Investment Funds 2020

Last Updated November 26, 2019

Hong Kong

Law and Practice

Authors



Shearman & Sterling has over 850 lawyers around the world, nearly half of whom practise outside the USA, speaking more than 60 languages and practising US, English, French, German, Italian, Hong Kong, OHADA and Saudi law. The full-service Investment Funds team is led by lawyers based in Hong Kong, Beijing, London, New York and Tokyo, with support from the firm’s global network of offices, advising clients across the full spectrum of investment funds, including private equity, hedge, real estate, infrastructure, growth and venture capital, credit and special situations, registered mutual (both open-end and closed-end) and UCITS funds. In addition to a deep bench and broad coverage across strategies, the firm has expertise in launching complex policy funds, leading sovereign wealth fund investments and providing advice to ambitious, growing PRC and Hong Kong-based asset managers, as well as advising on funds in other parts of Asia, including Japan, India and Singapore.

Hong Kong is a leading international financial centre known for its strategic position as a hub and gateway to mainland China, as well as for being one of the world’s largest capital markets. Hong Kong is also a principal centre for alternative investments, ranking second in Asia after mainland China for total capital under management by private equity funds (excluding real estate funds), which amounted to USD159 billion as at 25 March 2019. The Hong Kong industry for alternative asset management is strengthened by its diversity. Long a preferred destination for global and regional investment fund managers, more than 200 managers were based in Hong Kong in 2018. For these reasons, Hong Kong is likewise an important jurisdiction for leading pension funds, insurance companies, sovereign wealth funds, family offices and other investors.

Asset management and fund advisory businesses in Hong Kong amounted to HKD16,447 billion as at 31 December 2018, resulting in a moderate drop of 6% as compared to 2017. Nonetheless, the industry for alternative asset management continued to see an increase over the past few years in the number of licensed corporations and personnel. From September 2018 to September 2019, the number of corporations licensed in Hong Kong for Type 1 (dealing in securities), Type 4 (advising on securities) and Type 9 (asset management) regulated activities – the three types of licences most relevant to alternative asset managers – grew by 7%, 12% and 10%, respectively. Over the same period, the number of licensed representatives in Hong Kong for Type 1, 4 and 9 regulated activities increased respectively by 2%, 8% and 9%.

The continued growth of the alternative asset management sector in Hong Kong also reflects Hong Kong’s important role in China’s Belt and Road Initiative (BRI), one of Chinese President Xi Jinping’s signature initiatives for global infrastructure investment. In addition, the rapid development of the Guangdong–Hong Kong–Macao Greater Bay Area has created an additional need for private investment capital by start-ups in the innovation and technology field.

Hong Kong was well positioned heading into 2020, thanks in part to tax and legal changes initiated in the past few years by the Hong Kong authorities, including an expansion of the current profit tax exemptions, to encourage the use of vehicles formed locally in Hong Kong; amendments to certain codes of conduct regulating fund managers, to strengthen investor confidence in the Hong Kong private funds market; and tightened regulation over funds investing in virtual assets, to support and promote responsible innovation.

In addition, during 2019, a task force was formed to engage in research and discussions over a proposal for a new limited partnership regime in Hong Kong designed specifically for investment funds. If enacted as expected in 2020, the new regime would replace the existing, century-old statute and attract greater fund formation activity in Hong Kong, thereby strengthening Hong Kong’s position as a jurisdiction of choice for fund managers.

Market practice for private funds that have a managerial or advisory presence in Hong Kong is to form the fund entities in a tax-neutral, offshore jurisdiction, such as the Cayman Islands. Presently, Hong Kong is not often used by advisers and managers for the formation of these fund entities. One factor driving this is the lack of a modern limited partnership law in Hong Kong. If the current 100-year-old ordinance is modernised in 2020, as expected, to match the current needs and expectations of the market as described in 1.1 State of the Market, then the use of Hong Kong as a fund domicile may soon become more prevalent.

The common structure of a private fund that has a managerial or advisory presence in Hong Kong consists of (i) a fund entity formed as (a) a limited partnership (if the fund draws down capital over a fixed investment period), (b) a company (if the fund draws down all such capital at closing, as is typical for a hedge fund) or (c) an SPV; (ii) a general partner (if the limited partnership option is used) formed either as a limited partnership or as a company; and (iii) an investment manager or adviser established as a company, typically under the laws of a tax-neutral, offshore jurisdiction, such as the Cayman Islands.

Core fund documents include a limited partnership agreement (in the case of a limited partnership) or a shareholders’ agreement and articles of association (in the case of a company), subscription documents, a private placement memorandum (where applicable), side letters entered into with investors (where applicable), an investment management agreement and/or an investment advisory agreement.

Persons investing in private funds set up in commonly employed offshore jurisdictions generally will not be deemed to be taking part in the management of the business of these funds (and will therefore benefit from the safeguard of limited liability) so long as these persons act as passive, economic investors in connection with the investment, and locally qualified law firms may provide comfort on this point in the form of legal opinions. The contours of the exact legal requirements for how an investor may act as "passive" and "economic" varies across jurisdictions. Generally, the ability for investors to sit on a fund-level advisory committee that reviews conflicts of interest and other ancillary matters presented by fund management should not, by itself, result in the loss of these investors’ limited liability protection.

The Hong Kong Securities and Futures Commission (SFC) is the primary regulator of private funds and fund managers and advisers in Hong Kong. Hong Kong-based investment managers and advisers with SFC licences are subject to regulation under certain codes of conduct, including the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (the Code) and the Fund Manager Code of Conduct (FMCC), which prescribe a set of matters that are required to be disclosed to investors. The FMCC, for example, requires disclosure of cross trades, leverage arrangements, securities lending, repo and reverse repo transactions, risk management policies, custody arrangements and so forth, which are usually contained in marketing documents, such as a term sheet or private placement memorandum.

