A Brief Review of the First Administrative Regulation in China’s Private Funds Sector

On July 9, 2023, the State Council of the People’s Republic of China (“State Council”) officially announced the Regulations on Supervision and Administration of Private Investment Funds (the “Regulations on the Administration of Private Funds” or the “Regulations”), which will come into effect on September 1, 2023. This important regulation comes almost six years after the Legislative Affairs Office of the State Council issued the consultation draft of the “Regulations on the Administration of Private Funds” (the “Consultation Paper”) for public comments in August 2017. As the first administrative regulation in the private funds sector of China, the Regulations have finally been officially introduced amidst great anticipation, filling a significant regulatory gap in the private funds sector and set out high-level principles and rules regarding major issues in the sector.

1. Background and Legal Status of the Regulations on the Administration of Private Funds

Prior to the promulgation of the Regulations on the Administration of Private Funds, the regulatory landscape for private investment funds in China comprised the Securities Investment Fund Law of the People’s Republic of China (the “Securities Investment Fund Law”), as amended and promulgated by the Standing Committee of the National People’s Congress on December 28, 2012, and further amended on April 24, 2015, which was the highest level of law, and several departmental rules issued by regulatory authorities, including the “Interim Measures for the Supervision and Administration of Privately Investment Funds” (“CSRC Order 105”) published by the China Securities Regulatory Commission (“CSRC”) in August 2014, the “Guiding Opinions on Regulating the Asset Management Business of Financial Institutions” (the “New Regulation on Asset Management”) jointly issued by several government regulatory authorities in April 2018, the “Measures for Registration and Filing of Private Investment Funds” and its supporting guidelines (the “Registration and Filing Measures”) and other self-regulatory rules issued by the Asset Management Association of China (“AMAC”), the sector’s self-regulatory body, in February 2023.

The Securities Investment Fund Law only sets out framework requirements for the regulation of private funds at a high level with limited details. Since its Article 94 on “securities investment in the assets of a non-publicly offered fund” does not expressly include investment in alternative assets such as equity in unlisted companies, there has been uncertainty in the sector as to whether the Securities Investment Fund Law can be effectively applied to alternative investment funds such as private equity funds. Although CSRC Order 105 and a series of self-regulatory rules of AMAC have since expanded the definition and scope of private funds – and therefore include private funds within the ambit of regulations – these measures are limited in scope (both in terms of supervision and types and degrees of penalties that can be imposed where violations occurred) because they are only administrative rules issued by regulatory agencies and self-regulatory bodies. That is why the private investment fund sector has been in need of a comprehensive administrative regulation that can be applied to the entire sector effectively.

In addition, over the past 10 years since the promulgation of the Securities Investment Fund Law, China’s private equity sector has grown rapidly, as measured by the wider range of investment funds and investments made by the funds. Similarly, the sector has become more professional, with participants being required to have appropriate qualifications, replacing the Wild West early days of the sector which attracted rogue participants.

Therefore, the promulgation of the Regulations on the Administration of Private Funds is a significant milestone, filling a legislative gap applying to the private funds sector, as well as responding to the demands of a rapidly maturing sector.

2. Legislative Intent and Highlights of the Regulations on the Administration of Private Funds

I. Legislative Intent

The Regulations on the Administration of Private Funds consist of seven chapters and 62 articles. The document clarifies the scope of application, specifies the obligations and requirements of private fund managers and custodians, regulates fundraising and investment operations, and strengthens supervision and management of the sector by having greater legal liability imposed on those who do not comply.

The Regulations also make special provisions for venture capital funds, indicating that China is encouraging investments into technology companies and start-ups.

The Regulations aim to encourage the standardized and healthy development of the private investment fund sector, better protect the legitimate rights and interests of investors, and encourage the industry to further play a role in serving the real economy, as well as promoting scientific and technological innovation.

Furthermore, the Regulations both strengthen the existing regulatory requirements impacting participants in the private funds sector and also clarify regulatory requirements in light of the market dynamics of the private funds sector. The goal is to achieve a dynamic balance between legislative supervision and market-oriented operation.

The overall regulatory approach of the Regulations on the Administration of Private Funds is in line with the requirements of the existing regulations, and in particular, echoes the Registration and Filing Measures issued by AMAC in February 2023. Here, in short, are the key elements of the Regulations that reflect its legislative intent.

