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Chinese Regulation on Private Equity Industry

Chinese Regulation on Private Equity Industry (published on ALB)

I. Development of Private Equity Industry in China

Private equity is a broad term that refers to any type of equity investment in an asset in which the equity is not freely tradable on a public stock market. Although the legal structure might be the same more or less, there are many classifications within the equity fund due to the difference of investment style and the investment target. Such classification might cause confusions sometimes. An internationally accepted classification divide private equity fund into three categories: a. venture capital fund which targets at the start-ups or the hi-tech companies; b. Growth-oriented Fund, which targets at the enterprises at the growth period without being listed as a non-controlling shareholder; c. Buyout Fund, which targets at the private equity of the mature enterprise with an intent of control in order to restructure the resources of the targeted enterprise and increase the value thereof.

Private equity fund is in the limelight of the capital market recently. Even a new word “Private Equiteer” was created to describe the private equity investors. Worldwide, private equity funds manage approximately $1 trillion of capital. Private equity fund is an emerging market in China. It develops very fast in the year 2006. According to the studies of AVCJ, there are more than 350 private equity funds targeting Chinese market with a total 12.4 billion US dollars. Having said that, there are lots of things needed to be done to improve the legal environment of private equity market.

The definition of the private equity fund in China is much more confused reflecting a Chinese element. Different from developed countries, the Chinese government is playing an important role to regulate and control the private equity fund. The Chinese government intends to divide the private equity fund into three forms: venture capital fund, infrastructure fund and enterprises restructuring fund. While the venture capital fund is regulated by the Interim Measures for the Administration of Startup Investment Enterprises which was officially promulgated in November 15, 2005 and took effect in March 1, 2006, the other two types of private equity fund will be regulated by another regulation, named Measures for Administration of Industry Investment Fund which is still under draft by National Development and Reform Commission (NDRC). According to current version of draft, NDRC will keep a close eye on the operation of the Industry Fund.

II. Several Important Issues

Virtually all private equity funds are organized as limited partnerships, with private equity firms serving as the general partner (GP) of the funds, and large institutional investors and wealthy individuals providing the bulk of the capital as limited partners (LPs). In China, the situation is more complicated than that in the following: a. Chinese legal environment of private equity fund is far from behind and large foreign equity fund usually elects to establish their presence abroad and invest the domestic enterprise through FDI or the typical “Sina Model”; b. the Chinese government is having a tight control of the market and the overwhelming majority of the private equity funds are those with strong government background; c. there are no limited liability partnerships and enterprise or organizations are not allowed as the partner of the partnership. The new Partnership Enterprise Law of the People’s Republic of China which was officially promulgated in August 27, 2006 and will be effective on June 1, 2007 will break through the aforementioned limitations.

The legal systems of private equity market is under construction which will be regulated the Company Law, the Law of the People’s Republic of China on the Promotion of Small and Medium-sized Enterprises, the Partnership Enterprise Law of the People’s Republic of China, the Interim Measures for the Administration of Startup Investment Enterprises, the Provisions Concerning the Administration of Foreign-funded Business-starting Investment Enterprises plus other tax regulations including the newly promulgated tax preferential treatment on startup investment enterprises.

A. Entry Threshold

Within current Chinese legal system plus the ongoing Industry Investment Fund regulation which is under discussion, there are broadly three forms of private equity fund in China, namely, a. start-up investment enterprise as a limited liability partnership, b. start-up investment enterprise as a limited liability company; c. industry investment fund.

1. Start-up Investment Enterprise as Limited Liability Partnership

Apparently the number of partners shall not exceed 50 although the Interim Measures for the Administration of Startup Investment Enterprises allow a number not exceeding 200 because the former law has a prevailing power. For a foreign funded limited liability partnership, the minimum capital contribution is 10 million US dollars. There should be at least one GLP which is called indispensable investor. The accumulative total capital managed by it in the three years before the application is not less than 100,000,000 U.S. dollars, and of which no less than 50,000,000 U.S. dollars have been used in business-starting investment.

