Renminbi (Rmb) denominated funds present some of the biggest challenges in terms of complying with Institutional Limited Partner Association (ILPA) private equity principles.
Weil Gotshal & Manges’ partner and Asia funds practice head, John Fadely told delegates at IFLR’s Asia Private Equity Forum on September that the proliferation of Rmb funds has created China-specific problems relating to transparency and conflicts of interest between Rmb and US dollar vehicles advised by the same investment manager.
China’s domestic private equity fund industry formerly consisted primarily of US dollar-denominated offshore funds, but in 2007 China’s Partnership Enterprise Law allowed limited liability partnerships (LPs) to be used as fund vehicles and thereby led to the development of a small but growing local investor base.
These new LPs first looked to managers that already had a strong reputation based on their dollar funds. But as they and other firms went about raising – and then starting to invest – Rmb funds, existing offshore LPs became concerned about becoming marginalised.
Fadely expects the problem to persist. “China is slowly moving towards some sort of convergence between offshore and Rmb funds,” he said. “But LPs and general partners (GPs) will continue to debate the issue until Rmb funds are able to freely receive capital commitments regardless of where the investor is based and are not restricted as to their investment activities by virtue of having foreign LPs.”
Attempts at convergence are still limited to comparatively small and unproven pilot programmes, and sponsors of Rmb funds are thereby limited in their ability to overcome the cherry-picking concerns of their offshore LPs.
Until convergence is established, Rmb funds are likely to remain relatively small, to minimise conflicts of interest between GP and offshore LPs, he said.
Baring Private Equity Asia general counsel, William Hay said limiting fund size was relatively easy given the current regulatory requirement that half the capital for the Rmb fund has to be sourced from mainland investors.
“There simply aren’t that many of them,” he said. “Size is an intelligent way of doing this,” he added.
However, KPMG’s partner John Gu said that tax issues remain.
“An offshore US dollar fund GP managing a Rmb fund creates tax issues regardless of whether the manager is going to increase permanent establishment for the US dollar fund,” said Gu. “There are the same people making investment decisions for onshore funds and these people tend to be based in China.”
Fund structure and the source of income to managers are therefore relatively transparent to local tax authorities. “This increases the risk for US dollar fund managers, which also presents issues in relation to Rmb funds, particularly in light of the lack of clarity of foreign fund tax treatment.”
Local tax authorities had mixed views as to how foreign funds coming into China’s private equity space under the Qualified Foreign Limited Partnership (QFLP) programme should be treated.
Some argue QFLP participants should be viewed as passive investors and thereby subject to 10% tax, while others believe they should be treated as active investors and taxed 25% because they have engaged onshore managers to manage money.
“Uncertainty has resulted in pushback from participants, reluctant to potentially leave themselves open to a 25% tax leakage through involvement in the RMB funds platform,” he said.
But there are workarounds. “Many are working to encourage local government authorities to establish agreements regarding tax treatment in advance,” explained Gu. “We are seeing a lot of GPs shop around in China in order to find friendly locations to domicile funds under preferable tax treatments.”
Local authorities do not have the power within China to define the central government’s tax policy towards offshore LPs participating in Rmb funds, but many were tackling the issue by refunding local taxes to fund managers out of their own pockets to more closely achieve the same economics without violating national tax rules.
“The significance of this development should not be overestimated, however, given the growing trend among local tax authorities to change positions on previously-promised tax agreements when faced with a distressed situation,” he said.