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China has let more than a few investors down over the two decades-plus since Deng Xiaoping got the reform process rolling. But although the reality has fallen short of the hype over the years, an increasing number of private equity players are beginning to look on China as one of the region’s brightest hopes.

The long-awaited accession to the WTO is now imminent; economic growth — while slowing — is still running at a higher rate than most of its neighbors, and technology manufacturing is migrating at an ever-faster pace to take advantage of China’s blossoming facilities and low-cost, highly skilled engineering talent.

A recent enhancement has been the enactment in August of China’s first comprehensive private equity fund regulations, which are designed to encourage the setting up of domestic investment vehicles, referred to as "investment enterprises," that can operate much like typical offshore venture capital funds. Traditionally, China’s foreign investment rules have been designed for investors seeking to invest in a specified project and didn’t lend themselves to the kind of portfolio strategies adopted by funds — let alone allow for exit mechanisms.

As a result, observes Jonathan Lemberg, a Partner with Morrison & Foerster — which provided input to the Chinese authorities when they were drafting the new regulations — foreign venture capital investment in China has usually been conducted through offshore fund structures.

Investing side-by-side

"The new rules constitute a significant advance for the venture capital fund industry," says Lemberg. "But it remains to be seen whether they are sufficient to create a robust foreign-invested venture capital industry in China. The largest advantage of the new rules is that they present the first legitimate mechanism for domestic Chinese investors to invest side-by-side with foreign investors, and to have their funds managed by foreign fund professionals."

Under the new rules, Chinese investors can invest in Sino-foreign joint venture funds using domestic currency, which will provide foreign fund managers an opportunity to team up with Chinese investors or strategic partners that is not easily available under traditional offshore structures.

But the new rules impose strict eligibility requirements on the Chinese investors in a fund. For example, the minimum investment by a Chinese investor is US$5 million, and at least one of the Chinese investors in the fund must (among other requirements) have venture capital investment as its principal business and either have a net asset value of RMB100 million as of the end of the prior year, or have had at least RMB100 million of capital under management in each of the three prior years.

High qualifications

"There are very high qualifications both for foreign parties and, more importantly, for domestic partners," says Lemberg. "That naturally limits how useful these new regulations can be, because there aren’t that many good quality players. You can only get access to the domestic capital base if you bring in a qualified mainland company."

Still, observes Lemberg: "These rules are indicative to me of a sincere desire to create an industry here. The private equity industry is a cornerstone of capital markets worldwide. The new rules recognize that for China to become a real part of the global financial community, private equity investors and the benefits they bring are desirable."

Getting more flexible

The process of drafting the new rules got underway around a year ago, and Morrison & Foerster became involved in May, organizing a seminar to provide input on behalf of private equity clients. "They’d done extensive work before we talked to them," says Associate Paul Boltz, who was involved in liaising with MOFTEC and other authorities. "I don’t think we caused them to fundamentally change what they were doing. But I think we alerted them to a few issues that caused them to do a fair amount of redrafting and rethinking."

Boltz says his firm’s input focused on a number of fundamental issues, including how offshore venture capital funds are typically structured as a limited partnership (LP) or similar corporate entity that offers considerable flexibility with respect to both the management of the fund and the realization and distribution of profits.

One result, says Lemberg, was that the new rules make use of what has until now been an infrequently used entity, a Sino-Foreign Cooperative Joint Venture without legal person status, which affords the parties a large degree of freedom to structure the operations of the fund as they like through contractual arrangements. "The regulations note that there is at least one way that you can take this vehicle and make it work like an LP," he says. "It doesn’t get you all the way to a fully functioning offshore LP form in China. But many of the basic elements to make a fund work are there."