Hong Kong is an international market with many of the same key investor types that operate in other important jurisdictions, including pension funds, insurance companies, private banks, wealth management firms, funds of funds, high net worth individuals and family offices. Some of these institutional investors are branch offices of mainland China-based operations.

Investors in Hong Kong prefer to invest in private funds set up in a tax-neutral jurisdiction that has a track record of recognising the limited liability of investors.

As described in 2.1.2 Common Process for Setting up Investment Funds, the common structure of a private fund that has a managerial or advisory presence in Hong Kong would consist of (i) a fund entity structured as (a) a limited partnership, (b) a company or (c) an SPV; (ii) a general partner (assuming the limited partnership option is used) structured either as a limited partnership or as a company; and (iii) an investment manager or adviser structured as a company, all organised under the laws of the Cayman Islands.

Typically, a Cayman Islands-domiciled private fund with a team of investment professionals based in and working out of Hong Kong would also include a Hong Kong investment manager or adviser entity that employs these professionals and provides investment advice and operational support in respect of the investments.

Due to the periodic tightening of RMB capital outflows by the monetary regulators in mainland China, investors that have to source capital from their mainland China affiliate(s) may encounter difficulty in funding capital calls on a timely basis. In recent years, regulators in mainland China have revisited and tightened control on inbound and outbound investments. Prior to making a private fund investment, investors would be advised to carefully review and understand the impact of these rules, updates thereto and relevant law enforcement actions. Certain investors are subject to special regulations based on their investor type. For example, regulators in mainland China have steepened the requirements for China-based insurance companies investing in private funds, requiring such companies to report extensive, and potentially sensitive, information on their investments to mainland China government authorities.

Private funds set up in tax-neutral, offshore jurisdictions that have a Hong Kong-based team of investment professionals would typically retain, directly or indirectly, a Hong Kong investment manager or adviser.

The primary securities legislation in Hong Kong is the Securities and Futures Ordinance (SFO). Activities of an investment manager or adviser could, depending on the facts and circumstances, come within various categories of regulated activities under the SFO, including:

  • selling fund interests to residents in Hong Kong;
  • conducting selling activities in Hong Kong;
  • deal sourcing and execution of transactions;
  • making recommendations and advising with respect to potential deals; and
  • making investment decisions for the investment fund under management.

A Hong Kong investment manager or adviser entity, therefore, will usually be licensed under the SFC for conducting regulated activities in Hong Kong. The three types of licences that such manager or adviser is most likely to hold are Type 1 (dealing in securities), Type 4 (advising on securities) and Type 9 (asset management). Moreover, a manager registered in a jurisdiction other than Hong Kong that intends to conduct a regulated activity in Hong Kong, such as offering private fund interests to residents in Hong Kong or providing fund management or advisory services, must still comply with the private placement rule as detailed in 2.3.6 Marketing of Alternative Funds and the SFC licensing regime as detailed in 2.3 RegulatoryRegime, as applicable.

The core principle behind the Hong Kong licensing regime is that applicants must demonstrate, to the satisfaction of the SFC, that these applicants are fit and proper (SFO, Section 129) to be licensed. Being fit and proper involves, broadly, being financially sound, competent, honest, reputable and reliable. To obtain an SFC licence, an applicant would need to satisfy standards relating to the competence of responsible officers and other senior management and relating also to the adequacy of financial resources.

With regard to responsible officers (ROs), an applicant must appoint at least two such ROs to be tasked with direct supervision of the conduct of each proposed regulated activity, with at least one RO being available at all times to supervise each of the proposed regulated activities and at least one RO being designated as an executive director.

In addition to ROs, any individual who carries on a regulated activity on behalf of the corporation will similarly be required to obtain a licence as a representative (LRs) accredited to such corporation. As with ROs, LR applicants must satisfy the SFC that such LR has fulfilled the fit and proper requirement and must pass a related competency test.

Non-local service providers operating in Hong Kong are not, to the best of the authors' knowledge, subject to an additional legal registration requirement solely on account of being non-local.

If a non-local manager actively markets its services or products (whether by itself or by another person on its behalf) from outside Hong Kong to the public, which, if provided in Hong Kong, would constitute the carrying on of a business in regulated activity under the SFO, then such non-local manager should adhere to the Hong Kong licensing regime as discussed herein.

As indicated in 2.3.1 Regulatory Regime, the SFO prohibits "active marketing" of any service by any person (including those operating from an offshore jurisdiction) to the public if that would constitute a regulated activity if undertaken in Hong Kong, unless such person has obtained an appropriate licence.

SFC guidance suggests that the following factors would be considered in reaching the conclusion that this "active marketing" threshold has been crossed:

  • there is a detailed marketing plan to promote the relevant services;
  • the services are extensively advertised via marketing means such as direct mail, advertisements in local newspapers, the use of broadcasts or other "push" technology over the internet (as compared with situations where such services are only passively available; eg, on a "take it or leave it" basis);
  • the related marketing is conducted in a concerted manner and executed in accordance with a plan or schedule that indicates a continuing service rather than a one-off exercise;
  • the services are packaged to target the public of Hong Kong; eg, written in Chinese and denominated in Hong Kong dollars; and
  • the services are not sought out by the customers on such customers’ own initiative.

The SFO stipulates ten types of regulated activities, the most relevant of which for a private equity fund sponsor are Type 1 (dealing in securities), Type 4 (advising on securities) and Type 9 (asset management).

Type 1 (dealing in securities) regulated activity includes the making or offering to make an agreement with another person or inducing or attempting to induce another person to enter into an agreement for or with the view to acquiring or disposing of securities. If a company engages in the distribution and sale of securities, such as limited partnership interests or shares in a company, a Type 1 licence would thus be required. In addition, if a company engages in deal sourcing and the execution of private equity transactions, including negotiations with a target company, then this conduct may also constitute Type 1 regulated activity.

