By Zhang Yi, Alan Du and Ge Jiaying, King & Wood’s Banking & Finance Group

On March 15, 2010, Shanghai Municipal Government approved a pilot program in which foreign investors may become qualified foreign limited partners ("QFLP") of private equity investment funds ("Pilot Program") on its executive meeting. The Pilot Program, which is subject to confirmation and approval of the State Administration of Foreign Exchange ("SAFE") and other relevant authorities, is expected to be officially announced soon.


 To test the water, Shanghai will first implement the Pilot Program among the private equity investment funds ("PE funds") registered in Pudong New Area of Shanghai. One of the highlights of the Pilot Program is the introduction of QFLP into the current foreign exchange administration system to encourage foreign investment in China-based PE funds.

I. Foreign Exchange Control

Commonly, the general partners ("GPs") of a PE fund subscribe capital contribution equal to 1%-3% or more of the total capitalization of the fund. In the past, some foreign PE funds carried out PE investment in China by setting up a foreign-invested enterprise ("FIEs") which would then establish a PE fund in the form of limited liability partnership and would serve as the GP of the fund. However, these GPs often faced practical barriers when making capital contribution. According to the Notice of the General Affairs Department of the State Administration of Foreign Exchange on Relevant Operating Issues Concerning the Improvement of Administration of Payment and Settlement of Foreign Capital by Foreign-invested Enterprises ("Circular No. 142"), unless otherwise provided by the law, non-investment FIEs shall not make any PE investments within the People’s Republic of China with their registered capital in RMB. The FIEs that foreign PE funds established in China as investment vehicles are usually regarded as non-investment FIEs, as they often conduct investment management or consulting services. Due to the said restriction of Circular No. 142, these FIEs face substantive obstacles if they want to carry out PE investment with RMB settled from their registered capital in foreign currency.

Circular No.142 also establishes that FIEs, which are approved by the Ministry of Commerce or its branch offices and primarily engages investment, shall get the approval of SAFE or its branches before transferring their registered capital within China. The Reply of the General Affairs Department of the State Administration of Foreign Exchange on Issues Relating to Equity Investment by Foreign-invested Venture Capital Enterprise upon Settlement of Their Capital in Foreign Currency ("Circular No. 125") also provides that a foreign invested venture capital ("FIVC") may conduct equity investment in China with its capital in foreign currency and such investment shall be within its business scope. To get the approval of SAFE, the FIVC shall perform the approval procedures for an investment project. Moreover, the FIVC shall transfer its registered capital in foreign currency to the investee company, which shall settle the capital in RMB.

Clearly, Circular No.125 targets the FIVCs. At present, it remains unclear what foreign exchange administration rules a foreign invested partnership ("FIP") shall follow. A number of foreign-invested PE funds have been approved and established as FIPs since the implementation of the Administrative Regulation on the Establishment of Partnerships by Foreign Enterprises or Individuals within China and the Administrative Regulation on the Registration of Foreign Invested Partnerships on March 1, 2010. Before the official introduction of QFLP, it is likely that FIPs might be required to settle foreign currency in compliance with the rules for FIVC. This means that PE funds structured as FIVCs or FIPs may engage in PE investment in China, but their investments are subject to foreign exchange approval procedures. As the investees are required to be responsible for foreign exchange settlement when receiving PE investment, PE funds structured as FIVCs or FIPs may be in a precarious position when competing with other types of PE funds on PE investment projects.

