The rapid pace of PE business developing in China has seen the regulatory regime struggling to keep up.With no coherentlaw or regulation governing PE in Mainland China at a national level, the government has taken initiative by appointing the National Development and Reform Commission (“NDRC”) to take a leading role in forming a new regulatory environment for Private Equity and Venture Capital in China.

The recent outcry for regulation is due to Limited Partners(“LP”)[investors] becoming caught up in funds mimicking Ponzi-schemes, promising extravagant returns and attracting investors by flooding them with early high dividends that abruptly end as soon as the fund is closed for investments. Thisisa worst case scenario, but it illustrates the fundamental problems the Chinese Private Equity industry is facing; a lack of transparency and oversight. Also, the basic economics of the Chinese investment climate proves to be another problem; with too much capital to be invested, unsophisticated LP’s are often lured into these deals as PE’s renownedfor delivering extraordinary returns to its investors internationally.

The main points to take away from the NDRC circulars at the end of 2011 were the following:

The establishment of guidelines for specific entities

There are two forms of fund structures in Mainland China;Equity Investment Enterprises (“EIE”) and Equity Investment Management Enterprises (“EIME”).

The new rules allow an EIE to be organised as either a corporate entity (“LLC”) or a partnership.

The number of investors in an EIE must be subject to the limits set out in PRC Company Law or PRC Partnership Law; depending on the form of the EIE. Under PRC Company Law, a LLC must have no more than 50 shareholders. The number of partners in a limited partnership shall be between 2 and 50.

In calculating the number of investors, NDRC introduces a so-called “look-through” approach. It requires all legal persons and individual investors behind an unincorporated institutional investor in an EIE, such as a trust or a partnership investor, be counted as an investor, except if an institutional investor is a so-called“fund-of-funds”. This is a significant clarification on the basis of previous material by NRDC, and a measure intended to prevent funds from absorbing funds from unspecified members of the public. More importantly, NRDC now also requires each investor behind an unincorporated institutional investor to meet the qualification to be such an investor to an EIE.

Investors in an EIE must contribute capital in cash, which can be paid into the EIE according to a plan set out in the articles of association or partnership agreement of the EIE. An EIE, or EIME, must have at least 3 members of senior management, each with at least 2-years of experience in the equity investment business, or in a similar business.

Any individual, being or being regarded as a member of the senior management, must have no criminal record, and mustbe involved in any outstanding material economic dispute in the past 5 years.

Mandatory filings

NRDC now mandates all EIE’s(including fund-of-funds) to file with NRDC or a filing authority designated by a provincial government (“F A”).

The filing is required to be made within one month after the business license of the EIE is issued, except where:

(i) The EIE is a venture capital investment enterprise that should make filings in accordance with other applicable regulations; or

(ii) All its’ capital is contributed by one institutional or individual investor, or by two or more investors that are wholly-owned subsidiaries of the same institutional investor.

Unlike previous guidelines, which exempted funds under RMB500 million or an equivalent amount in a foreign currency from the filing obligation, the new guidelines requires all EIEs to file with a FA. Those equal to or exceeding RMB500 million, or the equivalent amount in a foreign currency, must file with NDRC. The EIEs of smaller size must file with a FAdesignated by the provincial government. Moreover, an EIME or EIE engaged to manage the assets of an EIE (“Manager”) must also file with the FA,together with the EIE under its management.

Fundraising and Investment Practices

An EIE is only permitted to raise funds from qualified private investors, i.e. the specific members of the public who are of sufficient ability to comprehend and bear the risks of their investment. New guidelines prohibit offering fund units to unspecific members of the public or soliciting investors through public media, such as sending materials or SMS’s to the public, organising conferences or forums open to the public, placing fundraising materials at publicly accessible counters of commercial banks, securities companies, or investment trust companies, etc... In addition, EIEs must not guarantee, in any form, a fixed return to their investors. Private equity fund managers conducting fundraising activities in China must keep in mind that illegal fund raising from unspecific members of the public can constitute a serious crime under the PRC Criminal Law.

EIE’s investment is limited to non-publicly-traded equities or fixed income financial products. The investment must be in compliance with China’s industrial, investment, and macroeconomic policies.EIE is not allowed to invest in publicly-traded securities or real property for purposes other than its own use. New guidelines also clarify that, when investing in fixed asset investment projects, both domestic and foreign-invested EIEs are required to seek and obtain specific project approval from NDRC or its local counterpart.

Reporting Requirements

The new guidelines provide for a broad range of reporting obligations for EIEs and Managers. For example, all EIEs are required to report their audited annual financial statements and annual business reportto the FA. In addition, during their operation period, EIEs or Managers are also required to report certain important matters to the FAwithin 10 days after the occurrence of such matters. Such matters include; changesin the EIE’s or Manager’s capital, extending any external debt financing, amendments to the articles, management and partnership agreements, change of fund Manager, custodian, or the Manager’s senior management personnel, corporate merger or split, dissolution, liquidation, etc.. Besides, a Manager or a custodian must also report timely to the FAannual asset management reports or annual assets custody reports.

Censere’s take on the developments

The saying: “Innovation always stays ahead of regulation” can be applied to this case. With NRDC trying to clamp down on abusive General Partners (“GP”) in Mainland China, they move in a direction of requiring only “filing” of the funds not an approval scheme. Between the two, there is a big difference and for the time being we don’t see a lot of change in the current climate for LP investors in Mainland China. With local investors getting burned on bad investments in both the domestic real estate sector, and now in the private equity sector, few outlets remain for Chinese LP’s. We see only one way out of this, and that is for LP’s engaging 3rd parties to force GP’s into compliance habits that align LP’s and GP’s interests.