Type 4 (advising on securities) regulated activity includes the giving of advice on whether to acquire or dispose of securities. If a company provides investment advice for which remuneration is received, then, unless such advisory activities are wholly incidental to Type 1 regulated activity, the company will need to apply for and obtain a Type 4 licence.

Type 9 (asset management) regulated activity includes the managing of a real estate investment scheme or securities or futures contracts. If a company provides portfolio management services and exercises discretionary investment authority to make investment decisions for its clients, then the company will require a Type 9 licence.

As the profile of each private fund management team or sponsor with a managerial or advisory presence in Hong Kong may differ depending on such factors as strategy, personnel, business capabilities and operational models, many firms decide to apply for one or a combination of the Type 1, 4, or 9 licences, while some other firms instead seek to rely on an exemption from the licensing requirements. Alternatively, some firms may choose to acquire a corporation that is already licensed and, through the acquisition, conduct the desired type of regulated activity. The SFO sets out various exemptions from the licensing requirements, the most relevant of which are profiled below.

A company may not need a licence for certain regulated activities if these activities are performed in a manner that is wholly incidental to the carrying out of another regulated activity for which the company is already licensed. For example, if a company holds a Type 9 licence, then that company may rely on the incidental exemption to carry out related Type 1 and Type 4 regulated activities, provided that the preceding activities are undertaken solely for the purposes of the company’s asset management business.

A company may not need a licence for Type 4 or Type 9 regulated activity if the company provides the relevant advice or services solely to (i) the company’s wholly owned subsidiaries, (ii) the company’s holding company that holds all of the company’s issued shares or (iii) other wholly owned subsidiaries of the company’s holding company.

Offerings in Hong Kong of interests in private funds structured as partnerships or trusts (in the case of closed-end funds) are subject to regulation under the SFO. Offerings in Hong Kong of shares or debentures issued by private investment funds structured as companies (in the case of open-end funds, such as hedge funds) are subject to regulation both under the SFO and the Companies Ordinance.

Offering documents relating to securities offered to members of the Hong Kong public, whether offered by a licensed person or not, must be authorised by the SFC unless an exemption applies.

One of the most commonly used exemptions applies to offers made solely to "professional investors", within the meaning of the SFO and its relevant subsidiary legislation. "Professional investors" broadly encompasses financial institutions, insurance companies, investment companies, retirement schemes, pension plans, government entities and certain high net worth individuals and large entities. If fund interests are marketed in Hong Kong, the relevant investors should be provided with a supplemental Hong Kong investor questionnaire to confirm and document their professional investor status. It should be noted, however, that the admission by a fund of certain types of professional investors, including individuals, may cause such fund to be subject to enhanced compliance and due diligence requirements.

To the extent all Hong Kong offerees cannot meet the professional investor standard, another exemption is available under current market practices for offerings to not more than 50 offerees in Hong Kong. Although the offering documents for the types of private offers listed above are not required to comply with prospectus content requirements, they should include an appropriate securities legend to highlight that the offering documents have not been reviewed by any regulatory authority in Hong Kong and that investors are encouraged to seek independent professional advice.

As mentioned in 2.3.6 Marketing of Alternative Funds, one exemption commonly relied upon by a private fund to facilitate private placement in Hong Kong is an offering limited to "professional investors". The term "professional investor", for this purpose, is defined in the SFO and its relevant subsidiary legislation, and is broadly split into three categories:

  • institutional professional investors;
  • individual professional investors; and
  • corporate professional investors.

Institutional professional investors generally include authorised or regulated entities, such as recognised exchange companies, recognised clearing houses, recognised exchange controllers, recognised investor compensation companies, authorised financial institutions and authorised collective investment schemes. Individual professional investors and corporate professional investors are usually determined on the basis of their asset value or portfolio size, including:

  • a trust corporation having been entrusted under one or more trusts of which it acts as a trustee with total assets of not less than HKD40 million;
  • an individual, either alone or with any of his or her associates on a joint account, having a portfolio of not less than HKD8 million;
  • a corporation or partnership having a portfolio of not less than HKD8 million or total assets of not less than HKD40 million; and
  • a corporation whose principal business is to hold investments and that is wholly owned by a professional investor under the three points above.

The SFC is the main regulator of funds and fund managers and advisers in Hong Kong. The SFC derives its investigative, remedial and disciplinary powers from the SFO and subsidiary legislation. The SFO has empowered the SFC with multiple roles. The SFC’s principal responsibilities include maintaining and promoting the fairness, efficiency, competitiveness, transparency and orderliness of the securities and futures industry. The SFC’s scope of work includes licensing and supervising persons that conduct activities under the SFC’s regulatory purview.

The SFC often publishes guidance on regulatory matters and is timely to act when dealing with pressing concerns. The SFC often consults the industry and public at large prior to enacting significant changes in regulation. In recent years, the SFC has focused on addressing irregularities in the market, developing regulatory approaches toward new, emerging asset classes such as virtual assets, strengthening oversight of fund managers and advisers, and taking account of the multi-jurisdictional nature of private equity.

The SFC, where applicable, initiates disciplinary actions against fund managers and advisers for misconduct. For example, the SFC recently reprimanded and fined an investment manager HKD3.5 million for regulatory breaches, including unlicensed dealing and delay in reporting a breach to the SFC. The SFC posts notices of enforcement actions to its website as a way of offering and providing insight into its regulatory approach and priorities. The SFC has also tightened its regulation on virtual assets and complex products in recent years, as detailed in 4.1 Recent Developments and Proposals for Reform.