II. Provisions in the Regulations specifying supervision

1. Expanding the concept of private funds and clarifying the investment scope of private funds assets

As already mentioned, the definition of “non-publicly offered fund” and its asset investments in the Securities Investment Fund Law does not explicitly cover the investment scope of private equity funds, venture capital funds and other private alternative investments funds. Since its promulgation in 2012, there have been debates in the sector on whether the Securities Investment Fund Law applies to private investment funds that make alternative investments and whether it can provide the necessary legal basis for the CSRC and AMAC to regulate such alternative investment funds. The sector has been clamouring for further regulations that may provide clearer guidance on this issue. Articles 2 and 24 of the Regulations on the Administration of Private Funds have effectively resolved this problem that has troubled the industry for many years.

• Article 2 broadens the definition of private funds by clarifying the scope of application of the Regulations. It states that the Regulations shall apply to fundraising in a non-public manner, the establishment of investment funds, establishing companies or partnerships for purposes of carrying out investment activities, whether managed by private fund managers or general partners, and carrying out investment activities for the benefit of investors in the territory of the People’s Republic of China. This language captures the key components of a private fund, which include private placement, entrusted management, and investment activities for the benefit of investors, and the form of private funds includes investment funds as well as companies and partnerships that are established for the purposes of carrying out investment activities.
• Article 24 expressly includes “shares in joint stock limited company”, “equity in limited liability company” and “other securities and their derivatives” into the investment scope of private fund assets, which expands the investment scope of private funds as set out in Article 94 of the Securities Investment Fund Law, and covers the entire spectrum of typical investment scope of alternative investment funds and securities investment funds, while retaining the flexibility of CSRC to further specify other types of underlying investment.

2. Specifying the requirements covering private fund managers and their controlling shareholders, actual controlling persons, general partners, directors, supervisors, senior executives, managing partners, delegated representatives and other related persons

Chapter 2 of the Regulations on the Administration of Private Funds specifies the qualifications, conditions, negative restrictions, registration requirements, duties, and ongoing compliance of private fund managers, their controlling shareholders, actual controlling persons, general partners, directors, supervisors, senior management, managing partners, delegated representatives and other related persons. Among these provisions, several items are in line with the provisions of the recently implemented Registration and Filing Measures, provide support for the Registration and Filing Measures as a superordinate law, and establish the principles and point out the direction for the CSRC to amend the CSRC Order 105. For example,

• Article 8 and Article 9 set out the circumstances in which a person is prohibited from acting as controlling shareholder, actual controlling person, general partner, director, supervisor, senior management, managing partner or appointed representative of the private fund manager respectively. These requirements are consistent with the provisions of Article 15 and Article 16 of the Registration and Filing Measures.
• Article 14 provides for six types of circumstances under which a private fund manager should be deregistered, including (1) applying for deregistration on its own, (2) being dissolved, revoked or declared bankrupt according to applicable laws, (3) being held liable for major illegal activities such as illegal fundraising, illegal business operations, and others, according to applicable laws, (4) failing to register the first private fund it manages within 12 months from the date of registration of private fund manager, (5) failing to register a new private fund within 12 months from the date of completion of liquidation after the liquidation of all the private funds under its management, (6) other circumstances as prescribed by the CSRC regulations. The circumstances in (1), (2), (4), (5) and (6) correspond to Article 76 (1) to (4) of the Registration and Filing Measures, while the circumstance in (3) corresponds to Article 77 (1) of the Registration and Filing Measures. Items (2) to (7) of Article 77 of the Registration and Filing Measures are further refinements of the other circumstances under which the private fund managers may be deregistered by the AMAC.
• The provisions of Article 28 regarding affiliated transactions, including the establishment of a rigorous management and control system for affiliated transactions, the definition and scope of affiliated transactions, the decision-making procedures and disclosure of affiliated transactions, among others, are similar to Article 38 of the Registration and Filing Measures and the previous “Instructions for Private Investment Fund Filing” of the AMAC (which is expected to be replaced by the subsequent filing guidelines) and other relevant provisions on affiliated transactions of private funds. But the language in the Regulation is more concise and emphasizes the regulation on affiliated transactions of private funds, requiring the decision-making process to comply with the requirements set out in the governing documents of the private fund and disclosures to be made truthfully and in a timely manner in order to protect investors. It is anticipated that, in future, AMAC will issue detailed rules on private funds filing and guidelines on fund agreements based on the Registration and Filing Measures, which will provide more specific and practicable regulations covering affiliated transactions of private funds for the industry to follow.

