Foreign Investment in PE/VC Funds in China under Legal Perspective By Shiduo XU   Liya TAO 2017-12-06

For a long time, China has a relatively stringent restriction on participation by foreign investors and foreign-invested enterprises (FIEs) in fund business in China via capital injection in foreign currency.  These restrictions are mainly reflected in foreign exchange control and national treatment (i.e. investment entry).  As economy develops, China has gradually liberalized its regulation on foreign exchange, which further facilitates foreign investors’ participation in and carrying out of the fund business.


As for foreign-invested funds’ downstream investments, their portfolio companies are also impacted to some extent by such foreign ownership, and those portfolio companies with foreign capital or currency investment may also need to face this issue in further capital market operations, including but not limited to prospective IPOs.


The so-called foreign investment in domestic private equity or venture capital funds (PE or PE/VC funds) covers the following general aspects:


(i)                 establishment and operation of foreign-invested fund manager;

(ii)               FIE’s investment in domestic PE/VC funds; and

(iii)             foreign investor’s direct investment in domestic PE/VC funds.


This article will explore the latest legislative development in these areas and outline practical solutions.


1.        Foreign-invested Fund Management Company


Investment Entry Restriction



The establishment of foreign-invested fund management company (FIE FMC) shall comply with industrial restriction on foreign investment.  Pursuant to the current Catalogue for the Guidance of Foreign Investment Industries (Guiding Catalogue), securities investment fund management companies (in practice, this mainly refers to publicly placed funds) falls into the restricted categories, and  majority equity interests must be held by Chinese party(ies), while private equity investment fund management companies are not covered in the restricted category.  However, due to the practical barriers encountered in settlement and use of foreign currency under capital account, the establishment of FIE FMC and foreign-invested fund has been difficult to operate for quite a long time.


FIE FMC under QFLP Mechanism


Since 2010, some of the local governments in China launched Pilot Programs for Qualified Foreign Limited Partnership (QFLP Pilot Program), such as Shenzhen, Shanghai, Tianjin, Beijing, and Chongqing.  In general, the QFLP pilot programs stipulate that QFLPs should be established as per certain requirements.  The requirements vary slightly in different regions, but all mainly focus on the qualifications, assets or scale of funds of the foreign investor. However, in practice, the establishment and compliance of FIE FMC are in lack of specific rules and guidance.


FIE FMC under Q&A No.10


In 2016, the Asset Management Association of China (AMAC) issued the Responses to Questions regarding Registration and Record-filing of Private Equity Funds (No. 10) (Q&A No.10).  Q&A No.10 clarifies for the first time that the fund management companies may be formed as a wholly foreign owned or Sino-foreign equity joint venture, and may complete registration as fund managers with AMAC. Q&A No. 10 also stipulates the procedures and conditions for an FIE FMC registration.  This provides an important guidance for FIE FMC to carry out businesses of fund management in China.


2.        Foreign-invested Enterprises Investing in Domestic PE/VC funds


The investment of FIEs into domestic PE/VC funds can be divided into two categories according to source of the currency: investment with registered capital and investment with income or profits.


(1)   Investment with Registered Capital


Foreign exchange control plays as one of the most important roles in regulating FIEs using their foreign currency registered capital to conduct capital account investment (e.g. equity investment) in China.  However, the change from the Circular of the State Administration of Foreign Exchange on Issues Relating to the Improvement of Business Operations with Respect to the Administration of Foreign Exchange Capital Payment and Settlement of Foreign-invested Enterprises ( Circular 142) to Circular of the State Administration of Foreign Exchange on Reforming the Management Approach regarding the Settlement of Foreign Exchange Capital of Foreign-invested Enterprises (Circular 19), signifies a gradual trend of easing foreign exchange control in China, which further facilitate foreign investors’ participation in and carrying out of fund business.


(a)    Circular 142


Circular 142 provides a negative attitude towards FIEs’ equity investment by using foreign currency registered capital.  It largely determines the possible structuring for foreign investors to invest in PE/VC funds in China.  In other words, foreign capital can only invest in PE/VC fund via certain specific types of PE/VC fund entities, under specially designed regulations as discussed in detail below.


