In the People’s Republic of China (PRC), investment funds are generally classified as publicly offered funds and private investment funds. Publicly offered funds mainly invest in securities. Private investment funds are further classified into private securities funds, private equity funds and other types of private investment funds.
Generally, in practice, retail funds refer to any fund that is offered to unspecified investors or more than 200 specified investors, and any other funds otherwise classified as retail funds under the applicable PRC laws. Retail funds can generally be divided into equity funds, bond funds, money market funds, fund of funds, hybrid funds and qualified domestic institutional investor (QDII) funds and other types of funds. There are also exchange-traded funds (ETFs) and listed open-ended funds (LOFs). Alternative investment funds generally refer to private equity funds and private securities funds.
According to PRC's Private Investment Funds Industry Development Report (2019) published by the Asset Management Association of China (AMAC), the size of the PRC private investment industry has grown rapidly from CNY3 trillion in 2015 to CNY12.78 trillion at the end of 2018. The growth has mainly come from private equity funds and venture capital funds, while private securities funds have experienced relatively slow growth due to the impact of primary market performance. However, in general, affected by the capital market environment, the growth of private investment funds has been slow over the past year within the internal comparison of the private investment industry.
The size of the PRC retail fund industry continued to grow in 2018, from CNY11.60 trillion at the end of 2017 to CNY13.03 trillion at the end of 2018, up CNY1.43 trillion. Retail funds in the PRC have grown faster than private equity funds, benefiting from the growth of money funds and bond funds. The size of money funds and bond funds increased by CNY0.88 trillion and CNY0.80 trillion respectively.
In addition to the onshore fund, the scale of offshore funds is also expanding year by year in the PRC, which is due to the following two reasons: on the one hand, China's capital market has remained active for many years, and cross-border transactions are more and more frequent; on the other hand, the demand for overseas asset allocation has been very strong in China for over two decades. These two factors have spurred the growth of offshore funds in China.
The Cayman Islands is the world’s fifth-largest financial centre and the pre-eminent offshore jurisdiction for private investment fund formation. The legal framework of the Cayman Islands is based on the understanding that Cayman Islands fund structures are primarily intended for investment by institutional and sophisticated market participants and are not marketed to retail investors in the Cayman Islands or elsewhere. It has been a natural choice for institutional investors and fund managers, for several reasons: tax neutrality, a respected legal system, high-quality service providers, etc.
Private Securities Funds
With regard to private securities funds, vehicles may be utilised, including PRC Sunshine Private Funds, under which, clients give their money to a trust company, the trust company signs a management agreement with an investment manager, and the bank is the custodian of the funds, as well as a limited liability partnership (LLP) and a limited liability company (LLC), which are popularly used for private securities funds in the PRC. Contractual funds are typically used to form a private securities fund. Compared to an LLP, which can only have up to 50 investors, a contractual fund is allowed to have up to 200 investors, which is better for the fund-raising process. Also, the essence of a contractual fund is not like an LLP, a separate entity from investors, so it is not subject to local Administration of Industry and Commerce (AIC) procedures, which may be more flexible and efficient in operation.
Private securities funds can be divided into the following types according to their investment target, including stock funds, which mainly invest in stocks, bond funds, which mainly invest in standardised and non-standardised bonds, money market funds, which mainly invest in money market instruments, asset securitisation funds, which mainly invest in asset securitisation products such as real estate, commodities, loans, derivative funds, which mainly invest in financial derivatives such as futures and options, hedge funds, as the pools of underlying securities and derivatives, to which investment targets are not restricted, and the investment strategy provides absolute returns for clients, and funds of funds (FOF).
The competitive advantage of a private securities fund is that it can flexibly adjust the investment portfolio according to the requirements of investors, that it can use a large amount of financial leverage and various forms of investment, and that it has a relatively high rate of return. However, the clear drawback brought with the high rate of return is that private securities funds also have high risks.
Private Equity Funds
With regard to private equity funds, various forms of structure may be taken, including an LLP, an LLC, a joint-stock limited company or a contractual fund. In practice, few private equity funds take the form of a company. For taxation considerations and management efficiency reasons, an LLP is the most popular form utilised by private equity funds, which consists of 2 to 50 partners, and at least one of them is a general partner. The general partner(s) generally refers to the fund manager of a private equity fund that has undertaken the form of an LLP and holds a general partner interest, directly or indirectly, through its affiliates, while investors, as the limited partners, hold limited partner interests.
Three main types of private equity funds are allowed to make investments in the PRC.