3. Setting out top-line new regulatory requirements and principles, leaving room for additional specifications at the level of regulatory agencies and self-regulatory bodies

Although the Regulations have not brought sweeping regulatory changes to the private funds market, they still put forward some new regulatory requirements and principles that will provide direction and guidance to the CSRC and the AMAC in respect of their own administrative rules. For example,

• Article 7 provides that if a private fund is established in the form of a partnership whose assets are managed by a general partner, such general partner will be subject to the same requirements and conditions under the Regulations that are applicable to private funds managers. There are many issues that may require further regulatory guidance, and how this provision would apply in practice will depend on further judicial interpretation, or specifications by CSRC’s departmental rules or AMAC’s self-regulatory rules. For example, how it is determined whether assets are managed by a general partner? Will general managers who are affiliated with fund managers be exempted from this provision? Is the general partner (if it also serves as the general partner executing affairs of the partnership) under the Co-GP structure who is not affiliated with the fund manager be subject to this Article? For QFLP funds (or foreign-invested partnerships) in which all the investors are foreign investors, are the GPs subject to the requirement under this Article?
• Article 14 stipulates the principles regarding disposal of assets of private funds managed by private fund managers prior to the deregistration of private fund managers. Specifically, prior to their deregistration, private fund managers must either complete the liquidation of the private fund assets under their management, or transfer the responsibilities for the management of such private funds to other registered private fund managers as required by laws or regulations. In the future, CSRC or AMAC is expected to issue detailed regulations and provide practical guidelines on how to replace fund managers, safeguard fund operations, and timely liquidation in the event of deregistration of fund managers, in order to protect the interests of investors. In fact, although in the past there were no clear self-regulatory rules, this requirement has already been implemented in practice. If private fund managers intend to voluntarily apply for deregistration in AMAC’s Asset Management Business Electronic Registration System, they must first complete the liquidation or transfer of all private funds they manage; otherwise, the system will not allow private fund managers to carry out further operations on the deregistration.
• Article 18 defines “qualified investor” of private funds more generally than the provisions of CSRC Order 105. It stipulates that “entities and individuals whose assets or income have reached a certain specified threshold, and who are able to identify and bear investment risks, and whose subscription amount is not less than the specified threshold”. This general definition leaves sufficient room to adjust specific criteria and threshold for qualified investors based on future economic development, inflation and other conditions.
• Article 26 requires private fund managers to establish management procedures for the declaration, registration, review and disposal of investments by personnel associated with such private fund managers. Previously, the Securities Investment Fund Law expressly required fund managers of publicly-offered funds to establish a reporting system for their directors, supervisors, senior management and other personnel, but did not require managers of privately-placed funds to establish a similar reporting system. AMAC only requires managers of private securities investment funds to establish a reporting system for the purchase and sale of listed securities by its personnel, which does not explicitly apply to private equity and venture capital fund managers. The provisions of the Regulations on the Administration of Private Funds now extend these requirements to all private fund managers, without making any distinction among different types of private fund managers.
• Article 29 requires private fund managers to engage an accounting firm to audit assets of private funds, provide audit results to fund investors and to the regulatory body in charge of registration and filing. This requirement is consistent with the requirement under Article 61 of the Registration and Filing Measures, which states that “the private fund manager shall submit the following information in accordance with the relevant provision… within six months from the end of each fiscal year, the relevant financial information of the private equity fund manager and the annual financial report audited by an accounting firm in compliance with the provisions”. However, the scope covered by Article 29 is broader, as it explicitly makes the audit of private funds (not limited to private equity funds) a statutory mandatory requirement.