(b)   Circular 19


The subsequent Circular 19 aims at replacing the above-mentioned Circular 142.  Article 1 of Circular 19 stipulates that FIEs are allowed to convert up to 100 percent of foreign currency in their capital account into RMB at their own discretion.  Article 4 further stipulates that in addition to equity investment directly in foreign currency, FIEs with investment included in their business scope (including foreign invested holding companies, FIVCE and QFLP) are permitted to convert their foreign currency registered capital into RMB at their own discretion and use these funds to conduct equity investment.  Moreover, Circular No. 19 also states that general type of FIEs may also carry out domestic equity investment with RMB settled from their foreign currency registered capital.


However, in practice, banks in most regions have a more conservative attitude and still restrict the settlement and use of foreign currency of FIEs.  Nevertheless, some banks have made some groundbreaking attempts.  Some banks allow those FIEs with their business scopes covering investment (and some banks also require investment to be included in company name) to conduct capital settlement to carry out equity investment, but each investment shall be subject to case-by-case review.


Furthermore, under the current PRC foreign investment rules, although equity investment is not a category subject to special approval by MOFCOM, in practice, it is relatively difficult to establish FIEs with investment in their business scope or name.  It depends on the practice of different local governments.  Some local governments hold a positive attitude towards this operation.


(2)   Investment with Income or Profit



If FIEs generate profits and income during the course of operation in China (in RMB), such FIEs can use it freely without special approval from State Administration of Foreign Exchange ("SAFE") or banks.  However, according to Article 5 of Interim Provisions on the Investment of Foreign-invested Companies in China, only when the following conditions are satisfied can an FIE engage in equity investment: registered capital been fully paid up; profitability; and compliance on record.


Regardless of currency source, foreign investors’ participation in PE/VC funds, and such PE/VC funds’ further downstream investments shall comply with the Guiding Catalogue in terms of industrial policy.  Foreign capital shall not invest in prohibited industries, and investment in restricted industries shall be subject to special approval by MOFCOM.  It is noteworthy that, under PRC law, the identification of foreign investment shall be conducted by looking through to the ultimate shareholders of an enterprise, which means if there is any foreign investor involved in any level of the shareholding structure, the invested enterprises shall be considered as containing foreign capital, which shall be subject to foreign investment administration in the terms of industrial policy, such as value-added telecommunication business.  


3.        The Forms of Foreign-invested PE/VC funds


As discussed above, Circular 142 stipulates that only the FIEs with investment as main business approved by MOFCOM can engage in domestic equity investment and Circular 19 further clarifies that foreign-invested holding company, FIVCE and QFLP shall be considered as FIEs with investment as their businesses.  Thus, under the legal framework of the foreign exchange control and other relevant laws and regulations, the three organization forms shall be the most important carriers for foreign capital to invest in domestic PE/VC funds.  The three types of organizational forms will be respectively introduced below.


(1)    Foreign-invested Holding Company


The main legal basis for the establishment of holding companies is the Provisions on Foreign Holding Companies Established by Foreign Investors. Pursuant to these provisions, foreign-invested holding companies could engage in direct investment via wholly foreign-owned and Sino-foreign joint venture enterprises.  However, the threshold for establishing holding companies is quite high, including the following conditions:


(a)    The total assets of the investor shall be no less than US$400 million in the year before the application, and has established an FIE within the territory of China, with the contributed registered capital in an amount exceeding US$10,000,000; or


(b)   The foreign investor has established ten or more FIEs within the territory of China, with the contributed registered capital in an amount exceeding US$ 30 million or more;


(c)    If a foreign holding company is established by means of joint venture, the total assets of the Chinese investor shall be no less than RMB100 million in the year before the application.


Therefore, the form of foreign-invested holding companies is mainly suitable for companies with a relatively large scale and an industrial background, especially for multinational corporations to make strategic investment or PE investment.


(2)    Foreign-invested Venture Capital Enterprises (FIVCE)


The main legal basis for the establishment of foreign-invested venture capital enterprises (FIVCE) is the Regulations on Administration of Foreign-invested Venture Capital Companies, which permits to establish FIEs that mainly invest into privately-held high-tech companies.  After the promulgation of Circulate 142, local SAFE in Shenzhen and Shanghai consulted the SAFE headquarters concerning the settlement of foreign currency capital, and in subsequent practice, various local SAFEs are of the view that the FIVCE approved by MOFCOM can use foreign currency registered capital for equity investment so long as its business scope include investment.  Although the legal rules are relatively explicit and SAFE also supports the settlement, in practice, FIVCE is not often used in the market.