The first type is the offshore US dollar-denominated fund, formed in non-PRC jurisdictions, most commonly in the Cayman Islands. Offshore funds are typically organised as limited partnerships so that investors can enjoy greater flexibility of commercial terms and the availability of pass-through tax treatment. As offshore funds are organised under the laws of the Cayman Islands, there is greater certainty and predictability pertaining to the legal enforceability of contracts and limited liability protection of limited partners than entities governed by PRC laws. Although offshore funds are not governed by PRC laws, investments made in the PRC will be subject to many special restrictions. According to the Foreign Investment Industrial Guidance Catalogue enacted by PRC’s State Council, many sectors and industries are closed to foreign investment. Even for accessible industries, every investment needs government approval. Since offshore funds are denominated in US dollars yet invest in renminbi, government approvals are also required for the conversion of US dollars into renminbi and associated repatriation.
The second type of structure is an onshore domestic-invested renminbi-denominated fund. Onshore domestic-invested renminbi-denominated funds are registered in the PRC, comprising exclusively of domestic source of capital. Onshore funds are typically organised as a limited partnership under PRC’s Partnership Business Law, and investors enjoy two typical advantages of partnership compared to corporations: greater flexibility of commercial terms and the exemption from double taxation. As domestic investors, onshore funds can invest in industries restricted to foreigners, such as television stations and publishing; thus, having access to more deals in a broader share of PRC’s economy.
The third type of structure is an onshore foreign-invested renminbi-denominated fund registered in the PRC, comprising at least partially of foreign source of capital. They could be organised either as foreign-invested venture capital enterprises (FIVCEs) or foreign-invested limited partnerships (FILPs). Onshore renminbi funds are typically organised as a limited partnership under PRC’s Partnership Business Law, and investors enjoy the same advantages of partnerships compared to corporations.
FILPs are still subject to the Foreign Investment Industry Guidance Catalogue, thus cannot invest in industries restricted to foreigners. The local limited partners may not be as sophisticated as international investors. Their lack of experience and unrealistic expectation of high yields may possibly damage the business operations.
For the offshore fund in Cayman, the three most common investment fund vehicles in Cayman are as follows.
The Cayman Islands has undergone a number of legal changes in response to global regulatory policy in recent years, in particular, since last year, most of the offshore companies are faced with the new economic substance requirements, which raise new challenges for investment fund managers to comply with in the Cayman Islands. In particular, on 7 February 2020, the Cayman government published the Private Funds Law, 2020, which requires certain close-ended funds to register with the Cayman Islands Monetary Authority (CIMA).
The common process for setting up a private equity fund is as follows.
The liability of investors is different depending on the specific legal forms of vehicles used by funds formed in the PRC.
With respect to a limited partnership formed under the Partnership Business Law, the limited partners, as investors of funds, only bear liabilities capped at their capital commitments to the limited partnership.
With respect to a company formed under the Company Law, the shareholders, as investors of funds, are liable to the extent of their capital contribution for subscription of the shares.
With respect to a contractual-type fund formed under the Securities Investment Fund Law, generally applying to securities investment funds within the territory of the PRC, the fund shareholders, as investors of funds, may authorise the fund manager and fund custodian to perform the duty of custody in accordance with the fund contract and bear the risks to the extent of the fund shares they hold.
AMAC has issued the Measures on the Administration of Private Investment Fund Information Disclosure (Measures), which took effect immediately. Pursuant to the Measures, “information disclosure obligor” refers to private investment fund managers, fund custodians and other legal persons and organisations designated by the China Securities Regulatory Commission (CSRC) or AMAC.
In practice, either the fund manager or the fund custodian shall bear the burden to disclose required information pursuant to the Measures, and such responsibilities and obligations in relation to the fund manager and/or the fund custodian shall be explicitly stipulated in the relevant fund contract.
In the event that “information disclosure obligor” delegate a third-party agent to disclose information, such third-party delegate only bears the disclosure obligation subject to the delegation agreement, which shall be without prejudice to the legal obligation of the fund manager or fund custodian.
Pursuant to the Measures, “information disclosure obligor” are required to disclose the following information related to a fund:
There are two ways to make disclosure:
AMAC regulates the private fund management industry by launching three different online platforms in accordance with the compliance requirements for the establishment, operation and management of the private fund:
After the completion of the filing for the fund, a fund manager is obliged to (i) annually and quarterly update AMAC, via the Asset Management Business Electronic Registration System, on the information with respect to the operation of itself and the fund managed by it, and (ii) make information disclosure to investors pursuant to relevant regulations and fund contracts, and submit such information disclosure via the Private Fund Information Disclosure Backup Platform of AMAC for the purpose of record.