Fund managers in Hong Kong have certain reporting obligations under the SFO, the Code, the FMCC and other applicable codes and guidelines. For example, licensed or registered persons are required by the SFC, on an ongoing basis, to submit records of audited accounts. Pursuant to the FMCC, fund managers may also be requested by the SFC on an ongoing basis to provide additional information to help enable the SFC to monitor systemic risk. Such information may cover matters such as fund-level leverage, the terms of securities lending and the substance and balance of other assets and liabilities. In addition, the Code requires licensed or registered persons to report to the SFC immediately following certain specified events, such as compliance breaches and the initiation of legal proceedings.

The FMCC, in particular, requires a fund manager that is responsible for overall fund operations to disclose to investors the expected maximum level of leverage that may be employed on behalf of such fund and the basis for calculating this leverage, which should be reasonable and prudent. Moreover, the FMCC provides that a fund manager should not borrow funds from a connected person on behalf of a fund, unless interest charged and fees levied in connection with the relevant loan are no higher than the prevailing commercial rate for a similar loan.

Although a breach of the Code or the FMCC should not directly cause the relevant licensed or registered persons to become subject to legal action, such a breach could reflect negatively on the fitness and propriety of the sanctioned persons and may thus create a basis for disciplinary action.

Asian private equity or venture capital funds have traditionally sought financing to bridge a funding gap, either by way of a capital call or subscription credit facility. Such facilities are useful to private equity and venture capital funds as they could access funds quickly to capitalise on investment opportunities, while waiting for capital calls from limited partners to arrive. Drawdown under a capital call facility could be arranged within as little as one business day, whereas a capital call could take ten business days or more. This firm has also seen capital call facilities being utilised to bridge the funding gap between the time in which an acquisition is completed and drawdown under a permanent asset level-financing.

If seeking to incur financing or leverage, these funds are most likely to do so by entering into capital call and subscription credit facilities from banks, including international banks with a Hong Kong presence. Capital call and subscription facilities are structured as a revolving facility with the private equity or venture capital fund as borrower. The facilities are secured by an assignment of capital call rights under the limited partnership agreement and unfunded commitments of the limited partners, together with a charge over the accounts to which capital calls are to be deposited. The facilities are not usually secured by any of the fund’s underlying investment assets.

Sponsors in Hong Kong prefer to set up private funds in certain offshore jurisdictions to enjoy tax neutrality or the otherwise preferential tax rates and treaty benefits that these jurisdictions may offer. Funds that are domiciled outside of Hong Kong may be exempted from the Hong Kong profits tax if certain conditions under the Inland Revenue Ordinance (Cap 112) are met. The profit tax implications may vary for the asset-based management fees and variable performance fees that are often payable to fund managers.

Although a Hong Kong-based investment manager or adviser may advise on the operation of the fund, a portion of profits and income may remain with a separate Cayman-based fund manager or adviser, pursuant to appropriate commercial arrangements. In recent years, taxation of fund managers and advisers in Hong Kong has drawn closer scrutiny by the Inland Revenue Department (IRD) in terms of both the nature and source of income derived and the sufficiency of amounts received by the Hong Kong-based investment manager or adviser.

In the current market, sponsors of private funds would be advised to carefully review the service agreements among managerial entities, alongside the underlying compensation arrangements, in order to anticipate and defend against any challenges from the IRD.

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During 2019, a task force was formed to develop a proposal for a modern limited partnership regime in Hong Kong. Benefitting from research into Hong Kong’s market landscape as well as international trends, the proposal should be better suited to the current needs and desires of market participants in Hong Kong’s alternative asset management industry than the existing regime, which was last amended in 1924. If the updated regime is enacted in 2020, as projected, then funds in the Cayman Islands or elsewhere being operationally managed from Hong Kong may re-domicile to Hong Kong (and, correspondingly, successor vintages of such funds may be formed in Hong Kong), thereby aligning legal structures with business activities, and contributing to Hong Kong’s ongoing growth as a global financial centre.

In light of the growing investor interest in virtual assets (including exposure to such assets through private equity funds) and the growth in unlicensed trading platform operators in Hong Kong, the SFC on 1 November 2018 announced a new regulatory framework for the governance of virtual assets. Among other things, the SFC announced that terms and conditions will be imposed on licensed corporations that manage or plan to manage portfolios with (i) a stated investment objective to invest in virtual assets, or (ii) an intention to invest 10% or more of the gross asset value of the portfolio in virtual assets (collectively, Virtual Asset Fund Managers).

On 4 October 2019, the SFC published Proforma Terms and Conditions for Licensed Corporations which Manage Portfolios that Invest in Virtual Assets, which further sets out the terms and conditions that will be imposed on all Virtual Asset Fund Managers, subject to minor variations and elaborations depending on an individual Virtual Asset Fund Manager’s business model and circumstances. These terms and conditions are mostly principle-based and will be imposed on Virtual Asset Fund Managers by way of a licensing condition. Failure to observe such licensing condition may be considered as misconduct under the SFO and may adversely affect the fitness and properness of a Virtual Asset Fund Manager and even result in disciplinary action by the SFC.

The SFC issued a circular on 13 June 2019 on implementation of regulatory requirements for online and offline sale of complex products. A complex product is “an investment product whose, terms, features and risks are not reasonably likely to be understood by a retail investor because of its complex structure.” Factors to determine whether an investment product is complex or not are further set out in the Guidelines on Online Distribution and Advisory Platforms and the Code, including (i) whether a secondary market is available for the investment product at publicly available prices, (ii) whether there is adequate and transparent information about the investment product available to retail investors, and (iii) whether any features or terms of the investment product might render the investment illiquid and/or difficult to value. Thus, a private fund is likely to be considered a complex product that is subject to enhanced requirements relating to suitability, the provision of information and warning statements.