(3)    Qualified Foreign-invested Limited Partnership (QFLP)


The policies and rules of Foreign-invested Equity Investment Enterprises (referred to as qualified foreign-invested limited partnership in practice, QFLP) has attracted wide attention upon promulgation.  The expectation was that the pilot programs on QFLP will open up a new pathway for foreign investors to engage in equity investment business.  Since Shanghai took the lead in introducing the Circular on Issuing the Measures for Implementation of the Pilot Project of Foreign-invested Equity Investment Enterprises in 2010, relevant rules of the QFLP pilot program have been promulgated and implemented successively in Beijing, Chongqing, Tianjin, Shenzhen and certain other cities.  However, due to the high requisites to establish a QFLP and limited quota for the total amount of QFLPs capital scale in every pilot area, QFLP was not used as widely as expected.


It is worth mentioning that the new policy of Shenzhen released in September 22, 2017 once again draws public attention on QFLP, initiating new expectations for its implementation in practice.


4.         The Practical Structure of Foreign-invested PE/VC funds


Since in practice, foreign holding companies are less applicable and FIVCE are not much used, this section will mainly focus on QFLP, combining it with other legal schemes of foreign investment to suggest different structural designs.  Since regulation on QFLP differs among regions, this section will focus on the new policy of Shenzhen.


The relevant departments of Shenzhen promulgated the following regulations of QFLP:


(a)    The Interim Measures for Implementation of the Pilot Program of Foreign-invested Equity Investment Enterprises in Shenzhen in 2012 (Interim Measures);


(b)   The Operation Procedures for Implementation of the Pilot Program of Foreign-invested Equity Investment Enterprises in Shenzhen in 2013 (Interim Procedures);


(c)    The Measures for the Pilot Program of Foreign-invested Equity Investment Enterprises in Shenzhen, issued by Finance Office of Shenzhen on September 22, 2017 (Shen Jingui [2017] No.1, Measures for the Pilot Program).


According to the Measures for the Pilot Program, the prevailing form of organization for a QFLP is limited partnership.  Following are discussion on specific structuring of limited partnerships.  The Measures for the Pilot Program explicitly stipulates that domestic and foreign investors can both invest in QFLP management companies, which, however, is not the focus in this article.  The discussion below will not distinguish between domestic and overseas regarding investors of QFLP management companies.


(1)    Foreign Investors as Limited Partners


The most typical structure of QFLP is one with foreign investors directly investing in it as limited partners (as shown in Chart-1).  To establish a QFLP with such structure, the foreign investors shall first establish a management company in Shenzhen in accordance with the Measures for the Pilot Program if there is no existing management company that meets the requirements, and then set up the limited partnership (which shall be the fund investment entity).


The QFLP so established will be identified as a foreign investor as its partners are foreign investors. Thus, according to Interim Administrative Measures for the Record-filing of the Incorporation and Change of Foreign-invested Enterprises, investments by such QFLP in encouraged and permitted industries shall go through record-filing with MOFCOM, while investments in restricted industries shall be subject to MOFCOM’s review, and investments in prohibited industries are not permitted.


*Note: GP and FMC can be separate entities.

(2)    Foreign Holding Companies as Limited Partners


Given that Measures for the Pilot Program clearly provides for three different forms of fund management (FIE FMC managing foreign-invested fund, FIE FMC managing domestic fund, and domestic FMC managing foreign-invested fund), the foreign holding companies may serve as limited partners in the QFLP structure (as shown in Chart-2).  Under this structure, foreign investors shall first establish a holding company in China which serves as the limited partner of QFLP.  According to Circular 19, the foreign holding company may directly settle the capital in foreign currency into RMB or transfer the original capital to the account of the investee based on the actual investment scale, thus the settlement and use of foreign currency capital are relatively convenient.  As discussed in section 3, due to the difficulty of establishing foreign holding companies, this structure is mainly suggested for foreign investors having already established holding companies.