If the private fund manager fails to fulfil its information disclosure obligations, the investor can complain or report to AMAC, and AMAC may then require correction by the fund manager within a time limit. In the event of overdue correction, AMAC may, depending on the seriousness of the violation of the obligations, take measures against the main person in charge, including engaging in a conversation to remind such person, sending a written warning, asking such person to participate in mandatory training, denouncing such person on the blacklist within the industry and other disciplinary action.
If a private fund manager fails to submit and update significant information via the Asset Management Business Electronic Registration System in a timely manner, or to submit semi-annual and annual reports and other information disclosure reports of a private equity fund via the Private Fund Information Disclosure Backup Platform for the record in a timely manner, AMAC may suspend the application for fund filing until the update or submission is completed. If the private fund manager fails to do so twice, such fund manager will be included in the list of abnormal organisations by AMAC. In addition, even if the update or submission is complete, it takes at least six months for such fund manager to be restored to normal announcement status on the AMAC website.
Such disclosure requirements imposed on a fund manager not only help guarantee the performance of the fiduciary duties of the fund manager, but also help realise the self-regulatory management of the private equity industry.
For private equity funds and private securities funds, the main types of investors include professional investment organisations, high net worth individuals, family offices, listed companies, trust companies, insurance companies and governmental funds. As China's middle-class demand for asset allocation has increased, investors such as high net worth individuals and family offices have been very active in recent years.
In the PRC, the common legal structure of a fund manager is a limited liability company, and sometimes the form of limited liability partnership may be adopted.
The legal structure of a fund manager of a private investment fund mainly consists of the authority, the supervision and the execution department. The fund manager of private equity funds generally sets up an investment committee and risk control committee under the board of directors, while the fund manager of private securities funds generally only sets up an investment decision committee under the board of directors.
Pursuant to the Interim Regulations on the Supervision and Administration of Private Investment Funds (Regulations) promulgated by the CSRC, only qualified investors within the definition specified in the Regulations are qualified to subscribe to private investment funds in the PRC.
Qualified investors are investors, whether individual or institutional, with the corresponding ability to identify and tolerate risk, who must invest at least CNY1 million as capital commitment in one fund, and (i) if an individual investor, his or her own financial assets (including bank deposit, stocks, bonds, mutual fund units, asset management plans, bank financial products, trust schemes, insurances, futures options, etc) must be at least CNY3 million, or his or her annual income during the preceding three years must be at least CNY500,000; or (ii) if an institutional investor, it has a net asset value of at least CNY10 million.
The Regulations also list certain institutions to be "qualified investors", including social/public interest-related funds such as pension funds, annuity funds, charity funds, investment schemes already registered with AMAC, fund managers and their employees who co-invest into the relevant funds under their management, and other qualified investors specified by the CSRC.
Moreover, in the event that any potential investor is a partnership, contract, or other non-legal-person form by pooling funds of most investors, the “look-through” doctrine shall be applied to determine the status and number of actual “qualified investors.”
The main regulatory bodies are the CSRC and AMAC. CSRC is a governmental organisation authorised by the central government to supervise and manage the national securities and futures market, and maintain the order of the securities and futures market. AMAC is a national, industrial and non-profit social organisation voluntarily organised by relevant institutions of the fund industry.
The regulatory framework for PRC funds legislation developed with the country's burgeoning fund industry. The level of legal authority of supervisory and administrative rules was relatively low years ago, and there were few compliance requirements in relation to this sector.
However, over the past few years, a series of laws and regulations regarding the private investment funds industry have been adopted and a well-defined regulatory framework is now in place in the PRC.
In June 2013, the State Commission Office for Public Sector Reform issued the Notice on Allocation of Administrative Authorities over Private Equity Funds that officially bestowed upon the CSRC as the primary PRC authority in charge of supervising and regulating PRC funds aiming at protecting the rights and interests of investors.
In August 2014, the CSRC promulgated the Interim Measures for the Supervision and Administration of Private Investment Funds, which established the system of registration of fund managers and record filing of private investment funds, defined qualified investor and clarified non-public fund-raising and disclosure requirements for fund managers. The CSRC also authorised AMAC, a self-regulatory organisation that represents the PRC funds industry, to be responsible for the registration of fund managers and record filing of private investment funds, and to perform the self-regulatory function over the entire private investment fund industry.
AMAC is dedicated to providing a uniform regulatory regime for the PRC asset management industry by exercising self-regulation administration within the industry. AMAC has released a series of self-regulatory rules, including the Measures for the Registration of Management Institutions of Privately Offered Investment Funds and the Recordation of Funds (for Trial Implementation), the Guidance of Internal Control of Private Investment Fund Managers, the Measures for the Administration of the Disclosure of Information on Privately Offered Investment Funds, the Measures for the Administration of the Fund-raising of Privately Offered Investment Funds, the Standards of Practice for Securities Investment Consulting Institutions (for Trial Implementation) and the Guidelines for the Administration of Recordation of Privately Offered Asset Management Plans of Securities and Futures Business Institutions (for Trial Implementation).
