Private fund filing guidance issued in China

On 23 December 2019, Asset Management Association of China (AMAC) released the Notice on Filing of Privately Offered Investment Funds (Notice, in Chinese 私募投资基金备案须知), with the purpose of reinforcing the Guiding Opinions of the People's Bank of China, the China Banking and Insurance Regulatory Commission, the China Securities Regulatory Commission, and the State Administration of Foreign Exchange on Regulating the Asset Management Business of Financial Institutions (Super Guidance) issued in April 2018 and supplementing specific requirements of AMAC.

General principles

The Notice stipulates that certain activities are incompatible with the fundraising and investment of “private funds” and hence will not be governed by the Notice, such as private lending and P2P investment. These excluded activities are generally inapplicable to foreign asset managers.

The duty of private fund manager and custodian are also briefly outlined in the Notice.

We have summarised below highlights that have not been adequately addressed before, which include (i) qualified investors, (ii) marketing, (iii) operations, (iv) information disclosure, (v) specific requirement for different types of funds (with a focus on private securities investment funds and private equity funds) and (vi) grace period.

Qualified investors

The Notice reiterates the obligation of the private fund manager to look through the direct investors to ascertain whether the ultimate investor is a qualified investor and as well as to count each underlying beneficial owner to ensure compliance of the 200-investor “slotting” limitation (save for exempted qualified investors).

The private fund manager (or the distributor) is also obligated to ensure there is no nominee holding arrangement in terms of the investment into the private fund. From our understanding, the nominee holding arrangement here refers to the beneficial holding involving transfers of legal ownership whereas derivatives such as swaps do not fall under this prohibition.

Marketing

The risk disclosure obligation is further elaborated in the Notice. The fund manager shall file the signed risk disclosure letters by all investors to the consolidated reporting platform for asset management business (also known as AMBERS system) during its quarterly updates (save for exempted qualified investors). The regular uploading of the risk disclosure letter ensures that the private fund manager has sufficiently disclosed pertinent risks of the fund and encourages the private fund manager to make more comprehensive disclosures.

Regarding the timing of filing, the private fund manager shall, within 20 business days from the “completion of fundraising”, apply for the filing of the fund through the AMBERS system and sign the filing undertaking letter to promise that the fundraising has been completed.

The Notice also clarified the definition of “completion of fundraising” for contractual private funds (i.e. the point where the fund contract is signed and subscription money has been remitted to the custodial account) and partnership private funds (i.e. the point where the LPA/articles is executed, filings with corporate registrar are done and initial round of capital contribution of no ness than RMB 1m per person has been remitted to the fund account, save for exempted qualified investors).

Operations

Investment activities between fund launch and fund filing

Previously no investments can be made during the time gap between the fund launch and completion of filing of the fund. Under the Notice, private funds can now invest in cash management products approved by China Securities Regulatory Commission (CSRC), such as bank demand deposits, treasury bonds, central bank bills and money market funds before the completion of filing.

Granting the funds leeway to invest in cash management products, which are less risky products, are beneficial to investors as the previous restriction during the said time gap is eradicated and funds are able to generate income in the time being.

Segregated portfolios

The Notice bans the existence of segregated portfolio company or anything alike. Private fund managers are restrained from setting up investment units under one single fund, under which different types of assets that investors may invest in are segregated. The purpose is to ensure the fair treatment to all investors.

Diversification

Consistent with the diversification obligation imposed by CSRS, private funds are encouraged to make asset allocation and may even go one step further to specify in the fund contract the proportion of the capital contribution to be invested in a single product or single type of assets.

That said, private fund managers should note that diversification of investment, although encouraged, is not a mandatory requirement for private fund managers. The restriction on asset allocation funds is slightly different, which will not be explained in detail here.

Duration

The Notice stipulates that private funds should have a fixed term, and in particular, private equity fund and asset allocation funds should have a fixed duration of no less than 5 years. Fund managers in general are encouraged to set up private funds with a duration beyond 7 years.

Given the above, we understand that perpetual funds would not be allowed in the future.

Related party transaction

The Notice reflects AMAC’s specific concerns about the related party transaction between the fund and the private fund manager, investor, other funds/accounts managed by the same manager or its affiliates. The Notice focuses more on cross trade types of activities whilst not addressing other conflicted acts such as manager managing multiple accounts, dual hatting of staff or multiple roles a service provider may play.

If the fund engages in a related party transaction, it should, among others, disclose such conflicts in its risk disclosures and establish an effective risk control mechanism.

Incapability of fund manager

To safeguard the smooth operation of the fund, the Notice states that the fund contract and risk disclosure letter should contain a contingency plan for the continuance of fund operation, in the event that the private fund manager becomes objectively incapable of managing the fund.

This encourages the inclusion of a mechanism to replace private fund managers in the extreme cases (such as upon the triggering of a key person event), which is in line with the international standards.

Information disclosure

Audit

A new audit requirement is added in the Notice which requires the annual report of a private equity fund or asset allocation fund to be audited.

Disclosure upon occurrence of extraordinary events

Upon occurrence of the following significant events to the fund, the private fund manager should within 5 business days report to AMAC and disclose the following to investors:

1. change in the fund manager or custodian;
2. significant changes in fund contract;
3. triggering of volume redemption;
4. significant litigation, arbitration or property disputes involving fund management business, fund property and fund custodial business;
5. inability to withdraw normally from projects, the investment amount of which accounts for 50% or more of the fund’s net assets; and
6. other events that have a significant impact on the continuing operation of the fund, investors’ interest and the fund’s net asset value.