4. Principle-based provisions on the regulation of private fund custodians and private fund service providers, leaving room for further refinement of the regulations

Unlike the more detailed requirements in respect of private fund managers and the “related persons” in other regulations, the Regulations only provide high-level principles when it comes to regulating private fund custodians, and instead leave room for promulgation of detailed regulations and rules by the applicable regulatory bodies. For example:

• Article 3 specifies the principles that private fund custodians should follow when entrusted with private fund assets, including compliance with laws and regulations, due diligence, honesty and trustworthiness, prudence and diligence, and so on.
• Article 15 requires that unless otherwise agreed in the fund agreement, private fund assets shall be held in custody by the private fund custodian. If no custodian is engaged, fund agreements should clearly describe the system, measures and dispute resolution mechanisms to safeguard the security of the fund assets. This provision is to a large extent consistent with the requirements of the Registration and Filing Measures and other self-regulatory rules on the custody of fund assets. While it promotes custody arrangement as the default rule, the Regulation retains flexibility for fund managers and investors to contract freely, and at the same time it also highlights the bottom line of safeguarding the safety of fund assets.
• Article 16 requires the custodians to fulfil their responsibilities in accordance with the laws or regulations, and maintain segregation of different businesses to ensure the segregation and security of private fund assets.
• In addition, the Regulations also subject custodians and their personnel to the same regulatory requirements as fund managers and their personnel, including Article 30 regarding certain prohibited conducts in connection with fund operations by fund managers, custodians and relevant personnel, and Article 32 regarding the reporting requirements of fund managers, custodians and their personnel. In terms of supervision and regulation, CSRC is empowered under the Regulations to supervise and regulate private fund custodians and investigate and take enforcement actions against illegal activities. Although there have been similar provisions in departmental rules and self-regulatory rules, the Regulations clarify the supervisory power of CSRC and AMAC over custodians from a higher administrative regulation level, which provides legal basis for them to fulfil their regulatory responsibilities.

Similar to other regulations on custodians, the Regulations also set out principles for the supervision on service providers to private funds, such as expressly granting CSRC with regulatory power to supervise service providers and their personnel, and power to investigate and take enforcement actions against illegal acts, as well as setting out the reporting obligation of service providers and prohibited acts.

5. Strengthening supervision and management of the private funds sector and increasing the level of penalties for violations

Chapter 5 of the Regulations on the Administration of Private Funds grants CSRC the power to supervise and regulate the activities of private funds, and specifies the measures for investigation and enforcement actions. In response to violations by private fund managers, Article 42 grants CSRC the power to issue orders or decrees to compel private fund managers to take corrective actions, suspend business activities, remove or replace senior managements, remove or replace shareholders or limit such senior management or shareholders’ rights, to compel fund managers to engage or otherwise have CSRC to appoint third party institution to audit private funds. The article also requires fund managers to bear the relevant costs, or in some cases appoint other fund managers or institutions to take over as well as notify AMAC to deregister the fund manager. At the same time, the Regulations also clarify the obligations of the regulators to perform their duties in accordance with the law, the obligation to keep information confidential, and the obligation of the regulated parties to cooperate. The Regulations also specify the establishment of a credit system related to private funds, the information sharing procedures with local governments, the collaborative processes for risk management, and the functions of local governments in risk management to maintain stability.

Chapter 6 specifies the legal responsibilities and penalties for violations by private fund managers, shareholders, actual controlling persons, partners, custodians, employees and other personnel, private funds service providers, staff members of CSRC and AMAC. Penalties may include decrees to compel remedial measures, confiscation of illegal gains, fines, warnings or public reprimand of supervisory personnel and other directly responsible personnel, imposition of market ban, public security administrative punishments by the Public Security Bureau or even being criminally liable for breaches of the relevant laws. These disciplinary measures are customary administrative penalties allowed under administrative laws. In contrast to the previous Securities Investment Fund Law under which the legal liability and penalties for private fund managers were only applicable to the private fund managers themselves, directly responsible executives and other directly responsible personnel, the Regulations have extended the legal liability and penalties to shareholders, actual controlling persons and partners of private fund managers, all of which is intended to act as a deterrent and have a stronger supervisory effect on the people affected.

At the same time, Chapter 6 also specifies that, for those who may be civilly liable for violation of the Regulations and fund agreements, if the assets of such persons are insufficient to cover both civil liability and payment of fines and confiscation of illegal gains, assets should be used to first satisfy their civil liability. The inclusion of this provision in the Regulations is intended to give priority to investors’ interests.