At the end of 2019, AMAC issued another critical document, the Notice for the Recordation of Privately Offered Investment Funds, which aims to enhance compliance operations and improve industry integrity by strengthening the requirements for participants of private investment funds and standardising the fund manager's fund-raising activities.
In the PRC, foreign managers themselves registered outside the PRC are not permitted to conduct marketing, management or advisory services for an investment fund, but subsidiaries of foreign managers duly registered with AMAC may act as private fund managers to provide services to private investment funds.
It usually takes several rounds of questions before the final decision on the approval of the registration application is given after application materials are submitted to AMAC, together with a legal opinion issued by a qualified PRC law firm. If an application moves to the fifth round of responses and AMAC is still not satisfied with the applicant’s answers, the application may be suspended for three months.
Generally, private investment fund managers registered with AMAC or institutions registered with CSRC and obtaining fund sales business qualifications are permitted to carry on marketing for private investment funds. Sales personnel must also have fund services qualifications.
Fund-raisers may not engage in the following activities when promoting interests in private investment funds to investors:
Private investment funds can only be offered to qualified investors, according to the Interim Regulations on the Supervision and Administration of Private Investment Funds (Regulations) promulgated by the CSRC. See 2.2.3 Restrictions on Investors.
Investors are classified into general investors or professional investors, and general investors are further classified into several categories, depending on their ability to tolerate risks, ranging from C1 to C5.
General investors enjoy special protections provided by the fund-raisers with respect to information disclosures, risk warnings, suitability matching and other protection measures. Generally, fund-raisers shall not actively conduct marketing of a private investment fund to investors whose tolerance is lower than the risk rate of such fund. Investors who belong to the lowest risk tolerance category are not allowed to invest in any fund with a risk rating above their risk tolerance. However, investors may invest in relatively riskier funds after accepting special risk warnings that the fund-raiser will issue in writing.
In addition, certain special classes of investors, such as insurance funds and commercial bank wealth management products, are restricted from investing in funds that do not meet specified industry investment requirements. For example, insurance funds that seek to invest in private equity funds and/or venture capital funds must ensure that these funds fully comply with standards stipulated by the China Banking and Insurance Regulatory Commission, including the fund manager’s investment experience, management scale and professional team, as well as the fund size, limitations on investments in listed companies or a single portfolio and fund information disclosures. In the case of commercial banks that invest in private investment funds through private wealth management products, the funds must be managed by a fund manager who has been duly registered with AMAC as a member of the association for at least one year and has no record of significant violations.
Telephone hotlines have been set up by AMAC and it also allows email enquiries so as to provide answers regarding questions related to the AMAC online information filing platforms and relevant regulations and compliance requirements.
AMAC keeps in communication with fund managers, scholars, government officials and lawyers, through various lectures and forums, and is receptive to the general public for suggestions regarding various details of the self-regulatory system.
In the event of any violations by funds or fund managers, AMAC will take disciplinary actions against such fund, fund manager and/or any main person in charge, which include blacklisting, public reprimands, cancelling fund manager registrations and/or cancelling the qualification to conduct private investment fund management practice of the fund manager’s employees. AMAC has the power to conduct routine or unscheduled on-site or off-site inspections of private investment fund managers. AMAC may sometimes co-operate with the CSRC to complete these inspections.
On 23 December 2019, the Notice for the Recordation of Privately Offered Investment Funds was issued by AMAC, which further emphasises that the nature and essence of investments made by private investment funds is investment activities rather than lending activities.
To be more specific, for the operation of a private investment fund, the following behaviours are prohibited:
The PRC's current legislation does not impose mandatory compliance requirements for custodians. In practice, the vast majority of private investment funds have appointed custodians, and the appointed custodians generally set the exemption clause in the fund contract. However, the latest notice stipulates that the fund contract and the custody agreement shall clearly stipulate the relative rights, obligations and duties of the fund manager and the custodian of a private investment fund, and the custodian shall not be exempted from its legal duties through the contract.
In addition, the Anti-money Laundering Law sets out comprehensive requirements for financial institutions and non-financial institutions. In practice, to comply with such anti-money laundering obligations, the fund manager generally requires investors to ensure that the investor’s subscription to the fund does not involve money laundering or other illegal funding sources by providing the fund manager with any reasonable, necessary or appropriate information to comply with the applicable anti-money laundering requirements.
