China looks to regulate PE industry

China’s National Development and Reform Commission (NDRC) announced its guidance on PE fund registration, operations and information disclosure in Circular 2864, which became effective earlier this month.

Circular 2864 is the Chinese government’s first attempt to regulate the PE industry and protect investors in the face of the increasing number of PE funds being established in China and, consequently, the associated growing challenges and issues. China is confronting what many would classify as a good problem: the country’s economic prospects are such that funds are constantly emerging and driving up valuations. Through regulation, Chinese officials look to prevent fraud and abuse, but, also, the creation of a bubble.

The rule covers fund establishment and capital raising, risk management, PE managers’ responsibilities and information disclosure requirements and regulatory supervision and self-regulation issues.

Regulatory Filing and Reporting
Any PE fund with more than RMB500 million (USD 78 million) or its equivalent in foreign currencies of assets under management including both contributed and committed, shall file and report to the National Development and Reform Commission (NDRC). For those below RMB500 million or its equivalent in foreign currencies of assets under management shall file and report to a designated provincial regulatory entity.

PE funds shall only raise capital through private placements from qualified investors who understand and accept the involved risk. PE funds shall not raise capital directly or indirectly through media including websites, community posters, handouts, text messages, seminars, lectures; nor shall they market through a prospectus from merchant banks, securities firms or trust investment companies. The party involved in fund-raising shall fully disclose investment risk and possible loss involved in investment in the PE fund and shall not guarantee the return of the principal nor a guaranteed fixed investment return.

Risk Control
PE funds shall follow the articles of incorporation or agreements and reasonably diversify investment to lower risk. PE funds shall not provide financial guarantees to companies in which they have no investment.

Annual Report
PE funds shall provide annual reports and audited financials to regulatory entities within 4 months of the end of their fiscal year, in addition to submitting reports to their investors according to each fund’s articles of incorporation and agreements.

Fund Formation and Administration
Funds can be formed as limited liability companies or joint stock companies. In either form, funds can be administered by internal management or an external management company.

Requirement for the Management
No senior manager of a PE fund or its management company shall have committed a violation of law within the past five years or be involved with any ongoing lawsuit or legal proceeding involving a substantial monetary value. A minimum of three senior managers must have at least two years of experience in private equity investment or related areas.

Those funds that fail to comply with Circular 2864’s filing requirements will be publicized on the official websites of the regulatory entity. Larger funds must abide by regulations to keep on central and provincial regulators’ good side. However, penalties for non-compliance are lax.

The regulation creates potential business for compliance service providers: most local PE funds do not have self-monitoring procedures in place, and face additional expenditures to keep up with the rule. However, hiring will also come on the regulatory side, as China’s officials look to monitor private equity, not unlike American legislators who approved laws demanding more disclosure in the wake of the US’ 2008 financial crisis. In the end, NDRC may find it almost impossible to handle by themselves and have to rely on a self-regulatory association, such as the case of NFA in the U.S., which helps CFTC do some monitoring work.

Coco Kee is Managing Partner of Kee Global Advisors LLC, a New York-based boutique advisory firm advising companies of different stages on China-related cross-border business development, financing and M&A.