*Note: GP and FMC can be separate entities.


(3)    Ordinary FIEs as Limited Partners


As discussed in section 2, since the promulgation of Circular 19, some banks permit FIEs whose business scope or name contains “investment” to settle foreign currency for the purpose of equity investment.  In view of this practice, ordinary FIEs can act as limited Partners in QFLP structures (as shown in Chart-3). In such structure, the foreign investors may first establish a wholly foreign-owned enterprise, and then inject capital into QFLP though the wholly foreign-owned enterprise.  Since the partners of QFLP are all FIEs under this structure, the downstream investments conducted by QFLP shall be recognized as the domestic investments under the Interim Provisions on the Investment of Foreign-invested Companies in China. Therefore, the legal formalities for investments by such QFLP in encouraged or permitted industries are quite simple.






*Note: GP and FMC can be separate entities.



(4)    Foreign Investment Entry Restrictions


All structures elaborated above will encounter issues of settlement and use of foreign currency, which shall be conducted in accordance with Circular 19 regardless of the structure taken.


In addition, the foreign capital in QFLP will be viewed in a penetrable manner regardless of the structure taken when the downstream investments are made in prohibited or restricted industries, and such downstream investments are subject to relevant restrictions.


5.        The Future of Foreign-invested PE/VC fund


With increasingly liberalized foreign exchange administration, more preferential policy on foreign investment, and improved regulatory regime on PE/VC funds in China, we might see more and more foreign investors participate in PE/VC funds in China, especial in industries free from restrictions on foreign investment, such as advanced manufacturing, high-tech industries, consumer goods and new retail.  We will analyze the Measures for the Pilot Program in Shenzhen as an example below.


(1)    The Diversification of Management Mode


According to Measures for the Pilot Program, there are three management modes of FIE FMC:


(a)      Foreign-foreign, i.e. FIE FMC managing foreign-invested PE/VC fund;


(b)     Foreign-domestic, i.e. FIE FMC managing RMB invested PE/VC fund (be noted that in case FIE FMC is not the GP of the fund, the fund does not involve any foreign capital).


(c)      Domestic-foreign, i.e. domestic FMC managing the foreign-invested PE/VC fund.


The management models listed above are all feasible under Measures for the Pilot Program which provides foreign investors with more available ways of participation. Meanwhile, Q&A No.10 by AMAC has improved the feasibility of registration of FIE FMC.


(2)    Criteria Distinguishing Different Types of Investors


The Interim Measures and Interim Procedures do not distinguish the criteria for investors of FIE FMC and the limited partners of QFLP.  They only generally provide strict requirements for foreign investors intending to participate in QFLP.  However, the Measures for the Pilot Program provides for different criteria for the investors of FIE FMC and the limited partners of QFLP, more specifically speaking, the threshold for limited partners of QFLP is remarkably lowered. Such change might significantly motivate foreign investors to participate in domestic PE/VC funds.


(3)    Restrictions of Contribution by Investors under the Same Control


The Measures for the Pilot Program prescribes that if the general partners and limited partners of a QFLP are under the same control, the controller shall contribute no more than 50% of the capital, which substantially prohibits foreign investors from establishing QFLPs with only self-owned capital.  Taking into account the aforementioned provisions lowering threshold for the limited partners of QFLP, it can be concluded that the Measures for the Pilot Program pays considerable attention to the width and depth of foreign investors participation.


(4)    Increase of Detailed Guidance


Moreover, some provisions regarding detailed guidance have been added in Measures for the Pilot Programs.  For example, the Measures for the Pilot Programs stipulates that the QFLP and its FMC applying for the pilot program shall be registered in Shenzhen, which prevent the enterprises established in other regions from enjoying the policy preference. Meanwhile, it stipulates that enterprises applying for the pilot program shall have “equity investment management” or “equity investment” in their names, and other FIEs shall not use such wordings in their names, which not only solves the naming issue of QFLPs, but also prevents other FIEs from gaining the convenience, thus further standardizing the market.  However, it is obvious that the detailed provisions are mostly of restrictive nature, and the effect of implementation of Measures for the Pilot Program needs to be further verified in practice.