In the PRC, in the process of the operation of private investment funds, hierarchical leverage may be utilised for the future and further expansion of the scale of fund-raising. The total assets of each product of a private investment fund shall not exceed 200% of the net assets of such product, and the total assets of the graded product of a private investment fund shall not exceed 140% of the net assets of such product. In addition to bank syndicated loans, there are other legitimate channels for debt finance for private investment funds in the PRC, such as via trust companies or asset management companies.
Private investment funds formed as corporates shall pay corporate income tax in accordance with the Enterprise Income Tax Law at a fixed tax rate of 25%. However, there are also certain tax incentives depending on the specific regions where the corporate private investment fund is incorporated. Fund investors are generally subject to income taxes on their dividend income in accordance with their shares received from the fund.
For private investment funds in the form of a limited partnership or a contractual fund, such fund will be treated as fiscally transparent for income tax purposes under a pass-through tax treatment, so the fund itself is not liable to pay income taxes, but investors are liable to pay taxes for income derived from the fund.
With respect to partnership private investment funds, investors are liable for two kinds of income tax in relation to production and operation income, and interest, dividend and bonus income. For profit distribution, if the investor is an individual, the general partner will pay individual income tax in accordance with the progressive tax rate (5%-35%), and the limited partner will pay individual income tax of 20% in Shanghai, Beijing and other places (the tax rate of each province is different). For the interest, dividend and bonus income, an individual investor will pay individual income tax of 20%; a corporate investor will pay corporate income tax.
In the contractual fund, the only taxable income of the private fund manager is the management or consulting fee, with the fixed tax rate of 25%.
Generally, value added tax (VAT) is also imposed on private investment funds and fund managers with respect to the fund’s gains from financial product transactions. For a contractual fund, such VAT shall be paid by the fund manager, while it is unclear whether the fund or the fund manager shall be liable for VAT when the private investment fund is formed in a limited partnership or a company structure.
In order to attract high-quality private investment funds, local governments in the PRC have introduced preferential tax policies, including Zhejiang, Jiangsu, Jiangxi, Guangdong, Tianjin and parts of the central and western regions. In principle, if relevant entities meet certain conditions – such as registered capital, paid-in capital requirements and other requirements stipulated by applicable laws and regulations – such entity may enjoy relevant tax preferential policies.
Retail funds in the PRC typically take the form of unit trusts or asset management schemes, in which the investors' interests are relatively called units or interests. Unit trusts, as collective investment schemes, could be offered by trust companies incorporated in the PRC to accredited investors within the definitions under the regulations issued by the CSRC and AMAC. Under such fund structure, a fund manager is entrusted to manage the fund and a custodian bank will hold fund assets in custody for the benefit of the fund unit-holders.
The main competitive advantage of retail funds is that retail funds are the most transparent and regulated funds in the PRC. There are strict regulations on the qualifications of fund managers and custodians of fund assets, and closed-end retail funds must publish their net worth once a week and their portfolios quarterly; thus, providing better transparency and protection of unit-holders’ interests in the fund. Besides, retail funds organised in the form of a unit trust or asset management scheme also enjoy the benefits of tax transparency and separation of assets and fiduciary duties for the fund manager and fund custodian.
Despite the advantages of retail funds organised in the form of a unit trust or asset management scheme, a clear drawback is that a trust or asset management scheme is traditionally a legal concept under common law, while the PRC adopts a civil law system, which lacks legal tradition and the concept of trust, so the rights and obligations in the governance of unit trusts or asset management schemes have not been clearly clarified under the existing legislation. Besides, retail funds formed as unit trusts or asset management schemes also face disadvantages of high liquidity risks, limited investment varieties and lack of innovation.
Under the current regulatory regime in the PRC, fund management companies and qualified asset management institutions may, subject to approval by the CSRC, conduct retail fund business, and the offering of retail funds is also subject to approval by the CSRC. The general process for setting up a retail fund in the PRC includes the following steps:
Key documents for the establishment and the offering of a retail fund mainly include an investor information table, a risk tolerance assessment questionnaire, a fund risk disclosure statement, a fund prospectus, a tax residency statement document, a fund contract, a custodian agreement and other documents as may be requested by the CSRC.
The fund manager is not permitted to publish the prospectus and offer fund units to investors unless approval is obtained from the CSRC. The CSRC generally decides whether to approve the application for the offering of a retail fund within six months.
Retail funds are usually structured as a unit trust and the participants’ interests in the fund are referred to as units. Investors generally enjoy limited liability protection in retail funds, and the liability of the investors is limited to the investment made by the investor in the fund.
The fund manager has the obligation to:
Retail funds can be marketed to and are offered to the general public in the PRC and any individual or institution is eligible to invest in retail funds.
