equity Fund Group. She focuses her practice on private equity fund formation, fund administration and operations and regulatory compliance matters. With more than 15 years dedicated to fund formation, Ms. Thomas has counseled numerous firms and institutions on the formation of private funds, including many of the largest private equity funds ever formed. Ms. Thomas represents sponsors and institutional investors in connection with U.S. domestic and global private equity and venture capital funds, infrastructure funds, funds-of-funds, secondary funds, debt funds, and social impact funds, ranging in size and investment strategies.
Jason R. Nelms is a corporate partner based in Morrison & Foerster’s Hong Kong office. He focuses on advising Asia-based and U.S. sponsors and investors in the structuring, formation, and offering of private investment funds, including private equity funds, real estate funds, venture capital funds, hedge funds, co-investment vehicles, and other alternative investment products. Mr. Nelms also advises fund sponsors regarding management company structuring, carried interest plans, shareholders’ agreements, and related internal governance matters, and has counseled investment firms and their principals in the purchase and sale of significant minority interests in asset management businesses.
Chuan Liu is an associate in Morrison & Foerster’s Hong Kong office. His practice focuses on the formation and operation of private equity funds, venture capital funds, real estate funds and other alternative investment products. Mr. Liu also advises clients regarding joint venture arrangements as well as related internal governance matters.
Morrison & Foerster was founded in San Francisco in 1883. Today, with approximately 1,000 lawyers in 16 offices across the U.S., Asia and Europe, Morrison & Foerster offers clients a comprehensive platform of global legal services, including extensive capabilities in the areas of corporate finance, mergers and acquisitions, tax, regulatory & compliance, litigation, and, project finance, among many others. China is a key market for us. We were among the first U.S. law firms to establish an office in each of China’s major business centers: Hong Kong (1983), Beijing (1998), and Shanghai (2003). For more information, please visit www.mofo.com.
2 “Control” is defined as holding, directly or indirectly, a majority of the voting rights of an entity, or being able to direct the operations, finance, personnel, technology, or other important matters of such entity.
3 Direct investments made by Chinese natural persons are not within the scope of Circular 11.