According to the Pilot Program, the QFLP might be able to remove the foreign exchange control barriers that PE funds and their GPs may encounter. The QFLP is similar to the Qualified Foreign Institutional Investors ("QFII"), under which the foreign investors meeting certain qualifications may invest in PE funds provided that the dollar amount of their investments do not exceed the limit approved by SAFE. The investments by QFLP may be in foreign currency but the investees shall settle the investments in RMB. However, the total dollar amount that each PE fund (which has QFLPs) settles in RMB shall not exceed USD 100 million or 50% of the total capitalization of the PE fund. The dollar amount of foreign currency that the GP of the PE fund settles shall not be more than 5% of the total capitalization of the PE fund. If the QFLP is implemented, GPs of foreign invested PE funds will no longer face substantive practical barriers when settling their capital from foreign currency to RMB to conduct PE investments in China

II. Eligibility of National Treatment

According to the existing PRC laws and regulations and the interpretation by relevant authorities, a FIVC or FIP established in China is generally treated as foreign investors when conducting investment projects. In essence, their investment projects are required to follow the filing or approval procedures applicable to foreign investment projects. In addition, the domestic company that a FIVC or FIP invests in will be regarded as a FIE. Compared with these procedures, the administrative procedures applied to domestic PE funds are much simpler. Moreover, the investees of Chinese PE funds remain to be treated as domestic companies so that they will face less obstacles if they plan to go public or enter into the reorganization proceeding. This is another disadvantage that FIVCs and FIPs experience when competing on investment projects with domestic PE funds.

It is possible that the Pilot Program is adopting a more lenient approach towards the national treatment for foreign invested PE funds. For example, the Pilot Program might grant national treatment to the PE funds with only one foreign general partner (possibly a FIE). In other words, a PE fund will be regarded as a Chinese PE fund, if one of its GPs is a FIE and the rest of its GPs are domestic entities. However, if any of the limited partners ("LPs") of a PE fund is a FIE, such a PE fund might not be entitled to national treatment under the Pilot Program.

Under the current PRC law, if all partners (LPs and GPs) of a PE fund are domestic entities (including FIEs), they may structure the PE fund as a domestic partnership, instead of a FIP. In practice, a PE fund may adopt a structure that is subject to the discretion of the competent local branch of SAIC and may be applicable only in some areas of China. PE funds structured as domestic partnerships might be deemed as domestic PE funds and entitled to national treatment when making investments, since the relevant authorities cannot legally require them to perform the administrative procedures applicable for foreign investors. However, this will remain a concern for FIEs that overseas PE funds establish in China as investment vehicles, before the legislation approves such national treatment to PE funds and their partners.

Relevant government authorities will be extremely careful when formulating the policies regarding the eligibility of national treatment. Where FIEs are the GPs of a PE fund, the percentage of their capital contribution to the total capitalization of the fund is relatively small. Therefore, these FIEs are less likely to circumvent the Chinese government’s industrial restriction on foreign investment, even if such a fund is given national treatment. Conversely, if FIEs are the LPs of a PE fund, the percentage of their capital contribution to the total capitalization of the fund will be large. In this case, these FIEs may by pass the industrial restriction on foreign investment by becoming LPs of a PE fund, (as there is no legal basis to require such PE fund to get approval) if they are granted national treatment. Due to the restriction of foreign exchange settlement established by Circular No. 142, the newly established FIEs face difficulty to obtain sufficient capital in RMB to make capital contribution to PE funds as LPs, unless they have generated RMB income in China. Essentially, QFLP may be only applicable to foreign LPs. In other words, QFLP might not be applicable to LPs that are FIEs to clear the foreign exchange administration barriers FIEs may encounter when they invest in China.

Although the Pilot Program has not yet been officially announced, it has already attracted wide attention and sparked extensive discussion in China’s private equity industry. If the Pilot Program launches a major policy breakthrough, it is very likely that we will see another boom of PE funds. In the past, although the relevant authorities in Beijing, Tianjin, and Shanghai introduced a series of policies to support the development of PE funds, these policies were unable to effectively motivate the investors as none of them provided solutions to foreign exchange control and national treatment restriction, two major roadblocks that PE funds involving foreign partners face in China. Upon the launch of the Pilot Program, the Pudong New Area of Shanghai could become a new venue for foreign investors to invest in China-based PE funds.