In the PRC, retail funds can only be offered and managed by fund management companies that are regulated by the CSRC and asset management institutions approved by the CSRC (ie, securities companies, insurance asset management companies, other asset management institutions specialising in the management of non-retail securities investment funds, equity investment management institutions and venture capital investment management institutions).
Generally, only adults can open an account in a retail fund. Other investment restrictions may be imposed by the fund contract between the fund manager and investors.
The CSRC is the primary authority in charge of supervising and regulating securities investment funds in the PRC. The offering of any retail fund, the establishment of any fund management company and whether asset management institutions can conduct retail funds management business are subject to the prior registration with or approval from the CSRC.
The regulatory bodies also include AMAC, a self-regulatory organisation, and the China Banking and Insurance Regulatory Commission (CBIRC), which is responsible for regulating insurance asset management companies engaging in funds management businesses.
The cornerstone of the regulatory framework in the PRC is the Securities Funds Law and its subsequent amendments. Under such regulatory regime, the CSRC has promulgated a series of regulations on the operation and management of funds and fund managers, including the Administrative Measures on the Operation of Publicly Offered Securities Investment Funds, the Administrative Measures on the Marketing of Securities Investment Funds, the Administrative Measures for Information Disclosure on Publicly Offered Securities Investment Funds, the Administrative Measures on Securities Investment Fund Management Companies, the Administrative Measures on the Qualification Requirements for Senior Officers of Securities Investment Fund Management Companies and the Measures on the Compliance Management of Securities Companies and Securities Investment Fund Management Companies.
Besides, additional regulations have been released by the CBIRC to regulate insurance asset management companies engaging in funds management businesses.
In the PRC, only Chinese retail funds that have been registered with the CSRC can be marketed, and foreign retail funds cannot be registered with the CSRC and, accordingly, cannot be marketed in the PRC.
The promotion of retail funds is subject to various restrictions. The fund manager of a retail fund is permitted to market and promote retail funds, while only qualified fund distributors engaged by the fund manager that satisfy the conditions and requirements imposed by the CSRC are permitted to do so.
As the PRC's economic market continues to open up to the global market, foreign commercial banks with a business presence in the PRC can now provide services to the retail fund industry. In 2018, the first foreign bank fund trustee qualification was approved. It can be anticipated that more and more foreign service providers, especially commercial banks, would be approved by the CSRC to engage in the business of retail fund unit distribution.
At the time of writing, in practice, only fund management companies and asset management institutions that have been incorporated in the PRC and approved by the CSRC can serve as the fund manager of retail funds in the PRC; foreign fund managers are not permitted to act as the fund manager of any Chinese retail funds. However, there are no specific provisions about foreign retail fund managers and AMAC has announced that foreign private equity managers are welcome to apply for conducting retail fund management business on the basis of compliance with requirements.
The applicant shall submit the letter of commitment, the verification confirmation, the application report, the business plan, the situation of the shareholders, the initiation agreement, the statement of the preparation for the establishment, the articles of association, the functions of the organisation, the internal management system, the reports of the practitioners, etc. After receiving related application materials, the CSRC generally decides whether to approve the application within six months.
The applicable laws and regulations governing retail fund marketing mainly consist of the Securities Investment Funds Law, the Measures for the Operation and Administration of Publicly Raised Securities Investment Funds and the Administrative Measures For Information Disclosure on Publicly Offered Securities Investment Funds.
Retail funds duly approved by or registered with the CSRC can be marketed to the general public in the PRC in writing or through electronic means, such as newspapers, the internet, television, and other communicational means.
The China Securities Investors Protection Fund (SIPF), run by the state-owned China Securities Investors Protection Fund Co. Ltd., is considered an important part of the PRC’s investor protection system. The SIPF was established in 2005 and was designed to compensate investors who lose money in cases where a brokerage fails or a company embezzles investor funds.
Aside from protecting investors from brokerage failures, the SIPF also functions to monitor the capital flows on the securities market by setting up a monitoring system called “Eagle Eye.” Besides this, the SIPF has been entrusted to mediate cases and advise the court on how to calculate compensation and determine how many investors should receive restitution funds as well.
To give full play to the role of the SIPF in protecting the interests of investors, a draft of the provisions of liquidity support of securities companies was released by the CSRC on 5 July 2019 for public comment.
According to the “white paper on investor protection in China's capital market” released by China Securities Investor Protection Fund Co. Ltd., four main indicators for investor protection, including investor protection mechanism construction, investment management, appropriate management and right to know protection, investor education service and complaint handling, are used to evaluate the status of investor protection, so, accordingly, retail fund companies generally carry out compliance construction from these four aspects.
The CSRC has set up telephone hotlines and receives email enquiries to handle questions from the general public and keeps in communication with fund managers through face-to-face meetings and other communicational channels.