6. Principle-based regulations for cross-border private funds activities, pending the implementation of specific rules

Article 61 of the Regulations provides high level general principles for foreign-owned private fund managers and foreign institutions to conduct private fund business within mainland China, and for private fund managers to conduct private fund business outside mainland China, leaving room for subsequent introduction of regulatory requirements by government regulators for cross-border private fund business. However, the provisions as currently generally worded without much specifics may lead to many questions and inquiries from the private fund industry. In practice, how private fund management institutions carry out cross-border private fund business has always been a hot topic, and it is not uncommon for investment firms to manage private funds denominated in dual currencies of RMB and USD. Previously, the regulatory requirements for cross-border private fund business at the national level have not been very clear, and the schedule to the Securities Investment Fund Law (article 152 thereto) does not address this either. For many years, there have been different and in some cases divergent views and interpretations in the sector regarding issues such as cross-border fund raising and cross-border investment of private funds. At present, the cross-border business of private equity funds mainly takes the following forms:

Firstly, many municipalities across the country have launched local pilot policies such as Qualified Foreign Limited Partnership (“QFLP”) and Qualified Domestic Limited Partnership (“QDLP”) or Qualified Domestic Investment Enterprises (“QDIE”), to address the needs for both capital in-flow and out-flow. Many sponsors have relied on these local policies to establish QFLP and QDLP managers and funds, but there has not been a unified national approach in regulatory policies with respect to QFLP and QDLP.

Secondly, foreign-owned private securities investment fund managers (“PFM”) have always relied on the relevant regulations of the CSRC and the AMAC to meet certain qualification requirements that are different from those of domestic securities investment fund managers in order to conduct business in China.

Thirdly, foreign-owned private equity fund managers or venture capital fund managers have been subject to largely the same regulations as their domestically owned counterparts, except that the investment scope of the private equity funds managed by foreign-owned fund managers is subject to certain restrictions and/or prohibitions in respect of investments in certain industries and sectors.

Fourthly, foreign private fund managers or their domestic branches (including registered private fund managers and wholly foreign owned enterprises (“WFOE”) participating in general advisory business) raise funds for their foreign-domiciled funds from Chinese investors or otherwise conduct fundraising activities in mainland China in respect of such foreign-domiciled funds.

The principles set out in Article 61 of the Regulations may have far-reaching implications on each of the four aforementioned types of cross-border private fund businesses. For example, will the “Measures for the Administration on Foreign-owned Private Fund Managers” contemplated in Article 61 will adopt a unified supervision approach for PFMs, QFLP managers, QDLP managers, and foreign-owned private equity fund managers or venture capital fund managers? The impact on PFMs is likely to be more focused on the elevation of regulatory levels due to their special qualification requirements. For QFLP managers and QDLP managers, the key question is whether the new measures will take a unified approach at the national level or only complement the existing local level regulations. For generic foreign-owned private equity fund managers or venture capital fund managers, will they be subject to additional qualification requirements? Will the exceptions for such managers in the Registration and Filing Measures (e.g., if a foreign-licensed financial institution is the controlling shareholder of a private fund manager, such private fund manager may be exempted from the requirement that senior management shall hold shares in such private fund manager) be retained in the contemplated new measures?

Article 61 also stipulates that foreign institutions may not directly conduct fundraising from Chinese investors for purposes of establishing private funds, except as otherwise provided by applicable laws or regulations. Is this carve-out intended to include relevant regulations applicable to QDII and QDLP (and QDIE)? How will the wording “directly” be interpreted in practice by regulators? Can foreign institutions set up subsidiaries in mainland China (such as WFOEs participating in advisory business) to raise funds from Chinese investors for foreign-domiciled private funds? As typically understood by the industry, fundraising in China for private funds should generally be conducted by licensed entities (or entities that have undergone certain registration and/or filing procedures), and it should not be the case that any entity can raise funds as long as it is established in mainland China. Does “private fund” referred to in Article 61 include foreign-domiciled private funds, or does it only refer to private funds established in China (i.e., the intended subject to be regulated by the Regulations)? If it only refers to domestic private funds, then it implies that fundraising activities in respect of foreign-domiciled private funds in mainland China will not be regulated, which may potentially lead to chaotic undesired consequences. Does “raising funds from Chinese investors” need to be further defined and delineated? For example, if the funds of the Chinese investors are overseas and the fundraising activities also take place overseas, the Chinese investors may violate regulations on foreign exchange control by using overseas funds for investment. However, there seems to be no legal basis and would be significantly burdensome for the regulators to hold foreign institutions accountable for their fundraising activities overseas. All these questions will need to be taken into consideration by the regulators when drafting the regulations and rules that will implement the Regulations.