On 7 January 2020, the SFC issued guidance on the licensing obligations of private equity firms and family offices that conduct business in Hong Kong. In a circular to private equity firms seeking to be licensed, the SFC clarifies certain existing licensing requirements, such as those applicable to general partners and investment committee members, offering co-investment opportunities and fund marketing activities. The circular also clarifies how the SFC assesses private equity firms’ discretionary investment authority and investments in securities of private companies, as well as the industry experience requirement for their responsible officers. A separate circular provides general guidance for family offices intending to carry out asset management or other services in Hong Kong and explains the potential implications for both single and multi-family offices. Licensing exemptions, or carve-outs, may be available depending on how a family office operates.

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Trends and Developments


Authors



Vivien Teu & Co LLP is a Hong Kong corporate and commercial law practice with a focus on investment funds, asset management and financial services, securities and regulatory, tax and trusts. Combining in-depth Hong Kong and international legal practice experience with deep and broad knowledge of China and regional markets, the firm regularly advises on cross-border matters. The asset management practice serves local and international clients establishing or operating asset management platforms in Hong Kong, as well as on fund formation and funds offerings. Its lawyers are experienced in advising on navigating the business, legal and regulatory environment in Hong Kong for asset management. Vivien Teu & Co LLP is a go-to firm for offering seamless Hong Kong law support on cross-border Mainland China and Hong Kong matters relating to asset management, investment funds, cross-border securities and investments, China market entry strategies, joint ventures and acquisitions. The firm has also strengthened the ESG focus of its investment funds and corporate practice.

Macro Trends Underlying the Hong Kong Funds Market

The investment funds market in Hong Kong continues to evolve and develop in the context of Hong Kong’s continuing role as an international financial centre in Asia and the gateway for Mainland China of the People’s Republic. This covers cross-border investments from global investors to Asia and Mainland China, and also as Hong Kong acts as the hub for Mainland China and Asia market players and investors to access international capital and investment opportunities.

With its deep market infrastructure, highly established and liquid markets, as well as an extensive pool of professional expertise in international finance, Hong Kong is expected to remain strategically important in China’s “opening-up” and integration with the global financial markets. Under “One Country, Two Systems”, Hong Kong’s common law legal system, unrestricted foreign exchange and capital flows and dollar-peg currency all offer a well-oiled operating environment for international and Chinese companies and institutions to tap cross-market opportunities relating to China as the second largest economy in the world.

Hong Kong has a well-established asset management and funds industry that has been successful under its dynamic and free markets, while global asset managers operating in Hong Kong have unique opportunities from the region’s close and strategic links to China’s growth and expansion, under various China market access schemes such as most recently the Mainland-Hong Kong Stock Connect and Bond Connect programmes. The Mutual Recognition of Funds (MRF) arrangements introduced in 2015 further boosted Hong Kong’s attraction as a fund management centre, as the MRF allows qualifying retail funds managed in Hong Kong to be registered for distribution in China, and for qualifying Mainland China retail funds to be available in Hong Kong. Hong Kong has also established MRF arrangements with the United Kingdom and several European jurisdictions, further to which Hong Kong-domiciled funds could be distributed in these markets.

While having one of the top three global markets for initial public offerings, Hong Kong is also increasingly a significant centre for China and Asia venture capital and private equity activities, especially as Hong Kong has revised its listing requirements in recent years to attract companies in emerging and innovative sectors, such as bio-tech and other technology fields. Hong Kong’s position as a key international financial centre is expected to be further consolidated under China’s Greater Bay Area plans, to leverage Hong Kong’s status as a key international financial centre and offshore Renminbi hub, and as an international asset management centre.

The strength and vibrancy of capital-raising activities and investment opportunities in both the public and private markets have drawn financial institutions and institutional investors, while private banks and financial advisory firms including multi-family offices are increasingly drawn to Hong Kong to meet the investment needs of growing wealth in China and the region.

Trends in Establishing and Managing Funds in Hong Kong

Under an open architecture framework, fund managers with overseas qualifications and experience of other markets may qualify to set up as licensed managers or intermediaries in Hong Kong and, furthermore, Hong Kong is domicile-neutral on the funds that may be offered in Hong Kong on a private placement basis or which may be approved for offer to the public in Hong Kong. Against this backdrop, Hong Kong continues to see many asset management firms or marketing offices set up here by international global fund houses and, in recent years, more market entrants from Mainland China and other parts of Asia.  

Broadly speaking, the nature of the activities intended to be undertaken in Hong Kong would determine the type of licence or categories of regulated activities to be approved by the Hong Kong Securities & Futures Commission (SFC), the primary regulator on the conduct of securities and futures businesses and markets in Hong Kong. A licence to conduct the regulated activity of “asset management” is required for engaging in fund management and/or investment management of portfolios investing in securities or futures contracts. On the other hand, the offering of fund products may fall to be licensed for the regulated activity of “dealing in securities”, although a licensed fund manager may be exempted in offering its funds pursuant to its conduct of licensed asset management business. For a retail fund to be offered to the public in Hong Kong, the fund would need to be separately authorised by the SFC, and the fund manager would need to be subject to further qualification requirements for managing an authorised fund.

However, it is increasingly common for managers and intermediaries to be licensed with the condition to only provide their services to “Professional Investors” – this covers institutional investors and also high net worth individuals or corporations that meet the relevant wealth or assets thresholds. As Hong Kong establishes itself as a wealth management centre, more managers and intermediaries are establishing in Hong Kong, primarily to target high net worth and ultra high net worth clients.

At the same time, growth in wealth is leading to the establishment of more family offices and multi-family offices in Hong Kong. While there are no laws or regulations that refer specifically to family offices, the actual nature of activities may trigger certain regulatory issues, particularly where an office is carrying on business involving investing or trading in securities or futures that may amount to regulated or licensable activities.