With regard to the asset portfolio of retail funds, the portfolio of assets of each retail fund must be held by the custodian of the fund for and on behalf of that fund and only commercial banks that have been duly approved by the CSRC and the CBIRC or other financial institutions that have been duly approved by the CSRC can serve as the custodian of a retail fund. Other investment restrictions and guidelines may be imposed by the fund contract.
In the PRC, funds are permitted to access fund finance for leverage, but such leverage is subject to a statutory debt ceiling limitation, which is calculated on the basis of net value of fund assets and does not include unfunded capital commitments.
The Guiding Opinions on Regulating the Asset Management Business of Financial Institutions, published in April 2018, set an upper limit on the leverage ratio depending on the types of funds. With regard to open-ended retail funds, total assets may not exceed 140% of net assets.
However, in practice, details in relation to fund borrowings are governed by the terms and conditions of the fund contract, such as the prior approval requirement of fund borrowings, under which funds are not allowed to conduct any borrowing without the prior consent of investors, especially institutional investors.
The Ministry of Finance and the State Administration of Taxation have released a series of regulations governing the taxation of asset management business operations (eg, retail funds), including the Notice on the Value-Added Tax Policies for the Deduction of Input Taxes on Rented Fixed Assets and Other Matters, the Notice on Issues concerning the Value-Added Tax on Asset Management Products, the Notice on Issues concerning Value-Added Tax Policies for Asset Management Products, the Notice on Further Clarifying Polices concerning the Financial Industry during the Comprehensive Promotion of the Pilot Programme of Replacing Business Tax with Value-Added Tax and the Notice on Implementing the Pilot Programme of Replacing Business Tax with Value-Added Tax in an All-round Manner (partially valid).
In accordance with the applicable laws and regulations on the taxation of asset management products, retail funds are not subject to VAT at a rate of 3% in relation to income received on the transfer of securities and bonds, and income received by securities investment funds – including capital gains, dividends and interest – is not subject to corporate income tax.
With regard to fund managers, the income derived from the transfer of securities and bonds is not subject to corporate income tax; however, such fees – including subscription fees, sales service fees and tail commission fees paid to sales organisations, custodian fees paid to custodian banks and transaction commissions paid to brokers and dealers if renting the trading unit of such brokers and dealers – are income belonging to such service providers themselves, and are subject to income tax and VAT.
With regard to investors, individual investors are not subject to income tax or stamp duty in relation to the purchase and redemption of fund units since the respective listed companies, bond issuers or banks have withheld 20% income tax on interest income when distributing dividends or income to the fund. However, institutional investors are subject to corporate income tax at a rate of 25% and business tax at a rate of 5% in respect of both dividends and investment returns derived from the price difference between the subscription and redemption of fund units.
AMAC has released the Notice for the Recordation of Privately Offered Investment Funds. Compared with the prior 12 January 2018 Notice, the new guideline has increased the compliance of recordation requirements, strengthened the responsibilities of custodians, clarified the criteria for qualified investors, improved the identification of related-party transactions and established a temporary filing mechanism.
In recent years, the retail fund industry has seen many new changes. In particular, the official launch of a pension target public offering fund scheme means the retail fund has entered a new stage to cater for/service individual pension investment. At the same time, a series of subdivided areas of the products of index funds are also emerging. In addition, with the support of national policies, private investment funds have begun to invest in retail funds.
Influenced by the enhanced regulation of financial products such as bank asset management products, which are generally no longer allowed to invest into private equity funds, as well as the economic downturn, the fund-raising market of the private equity funds industry in China has experienced great depression since 2018. Based on the latest statistics published by Zero2IPO Research, the amount of funds raised in the private equity fund market as of November 2019 was barely close to RMB1,080 billion, which represented a decrease of 10% compared to 2018.
In 2019, various laws and regulations affecting private investment funds were promulgated, including:
Notice on Private Investment Funds Filing
On 24 December 2019, the Asset Management Association of China (AMAC – a self-disciplinary organisation that is the de facto regulator of the private investment funds industry in China) promulgated the Notice, replacing the previous version, which had been effective since 2018. The Notice adopted certain key points in the Guiding Opinion on Regulating the Asset Management Business of Financial Institutions (Guiding Opinion), and addresses essential issues formerly encountered in the fund filing process.
No credit fund is allowed among private investment funds
The filing of a credit fund investing in loans and other fixed income investments (other than listed bonds, which may be purchased by private securities investment funds) has generally been banned by AMAC, which holds the general view that any investment looking for fixed income shall not be the investment target of private investment funds. The Notice further confirms that private investment funds shall not conduct the following:
Furthermore, the engagement of such businesses is also prohibited, either indirectly or in a disguised way through investing in a partnership, company or asset management products.