2. Start-up Investment Enterprise as a Limited Liability Company

As a limited liability company, the number of shareholders shall not exceed 50. For a foreign funded limited liability company, the minimum capital contribution is 5 million US dollars. An indispensable investor of a foreign-funded incorporated Start-up Investment Enterprise shall subscribe to and actually pay not less than 30% of the subscribed contributions and the actual total contributions respectively

3. Industry Investment Fund

As the regulation on Industry Investment Fund is not officially promulgated, it is still unclear the threshold therefor. However, the regulation of Industry Investment Fund is similar to the regulation on securities mutual fund.

B. Tax Treatment

1. Start-up Investment Enterprise as a Limited Liability Company

On February 15, the Ministry of Finance and State General Administration of Taxation jointly issued the Notice regarding the Tax Policy to Facilitate the Development of Start-up Investment Enterprise (the “2007 Notice”). According to the 2007 Notice, 70% of the investment amount on the small and medium-sized high-tech enterprise can be deducted from taxable income subject to a few conditions such as that the investment shall have lasted for at least two years. According to the new Enterprise Income Law which will take effect in 2008, the deductible tax will be 17.5% of the investment amount (25% as uniform tax rate). According to the Notice on Some Issues Concerning the Income Tax Related to Equity issued in June 21, 2000 (the “2000 Notice”), in case the shareholders of the Start-up Investment Enterprise is still an enterprise, then the shareholders will also be entitled to non-payment of taxes which will avoid the double taxation. However, in case the shareholders are individuals, they shall pay 20% of the income obtained from the Start-up Investment Enterprise.

2. Start-up Investment Enterprise as Limited Liability Partnership

According to the 2007 Notice, whether the Start-up Investment Enterprise as Limited Liability Partnership will also enjoy the tax preferential treatment is not very clear. According to the new Partnership Enterprise Law, for the production and business operation incomes and other incomes of a partnership enterprise, the partners shall pay their respective income tax in accordance with the relevant tax provisions of the state. Therefore it seems that the investors shall pay the income tax in full amount without deduction. However, according to Notice of the State Administration of Taxation on Relevant Issues Concerning the Payment of Enterprise Income Taxes by Foreign-Funded Start-up Companies issued in June 4, 2003 (the “2003 Notice”), for a foreign funded start-up enterprise which is restructured as a non-legal person, the enterprise income tax returns may be filed and the enterprise income tax may be paid either by the investing parties respectively or uniformly by the start-up enterprise after being approved by the local taxation organ in accordance with the Tax Law. In such case, the foreign funded Start-up Investment Enterprise as Limited Liability Partnership might enjoy the preferential tax treatment under the 2007 Notice. Anyway, it seems that the Chinese government is encouraging the Start-up Investment Enterprise as a Limited Liability Company.

C.. Protection on Investors

Usually, the investor shall have such following rights, among others: right of first refusal, tag-along rights, drag-along rights, pre-emptive rights, anti-dilution right, conversion right, redemption right, registration right. According to our experience, what the investor care about the most are two folds: a. the right to control the change of equity of the invested company; b. the right of initial public offering (IPO) as the most important exit mechanism. With the aforementioned rights vested in the investor, the founders can not easily get away with the investor later on once they accept the investment because the private equity fund will allocate a much higher PE rate to the invested enterprise which can only be usually accepted by the private equity funds. Naturally the second-round investor will defer to the opinion of the first investor to a much extent. Chinese capital market has fallen far behind the developed countries without offering the sufficient exit mechanism to the investor. The good news is that Chinese capital market including the stock exchange market is growing fast. We expect Chinese private equity market will play an important role in Chinese fast-growing economics.

This entry was posted on Friday, August 3rd, 2007 at 6:58 pm and is filed under Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.