Under the existing rules, occurrence of the above-mentioned events would trigger a “timely” disclosure to the investors. The Notice has made it clear that disclosure to the investors should take place within 5 business days.

The Notice has also added items # 3, 4 and 5 as matters that would trigger an AMAC reporting to the existing list.

Timely report and abnormal institution

The Notice has listed out more severe consequences for failure to perform information disclosure obligations, as set out below.
Fund managers failing to fulfil their quarterly and annual obligations will lead to AMAC not accepting the private fund manager’s new application for fund filing until the private fund manager carries out the requisite rectification measures.

Another more stringent requirement is that, if the private fund manager fails on its filing obligations for more than once, the private fund manager will be listed as an abnormal institution, which will also be publicized. Once the fund manager was declared as an abnormal institution, it will take at least 6 months for the restoration to the normal status, despite the rectification.

In addition, if the scale of the funds is less than RMB 5 million, its capital contribution is less than 20% of the subscription or there is any individual investor who fails on their capital contribution obligation of the initial round, AMAC will disclose the relevant information to public until the rectification of the situation.

Suspension of filing in case of emergency

AMAC may suspend filing of the private fund manager if it is of the opinion that the fund manager is encountering one of the prescribed situations during the filing of the fund, such as:

1. being placed on investigation by a public security, procuratorial or supervisory organ;
2. being listed by an administrative organ as a person committed a serious breach of trust, or by a people's court as a dishonest person subject to enforcement;
3. being given administrative penalty by CSRC and its agency due to any severe violation of the rules;
4. refusing or obstructing the supervisory personnel from exercising their lawful powers of supervision, inspection and investigation;
5. suspected of having committed serious violations of laws and regulations;
6. repeatedly being complained about by real-name investors and failing to provide a reasonable explanation to AMAC; and
7. other violation of the existing rules, in particular, AMAC FAQ No 14, which ban on engaging in public offering, providing false or misleading disclosures, engaging in P2P or private lending, senior management committing a serious breach of trust or prohibited from trading by CSRC and etc.

Specifics of different types of funds

Private security investment fund (and fund of private securities investment funds)

Ad hoc trading day

Under the existing rules, the private fund manager has discretion to invoke the ad hoc dealing day. Following the Notice, an ad hoc dealing day will only be triggered pursuant to contractual provisions and in principle, it can no longer be used as an arrangement to facilitate subscription or purchase on an ad hoc basis. We understand that this would not affect the private fund manager’s ability to use an ad hoc dealing day to effect redemptions, for the purposes of, for example, amendment of the fund contract or mandatory redemption.

Performance fee

To ensure fair treatment to investors, the proportion of the total of performance fee shall not exceed 60% of the investment proceeds (to the extent such proceeds exceed the agreed threshold).

The Notice also requires the crystallization frequency shall be no more frequent than quarterly (whilst encouraging a semi-annual or annual crystallization), save where the performance fee is crystallized upon redemption or liquidation. (The Notice does not mention dividend payment; however, we understand crystallization upon dividend payment should also be counted towards the exceptions).

According to the Notice, a private fund shall adopt a consistent method of crystallization (across different classes of investors).
Private equity fund (and fund of private equity funds)

Close-ended fund

Private equity funds (including venture capital funds) should be operated as closed-ended funds. Under the Notice, subscription/purchase or redemption is not allowed once the fund has completed the AMAC filing. The requirement is commonly recognized as difficult to be complied with in practice since multiple closings within the first 12 – 18 months has long been a common practice among private equity funds.

Notwithstanding the broad prohibition against multiple closings, private equity funds which have been filed for approval may rely on the exception to allow for subsequent closings, to the extent that any subsequent capital commitment will not exceed three times of the initial capital commitment as of the time of product filing, provided that the following conditions are satisfied simultaneously:

1. the fund is organized as a company or partnership;
2. the fund has appointed a custodian;
3. the entry of new investors or increase of capital commitment occurs within the investment period stipulated in the fund contract;
4. the amount of funds invested in a single target should not exceed 50% of the total amount of capital commitment in the context of portfolio investments; and
5. subsequent closings have been unanimously consented to by all investors.

In other words, even with the benefit of the exception, private equity funds must secure an initial capital commitment before proceeding with the AMAC filing representing at least 25 percent of the total capital commitment.

Successor Fund

Prior to the deployment of 70% of the total capital commitment, unless otherwise consented to by all of the investors or as agreed in the LPA, the private fund manager shall not set up a successor fund that adopts substantially the same investment strategy and scope.

This is largely in line with the market standard. To avoid any future disputes, the private fund manager may consider adding a clear mechanism on setting successor funds and carving out certain types of funds from the definition of “successor fund” in the LPA in the first place, such as funds with other distinctive types of strategy or targeting at another group of investors.

Grace Period

With the implementation of the Notice, all private funds which are contemplating to file on or after 1 April 2020 have to comply with the requirements under the Notice, whereas those filed before this date are still governed by the existing rules. However, existing funds which do not conform to the nature of the “fund” under the Notice (e.g. those which engage in P2P or private lending) will not be allowed to increase the fundraising scale or make new investment and shall start liquidating after 1 September 2020.

Refer here for our client alert on AMAC’s further notice on private fund filing.