As clarified by the SFC in its Circular on the Licensing Obligations of Family Offices issued in January 2020, single family offices may rely on the licence exemption for providing asset management services solely to related entities, which is an existing exemption for providing services to wholly-owned subsidiaries, its holding company holding all its issued shares, or the wholly-owned subsidiaries of its holding company. Multi-family offices that provide services beyond such related entities would likely be subject to licensing requirements.

There is also growing regulatory attention on the conduct of fund management activities in private equity, with a clarification issued in January 2020 from the SFC to stamp out previous uncertainty and doubts on the applicability of licensing requirements to private equity fund managers. In its Circular to Private Equity Firms Seeking to be Licensed, the SFC noted that it will consider the composition of the investment portfolio, which may trigger licensing requirements if the underlying specific purpose vehicles or underlying investments of the private equity fund under management fall within the definition of “securities”. The term "securities" has a broad definition under the Securities and Futures Ordinance (SFO), but the definition excludes shares or debentures of a company that is a private company within the meaning of section 11 of the Companies Ordinance (Cap. 622). The SFC has confirmed a clear view that only shares and debentures of Hong Kong-incorporated private companies are excluded from the definition of “securities”.

These Circulars published at the start of the year by the SFC should serve as a reminder to market participants that it is ever more important to engage in a careful review of the intended fund management and investment activities to be carried out in Hong Kong in order to determine the specific licensing requirements to be complied with. In this connection, it would be necessary to consider the proposed set-up, taking into account the intended investment management and operational arrangements, the location and personnel where and by whom such activities would be conducted, and the related licensing, regulatory and also tax implications.

Fund Domicile Trends

Hong Kong open-ended fund company structure

Under Hong Kong’s open framework, Hong Kong is domicile-neutral on the funds that may be offered in Hong Kong on a private placement basis or which may be approved for offer to the public in Hong Kong. It has been rather well accepted and common practice for Hong Kong fund managers to establish private funds domiciled in an offshore jurisdiction, with Cayman Islands’ exempted company structures or segregated portfolio company structures being the most popular.

In July 2018, the legal framework was put in place for establishing Hong Kong-domiciled open-ended investment funds structured in corporate form. Before this, a Hong Kong-domiciled open-ended fund took the form of a unit trust constituted under a Hong Kong law-governed trust deed. It is now possible to establish a Hong Kong-domiciled open-ended fund in the form of an open-ended fund company (OFC) structure with variable capital, under the amended Securities and Futures Ordinance (SFO), together with the Open-ended Fund Companies Rules (as a subsidiary legislation of the SFO) (the OFC Rules) and the Code on Open-ended Fund Companies (the OFC Code) issued by the SFC.

This introduced an alternative structure, which may be adopted for private funds or retail funds. The Hong Kong OFC offers an additional choice that Hong Kong fund managers may consider in fund formation, subject to complying with the OFC Rules and the OFC Code. Setting up an OFC is subject to obtaining the prior approval of the SFC, which is expected to be a "lighter-touch" process compared to the approval process in the case of an application for authorisation of a retail fund.

Furthermore, revised profits tax exemption rules came into effect in April 2019, replacing the previous tax exemptions for offshore (non-resident) funds and for the OFC. The new tax law essentially provides an exemption from Hong Kong profits tax for structures meeting the definition of "fund" (which mirrors the definition of "collective investment scheme" in the SFO), in respect of "qualifying transactions" and "qualifying assets". This levels the playing field for offshore private funds and private funds structured as the Hong Kong OFC. In view of ring-fencing features considered as harmful tax practice and also to enhance the OFC structure, offshore private funds no longer need to be non-tax-resident in order to qualify for the profits tax exemption (thereby encouraging the central management and control to be relocated to Hong Kong), and the previous stringent conditions that the OFC had originally been required to meet in order to enjoy tax exemptions have been removed.

Mutual recognition of funds arrangements

With respect to the public funds market, the authorisation of retail funds in Hong Kong has not been restricted to Hong Kong-domiciled funds and, as it stands, around 60% of SFC authorised funds are UCITS funds. The SFC accepts applications for the authorisation of non-Hong Kong-domiciled funds or schemes, and broadly speaking overseas-approved schemes may be authorised in Hong Kong under two available schemes: recognised jurisdiction schemes (RJS) and schemes authorised under the mutual recognition of funds (MRF) arrangements.

The majority of RJS are undertakings for collective investment in transferable securities (UCITS) funds domiciled in Luxembourg, Ireland and the United Kingdom, and RJS are considered to already comply in substance with certain provisions of the UT Code by virtue of prior authorisation in a recognised jurisdiction, although schemes would still be subject to review by the SFC during the authorisation application process, for compliance with certain requirements under the UT Code, including regarding the management company and trustee or custodian of the RJS.

Conversely, the MRF is a relatively new innovative programme that has been ground-breaking in giving SFC-authorised Hong Kong funds the potential to be registered for direct retail distribution in Mainland China (and tap its immense market), and for eligible and approved Mainland China funds to be directly offered and available to the public in Hong Kong (and, through it, to international capital).

Since its launch in 2015, more than 40 Mainland China funds have been authorised by the SFC for retail offer in Hong Kong under the "Mainland-Hong Kong Mutual Recognition of Funds", while more than ten Hong Kong funds have been registered for retail distribution in Mainland China.

A key feature of the MRF is that an SFC-authorised fund seeking recognition in a host jurisdiction must be a Hong Kong-domiciled fund (amongst other qualifying criteria). This has encouraged the use of Hong Kong-domiciled unit trusts, which may now be established alternatively as an OFC structure. This could become more attractive as the MRF programme continues to expand. Currently, in addition to the arrangements with Mainland China, Hong Kong has also entered into respective MRF arrangements with France, Switzerland, the United Kingdom, Luxembourg and the Netherlands.

