The New Nation - Internet Edition

Xu Limei

At the 2007 China M&A Annual Conference in Tianjin, Wu Xiaoling, Deputy Governor of the People's Bank of China, pointed out that the slow pace of private equity fund growth is partly to blame for insufficient resources available for creating healthy public companies.

Article 50 of China's Securities Law states that all public companies should have a minimum capitalization of 30 million yuan, a requirement many start-up companies find hard to meet But what if a start-up company is in need of financing during the period from inception to IPO? Private equity is an indispensable solution for companies in this period in terms of funding future growth.

In general, sector funds invest in companies with mature technologies; venture capital funds invest in hi-tech firms; and private equity funds primarily focus on companies approaching their IPOs, which are catalysts for boosting the value of start-up companies and a major driver of mergers and acquisitions.

"We need a further boost in yuan investment funds," Wu said. "With China's dual-surplus in its balance of international payments, we are no longer short of foreign exchange. The inflow of overseas private equity funds will bring advanced technologies and help groom talent Therefore, we need to borrow ideas from overseas private equity funds."

When asked about the government's role in supporting the development of private equity funds, Wu responded that the government should first work on building a highly qualified management team for enhanced supervision of fund companies.

Be it private equity funds that raise money from a small scope or public funds with a broader range of fundraising sources, the essence of their business is financial management and the quality of their team is the key, she said. The government should step up the grooming and supervision of funds management teams rather than focusing on the investment projects themselves, she added.

Furthermore, the government needs to improve legislation regarding the supervision of asset management institutions, according to Wu. For example, the U.S. Investment Company Act of 1940 and the Investment Advisers Act of 1940 were set in place to regulate funds management conduct However, China's private equity funds came into being without such laws. The addition of limited partnerships in the latest Partnership Enterprise Law provides a legal basis for institutional engagement from banks and insurers in private equity funds. Supervisory bodies are therefore advised to keep up with the times and duly revise the laws and regulations.

"It has become a trend that financial institutions take part in private equity funds, so the government is advised to allow banks, insurance companies and social securities firms to hold stakes in private equity funds," said Wu. As private equity funds put investments in start-up businesses, high risks may ensue, but high returns are also expected. "Financial institutions run risks, and it's vital to keep the risks within the controllable range rather than concentrating on the risks themselves."

Regulators of institutional investors and main shareholders are advised to examine the investment portfolio concept, risk control and risk appetite, before deciding whether or not to let institutional investors become involved with private equity finds.

"About 1-2 percent of capital set aside from banks or insurance companies for high-risk investments will not detract from their healthy operation," Wu said. "Every financial institution should have appropriate risk investment portfolios."

The other pivotal role of the government is to pave the way for private equity funds to exit their investments. The number of businesses trading on the exchange is small after all. In the United States, public companies account for only 1.99 percent of all joint stock companies and the percentage in Japan and Hong Kong is 1.3 percent and 2.3 percent respectively.

It is essential to clear the way for developing over-the-counter channels such as growth enterprise markets and perfecting market-maker regulations.

At present, nurturing the varied layers of the capital market is a top priority. "Without over-the-counter trading and private equity dealing outside the exchange, it could be difficult to create a favorable environment in which enterprises can mature and grow, and it would also be impossible to provide healthily-running candidate companies to the exchange," Wu said.

The revised version of the Partnership Enterprise Law, effective as of June 1, offers vast information in favor of private equity funds-the introduction of limited partnership will be the right solution to the issues of trusts and taxes which have hindered the growth of private equity for some time.

Wang Weidong, atorney at Grandall Legal Group, said that the most popular legal form of existence for private equity funds in China is a limited company. That is, he explained, a fund operates as a limited company. Investors maintain their rights as shareholders, and fund managers, either in the capacity of shareholder or investment advisor, take the management role.

However, neither form is appropriate for private equity funds-a fund manager's rights and interests do not match his responsibilities, undertaken as a shareholder or investment advisor. Besides, a company-based fund is faced with stiff procedures for paying capital or quiting, which also doesn't match the characteristics of investment funds.

According to the new Partnership Enterprise Law, private equity funds are allowed to operate on the basis of a limited partnership. Under this framework, a fund management company, established as a common partner, is liable to unlimited responsibility and controls decision-making rights from management to investment, while also navigating some investments, capitalizing on an amount representing 1 percent of the total subscribed capital. Gains are comprised primarily from fund management fees and various dividends. The investor, taking the role of limited partner, is primarily obliged to finance but not manage the fund and answers to limited responsibility proportionate to investment quota.

The advantages of a limited partnership are that it maximizes the value of professional investment managers and provides a beter agreement on their rights and responsibilities, among other things.

The new Partnership Enterprise Law also has explicit rules on taxes. The tax imposed on operating revenue and other income of the partnership enterprise shall, pursuant to state tax regulations, be borne by the constituents in the partnership separately.

In fact, regardless of the tax conditions of different investors, the partnership mechanism offers to create a "penetrated financial" conduit, that is, profit or loss arising from fund investment is directly reflected in the financial statement of the investors, and tax treatment shall remain unchanged. This is the biggest benefit limited partnership brings to the fund in terms of tax issues.

To put it simply, the problem of fundraising is solved as a result of limited liabilities imposed on more individuals, based on the unlimited liabilities to be borne by an individual. In the eyes of investors, funds with a partnership structure are more flexible for them to enter or exit than funds with corporate and contractual structures, freeing them from onerous procedures when increasing or reducing their capital.

Partners are able to share dividends according to terms and conditions as stipulated in the partnership agreement This is conducive to flexible distribution of investment gains between the fund manager and investors.

At present, preparations for ownership reform and IPOs are in full swing, offering big opportunities for private equity funds. Take the Zhongguancun Science Park as an example. A litle over 200 of the total 18,000 enterprises that have registered in the park have completed their ownership transformation. The number of public companies is less than 100, leaving the remaining 90 percent incorporated as limited liability companies.

This year, the China Beijing Equity Exchange, working in collaboration with Zhongguancun Administrative Commitee, is pushing forward a drive to facilitate the ownership reform and listing process for companies located in the park.

It is expected that at least 100 companies may complete the reform process for a conversion into joint stock companies this year. In three years, the number of companies having converted is expected to hit 1000.

Be it in the process of reform or IPO, financial support is essential, and this is where the opportunity lies for private equity funds. First of all, the bulk of hi-tech companies in the park have net assets of over 10 million yuan, clear business structures and established corporate governance.

To complete a conversion into a joint stock company, a capital infusion is vital. However, companies don't want to lose control, either; in this case a grouped entry of private equity funds may be the way out Presumably, a hi-tech company will sell 30 percent of its stock as equity, divided by three different funds, each representing 10 percent

The process changes the equity and governance structure and offers a warranty for security for the private equity funds. To this end, the China Beijing Equity Exchange is in the process of gathering together a group of private equity funds set up around the exchange for investment

The period prior to public listing means a second round of investment opportunities for private equity funds, as another round of fundraising is needed during this period.

All the non-public companies in the park will be held under the custody of the China Beijing Stock Register and Custody Center after completing shareholding reform. Private equity funds are accessible to information from this platform and are able to negotiate the second round of investment in return for greater return if these growth enterprises should ever plan to go public.

Besides, the equity market also offers assistance in creating exit channels. Private equity funds usually choose to exit on domestic and overseas stock markets. They are also provided with free access to exit by conducting an equity transfer on the equity exchange platform, if the company receiving their investment remains unlisted.