Article 61 of the Regulations stipulates that private fund managers conducting private fund activities overseas shall comply with other relevant regulations of China. Currently there does not seem to be much existing regulations in this regard. For domestic private funds, there exist certain regulations that may be relevant such as the regulations on direct outbound investment. However, for fundraising activities overseas in general, more specific regulations and guidance may be necessary. In fact, regardless of outbound investment or fundraising activities overseas, the private fund sector needs more guidance and support from regulators. In recent years, many domestic private fund managers have had stronger capabilities and greater needs to conduct private fund business activities overseas. Under the existing legal framework, there are multiple ways for domestic private fund managers to achieve that. For example, domestic private fund managers can raise funds in China and then invest overseas through channels such as QDLP or QDIE; they also may establish foreign-domiciled private fund manager including through the registration process under Circular 37 by the individual founder(s) and then conduct fundraising for foreign-domiciled private funds managed by them. How the Regulations may impact these practices remain to be seen. The industry would welcome further detailed and practical regulatory rules to be issued by regulatory authorities in accordance with the principles outlined in the Regulations.

III. Provisions in the Regulations in Response to Industry Demands and Respecting Market Rules

1. Providing a legal basis for differentiated supervision and regulation of private fund managers

Article 6 of the Regulations has set out a new principle of implementing a tailored approach of differentiated supervision and regulation of private fund managers based on their business type, size of assets under management, ongoing compliance status, risk management status, and ability to serve investors.

CSRC and AMAC have so far to a large extent achieved differentiated supervision and regulation of different types of private funds. However, differentiated supervision and regulation of private fund managers with different types, size of assets under management, compliance and risk management status has not yet been established. Now that China’s private fund sector has developed into a relatively mature stage, with various private fund managers with different investment types, size of assets under management, sponsor backgrounds and structures, compliance and operational requirements, and risk appetite. A “one-size-fits-all” regulatory approach may not be sufficient as a way to regulate the sector and to address the different needs of different types of private fund managers. The Regulations currently include the principle of differentiated supervision and regulation in response to demands from the sector, and leave the implementation to CSRC and AMAC by departmental rules and self-regulatory rules to be issued by them.

2. Expanding the investment scope of private funds

As mentioned above, Article 24 of the Regulations expressly specifies and expands the investment scope of private fund assets, which includes buying and selling shares in joint stock limited company, equity in limited liability companies, bonds, partnership interests, other securities and their derivatives, as well as other investment targets that comply with the CSRC regulations. This provision is in response to the demands of academia and the sector, expanding and clarifying the scope of “securities investment in assets of a non-publicly offered fund” in the Securities Investment Fund Law.

Article 24 of the Regulations also sets out certain restrictions to the investment scope of private funds, which includes the prohibition of using private fund assets for money lending and loan businesses either directly or covertly, as well as the newly added prohibition that private fund managers shall not cause local government to increase their shadow debt by requiring local governments to commit to repurchase of investment capital. This second point is related to the regulatory requirements for regulating cooperation between public-private partnership (“PPP”) mentioned in the “Notice on Further Regulating Debt Financing of Local Governments” issued by the Ministry of Finance in 2017 (“Circular 50 of the Ministry of Finance”). According to the provisions of Circular 50 of the Ministry of Finance, unless otherwise provided by the State Council, when participating in PPP or in connection with setting up investment funds invested by the government, local governments and their departments shall not commit to repurchase investment capital of non-government investors, be responsible for such non-government investors’ investment capital losses in any manner, promise guaranteed minimum returns to non-government investors in any manner, or impose additional terms to equity investments such as investments in limited partnership funds to covertly incur shadow debt. The Regulations reiterate this requirement in the context of private funds, in order to prevent local governments from engaging in illegal debt financing by cooperating with social capital such as private funds.

3. Fund of funds are exempt from nested layer restrictions

Article 25 of the Regulations states that the private funds should comply with the regulations of the financial regulatory department of the State Council in regard to investment layering. However, private funds that meet the requirements of CSRC and primarily invest assets in other private funds are not counted as one investment layer. This provision supplements Article 22 of the New Regulation on Asset Management, which states that “an asset management product may further invest in another layer of asset management product, but the latter may not further invest in an asset management product other than a publicly offered securities investment fund”.