Moreover, the MRF programme may welcome new entrants from these European jurisdictions to the Hong Kong retail funds market, beyond the current players with existing UCITS authorised by the Hong Kong SFC as RJS. UCITS seeking authorisation under the MRF programme may enjoy a speedier approval process as, broadly speaking, the management company and the fund shall be deemed as compliant and acceptable to be authorised if eligible under the applicable MRF requirements.

Hong Kong limited partnership fund

While the OFC structure, as its name suggests, is not intended for private equity funds that are typically structured as closed-ended, it is technically possible to adopt the OFC for a private equity fund, with the relevant lock-up or redemption restriction to the OFC. Having said that, it is worth noting that, according to the OFC Code, at least 90% of the gross asset value of a private OFC must consist of assets that are of the nature of securities and futures (assets whose management would constitute a regulated "asset management" activity under the SFO) and/or cash, bank deposits, certificates of deposits, foreign currencies and foreign exchange contracts. As noted above, shares or debentures of a company that is a Hong Kong private company under the Hong Kong Companies Ordinance fall outside the definition of "securities", with the position that shares or debentures of private offshore companies that fall outside the definition of "private company" under the Companies Ordinance can be considered "securities".

In terms of structure, private equity fund managers operating in Hong Kong tend to establish private equity funds structured in an offshore jurisdiction (again, the Cayman Islands is the most common) as limited partnership funds (with an incorporated Cayman general partner). To encourage fund managers further to adopt Hong Kong as the domicile of choice when establishing private funds, Hong Kong is considering updating its limited partnership law to cater to the private equity funds industry. As stated in the 2019-2020 budget speech of the Hong Kong Financial Secretary, Hong Kong is now studying the establishment of a limited partnership regime for private equity funds, in order to provide the industry with more choice of fund structure. The Hong Kong government will also study the potential introduction of a more competitive tax arrangement to attract private equity funds to set up and operate in Hong Kong.

Updated Requirements on Retail Funds

In 2019, the SFC issued a new revised Code of Unit Trusts and Mutual Funds (UT Code), under which a number of key updates were made to the primary requirements applicable to the authorisation of funds for public offer in Hong Kong. Following the 12-month transition period, which expired at the end of 2019, all SFC-authorised funds should already be compliant with the relevant requirements, including the new or updated disclosure requirements.

Enhanced regulations on the use of derivatives

All SFC-authorised funds must disclose the purpose of and the expected maximum net derivative exposure arising from the use of financial derivative instruments (FDI), in their product key facts statement (KFS). Furthermore, fund managers are required to determine/categorise whether their SFC-authorised fund is or is not a derivative fund pursuant to the SFC Guide on the Use of Financial Derivative Instruments for Unit Trusts and Mutual Funds (FDI Guide), published in December 2018, based on the net exposure arising from the fund’s use of or investments in FDIs.

In general, a plain vanilla retail fund authorised by the SFC may use FDIs for hedging purposes, whereas the use of FDIs for non-hedging (ie, investment) purposes is subject to a limit that the fund's net exposure relating to these financial derivative instruments should not exceed 50% of its net asset value. The calculation methodology of the net derivative exposure is set out in the FDI Guide. Hong Kong (-domiciled) retail funds that use FDIs extensively for investment purposes would be considered as specialised funds, which would then be subject to a maximum net derivative exposure of 100% of their net asset value, applicable investment restrictions and additional disclosure requirements. For UCITS funds authorised by the SFC for retail offer in Hong Kong, UCITS whose net derivative exposure exceeds 50% of the net asset value are deemed to have already complied with the relevant UCITS requirements, and therefore are only subject to the disclosure requirement in the fund's offering documents and KFS. A fund with a net derivative exposure of more than 50% of its net asset value would be categorised as a "derivative fund" and would be marked as such on the SFC’s register of authorised funds.

Group resources

An encouraging update is that the SFC will now permit a management company or its delegate to rely on the broader support and expertise of its group to meet the investment management personnel requirement for retail funds – ie, having at least two key investment management personnel, each with at least five years of relevant investment experience in managing public funds. Fund groups setting up in Hong Kong may therefore engage more quickly in the business of establishing or operating retail funds without having to wait or compete to hire and house in Hong Kong at least two key investment management personnel with the requisite experience. This is also a step towards developing Hong Kong as a centre for the formation and management of funds, along with the introduction of the regulatory policies of having the OFC structure and the MRF programme for Hong Kong-domiciled funds.

Product innovation

Moreover, the revised UT Code introduced potential new innovative products that may be approved as retail funds in Hong Kong, such as the listed open-ended funds (ie, actively managed exchange-traded funds (ETFs)). Previously, the UT Code catered for passively managed ETFs, which track the performance of indices or benchmarks. However, noting the growth of active ETFs in various overseas jurisdictions and also due to market interest, active ETFs are now included with a view to offering more investment choices to investors.

Green Finance, ESG and Sustainability

Hong Kong is also keeping up with the global trends towards green and sustainable investments and the greater emphasis on responsible corporates taking environmental, social and governance (ESG) factors into account.

In addition to efforts on Hong Kong becoming a regional green finance hub and a centre for the issuance of green bonds, the Hong Kong Stock Exchange (HKEx) released its consultation conclusions and the new ESG Reporting Guide for companies listed on the HKEx, which now mandate disclosures on board engagement and oversight over ESG and materiality assessment, as well as requiring “comply or explain” disclosures of both environment and social performance indicators.

Further to its Strategic Framework for Green Finance, the SFC also conducted a survey with Hong Kong-licensed managers to obtain insight into whether and how asset managers are integrating ESG factors in their investment and risk management processes, as well as into questions relating to responsible owner stewardship (post-investment ownership practices and disclosures). When publishing the survey results in December 2019, the SFC indicated that it plans to promote the management of climate risks by developing expected standards, providing practical guidance and encouraging best practices.