Correlation with guiding opinion
The Guiding Opinion has had a profound effect on China's financial market since its implementation. As the Guiding Opinion does not apply to private investment funds directly, AMAC has been working on the corresponding rules thereafter, and the Notice sets forth certain terms reflecting the Guiding Opinion:
Restrictions on subsequent closing
The Notice generally prohibits subsequent closings after the filing of a private equity fund, unless the fund satisfies certain requirements, such as:
The purpose of this is to prevent fund managers filing a small-sized fund invested by affiliates as a standby shell fund for future use, so as to avoid the scrutiny of AMAC at the fund filing stage of a much larger fund with more investors.
It has been market practice, both internationally and in China, to have several subsequent closings within a certain period after the first closing. The Notice makes it difficult for fund managers to decide the occurrence of the first closing, or whether to complete the fund filing and start making investments after the first closing (fund filing is a pre-condition for the fund to make investments), because the fund filing effectively sets the ceiling of the fund size – ie, four times the commitment at the time of the fund filing. When raising a RMB1 billion fund, fund managers can choose to have a first closing to secure a RMB200 million commitment, but may postpone any capital call and the fund filing until accepting a RMB250 million commitment, so that the subsequent closings may still accept a RMB750 million commitment.
Constraint on successor fund
According to the Notice, a fund manager is not allowed to establish a competing private fund with a similar strategy, scope and phase of investment before a 70% commitment of the existing fund has been applied to investments or reasonably reserved for tax and expenses, unless otherwise agreed by all investors or passed through the decision-making mechanism agreed by all investors, which means the fund manager is subject to such restriction regardless of whether or not they are contained in the LPA.
SAFE Circular No. 28
According to Circular No 28 promulgated on 25 October 2019 by State Administration of Foreign Exchange (SAFE), foreign invested non-investment enterprises are allowed to use their foreign exchange capital to make equity investment, provided that the investment is not within the negative list for foreign investment and the onshore investments are true and compliant. Before that, only foreign invested investment enterprises (ie, those with the business scope of investment, such as a foreign invested investment holding company, or Qualified Foreign Limited Partner – QFLP) are allowed to use their foreign exchange capital to make equity investments.
There is some speculation that, after Circular No 28, foreign investors can easily set up a vehicle in China in the form of a company or a limited partnership with the business scope of providing consulting services, etc, but then use that vehicle to invest in private equity, or even real estate project companies. This does not appear to be the SAFE regulatory approach as perceived in the last two decades. The purpose of Circular No 28 is understood to be the facilitation of foreign invested non-investment enterprises to make appropriate equity investments in China, but not to facilitate foreign invested investment enterprises (in substance) disguised as foreign invested non-investment enterprises to make equity investments.
Minutes of Work Conference for Civil and Commercial Trials
The Supreme People’s Court of China issued the Minutes on 8 November 2019, covering extensive sectors of civil and commercial trials, including corporation, contract, insolvency and finance, etc. Although the Minutes cannot be cited directly as clarified by the Supreme People’s Court, they still provide guidance and reference for judges.
As per the Minutes, sellers of financial products are obliged to know their investors and financial products, and to sell (or provide) appropriate products (or services) to investors (Appropriateness Obligation). If the failure to fulfil such Appropriateness Obligation results in a loss of investors, the investors are entitled to request the issuer/seller of the financial product to bear the liability for compensation, or to request both the issuer and the seller to bear the joint liability for compensation. This will cause fund managers to be more careful in their appropriateness management process during fund-raising.
Trends for 2020
Fund-raising in the private investment funds market in China is expected to continue to decrease in 2020, especially for private equity funds, considering the general economic status, the effect of coronavirus, and the stringent regulatory attitude towards asset management products.
The market is expecting some good news from wealth management subsidiaries of commercial banks (Bank Wealth Manager) because, in theory, private asset management products issued by Bank Wealth Managers are allowed to invest in private investment funds, including private equity funds. As of January 2020, 11 Bank Wealth Managers in total have been permitted to open by the China Banking and Insurance Regulatory Commission. However, considering the high risk and largely unpleasant experience of investors investing in private equity funds, the ability of Bank Wealth Managers to sell such products to high net worth individuals is uncertain.
While the depression in the fund-raising market continues, the corporate venture capital (CVC) model adopted by industrial giants has gradually become more eminent in the equity investment market since last year. More CVC is expected in 2020.
Finally, the emergence of LP defaults due to the lack of liquidity will cause more sales of LP interest, and secondary funds may have a role in the market. The secondary fund market of China is still at a quite early stage compared with the international market, but there may be more opportunities in this area in 2020.