In April 2019, a Circular was issued to management companies of SFC-authorised unit trusts and mutual funds to address "Green" or "ESG" funds, with the aim to enhance disclosure comparability between similar types of SFC-authorised Green or ESG funds and their transparency and visibility, in order to facilitate investors making informed investment decisions in this evolving investment area.

Pursuant to the Circular, investment managers offering investment products with an expressed green or ESG focus, or who intend to do so, should carefully consider whether their fund would and is able to comply with the SFC’s expected framework for Green or ESG funds and become designated as such. An investment manager of Green or ESG funds would also be expected to have a proper and robust investment selection process and assessment criteria, in line with its stated investment focus and green or ESG principles, and may seek to obtain a third-party certification or fund labelling, or could rely on its self-confirmation. The SFC will keep local and international market and regulatory developments in view, and may provide further guidance or impose additional requirements for green or ESG funds, where appropriate.

Complex Products

Effective from July 2019, Hong Kong-licensed intermediaries (including fund distributors and placement agents) are required to determine whether a product (including private or retail funds or other types of financial products) that is being marketed is a complex product, which in turn attracts more stringent standard under the SFC Code of Conduct on determining the product's suitability for an investor (unless relevant exemptions apply).

For retail funds, the categorisation published on the SFC’s register of authorised funds of whether or not a retail fund is a derivative fund will be relevant in categorising the fund as a complex product. Intermediaries are also required to apply a stricter suitability standard when marketing private funds that are complex products, and the use or extent of investments in derivatives by a private fund should also be taken into account, by reference to the SFC FDI Guide for authorised funds, when determining whether the private fund is a derivative fund and complex product.

These enhanced requirements were first introduced by the SFC in its Guidelines on Online Distribution and Advisory Platforms (Distribution Guidelines) and, as effective since July 2019, the additional investor protection measures on the sale of complex products shall apply under both online and offshore sales and marketing environment. Other than the extent of use or investments in FDI, intermediaries are expected to consider other factors in determining whether private funds are complex products.

According to the Distribution Guidelines, a complex product is an investment product whose terms, features and risks are not reasonably likely to be understood by a retail investor because of its complex structure. Factors include whether it is a derivative product, whether a secondary market is available for the product at publicly available prices, whether there is a risk of losing more than the amount invested, and whether any features or terms of the product might render the investment illiquid and/or difficult to value. The SFC takes the view that private funds are more likely to be categorised as complex products due to the limited availability of information on the fund or liquidity in the secondary market. The distribution and marketing practices for private funds to individuals (including private high net worth clients) going forward would be affected by the Distribution Guidelines.

Virtual Assets

In November 2018, the SFC issued a Statement and accompanying details on its regulatory approach on virtual assets (encompassing "cryptocurrency", "crypto-assets" or "digital token"). The SFC’s measures seek to regulate the investment or portfolio management or distribution of investment products that involve investing in virtual assets, and this is expressly stated to include virtual assets that may fall outside the definition of "securities" or "futures contract" under the SFO. Additional conditions shall apply to licensed managers that manage portfolios that invest solely in virtual assets, or that involve virtual assets above a 10% threshold. There are also separate additional specific requirements that apply to licensed intermediaries distributing virtual assets funds.

In October 2019, the SFC published a proforma set of terms and conditions that apply to virtual asset portfolio managers as an extension to the 2018 Statement, which will be imposed on licensed corporations that manage or plan to manage funds (or portion of funds) where:

  • there is a stated investment objective to invest in virtual assets; or
  • the intention of the fund is to invest 10% or more of its gross asset value in virtual assets.

A virtual asset portfolio manager is subject to a higher minimum liquid capital requirement, and may only provide its services to “Professional Investors”. There is also a requirement to assess a client’s knowledge of investing in virtual assets or related products, or, alternatively, any investment experience in private equity, venture capital or start-ups, prior to providing its services. If the client does not possess any such knowledge, the virtual asset manager may only provide services to the client if it would be acting in the best interests of the client. The SFC also published a position paper in November 2019 on its regulatory framework on virtual assets trading platform operators, following a year-long assessment of operators currently in operation.

The SFC generally takes a measured cautious approach, from an investor protection perspective, on the risks that virtual assets may pose, though expressing an openness to encourage the responsible use of technologies that could offer better choices or better outcomes.

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Shearman & Sterling has over 850 lawyers around the world, nearly half of whom practise outside the USA, speaking more than 60 languages and practising US, English, French, German, Italian, Hong Kong, OHADA and Saudi law. The full-service Investment Funds team is led by lawyers based in Hong Kong, Beijing, London, New York and Tokyo, with support from the firm’s global network of offices, advising clients across the full spectrum of investment funds, including private equity, hedge, real estate, infrastructure, growth and venture capital, credit and special situations, registered mutual (both open-end and closed-end) and UCITS funds. In addition to a deep bench and broad coverage across strategies, the firm has expertise in launching complex policy funds, leading sovereign wealth fund investments and providing advice to ambitious, growing PRC and Hong Kong-based asset managers, as well as advising on funds in other parts of Asia, including Japan, India and Singapore.

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Vivien Teu & Co LLP is a Hong Kong corporate and commercial law practice with a focus on investment funds, asset management and financial services, securities and regulatory, tax and trusts. Combining in-depth Hong Kong and international legal practice experience with deep and broad knowledge of China and regional markets, the firm regularly advises on cross-border matters. The asset management practice serves local and international clients establishing or operating asset management platforms in Hong Kong, as well as on fund formation and funds offerings. Its lawyers are experienced in advising on navigating the business, legal and regulatory environment in Hong Kong for asset management. Vivien Teu & Co LLP is a go-to firm for offering seamless Hong Kong law support on cross-border Mainland China and Hong Kong matters relating to asset management, investment funds, cross-border securities and investments, China market entry strategies, joint ventures and acquisitions. The firm has also strengthened the ESG focus of its investment funds and corporate practice.

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