On the one hand, the Regulations make it clear that the restrictive provisions of Article 22 of the New Regulation on Asset Management apply equally to private funds. Before the Regulations were issued, there had been different views in the sector as to whether or not the New Regulation on Asset Management applied to private funds, as there was no definitive legal or regulatory consensus as to whether “financial institutions” in the New Regulation on Asset Management would include private fund managers. Out of compliance concerns and taking a conservative approach, many private fund managers in practice abide by the applicable requirements of New Regulation on Asset Management in operating their private funds, including the provisions of Article 22 of the New Regulation on Asset Management concerning the prohibition of multiple-nested layers of asset management products. Now, the Regulations have provided definitive answer to this point.

On the other hand, the Regulations have provided exemptions to the multi-layered nesting rules. Article 22 of the New Regulation on Asset Management provides that publicly offered securities investment fund will not be considered as an extra layer for purposes of multi-layered nesting rules. The “Notice of Further Clarifying the Matters Concerning Regulating Asset Management Products for Financial Institutions to Invest in Venture Capital Funds and Government-funded Industry Investment Funds” issued after the New Regulation on Asset Management explicitly states that when asset management products invest in venture capital funds and government-funded industrial investment funds, these two types of funds are not considered one extra layer of asset management products, for purposes of multi-layered nesting rules. The Regulations not only confirm these exemptions, but go one step further by expressly providing exemption to all funds of funds that invest in private funds.

Before this latest development and breakthrough in the Regulations, this layering issue has been causing headaches for the sector, and in many cases causing a dilemma for private equity funds and fund managers and, in turn, compromising their commercial goals. For example, asset management products offered by financial institutions are often themselves investors in private funds, such as funds of funds managed by the subsidiaries of securities company for private investment fund business and private funds of funds established by insurance capital. Such asset management products often require the private funds to agree to not further set up joint investment funds or project funds as investment structures underneath such private funds, in order for such asset management products to comply with multi-layer nesting rules – despite the fact that setting up investment structures such as joint investment funds and project funds for individual projects are often essential for commercial reasons. Some fund managers may try to register joint investment funds and project funds as venture capital funds in order to take advantage of the nesting rule exemption available to venture capital funds; however, this approach could lead to a new predicament for the fund managers since venture capital funds and their sub-funds cannot carry out private investment in public equity (“PIPE”) (private placements, agreed transfers, block trades, etc.) investments.

In recent years, the emergence of S-funds has further underlined this dilemma in fundraising and investment. Under the current regulatory regime for private funds, S-funds are themselves a special type of fund of funds. If S funds raise funds from asset management products of financial institutions, S-funds themselves must be registered as venture capital fund of funds in order to be exempted as one layer for purposes of multi-layer nesting rules, so that they can carry out their normal business of purchasing limited partnership interests of direct investment funds. However, the direct investment funds to be invested by S-funds may have already completed most of their investments, especially those funds focusing on late-stage investments, which may have participated in PIPE investments. Therefore, it may be difficult for S-funds registered as venture capital fund of funds to be accepted as investors by direct investment funds, which adds obstacles to S-funds in carrying out the S-transactions.

The new provision in the Regulations considers the market needs for fund of funds’ operations, and clarifies that a “fund of funds” can be exempted as one layer for purposes of multi-layer nesting rules. This development is beneficial for those setting up a fund of funds to carry out external investments without overly interfering the private fund registration types of the funds that such funds of funds invest in, and is a significant step forward for the development of the S-fund sector in China, and will play an important role in solving the “exit difficulty” dilemma in the current private fund industry.

4. Special provisions on venture capital funds provide the basis for differentiated regulation

Taking into account the differences between venture capital funds and general private equity funds in investment targets, investment operations and investment exits, the existing laws and regulations adopt differentiated management measures and incentivizing policies for venture capital funds. The Regulations also follow this principle and set out the regulatory requirements for venture capital funds in Chapter 4.

Article 35 of the Regulations first defines venture capital funds, which is identical to the definition in Article 45 of the Registration and Filing Measures and more detailed than those in the “Interim Measures for the Administration of Start-up Investment Enterprises” and the Consultation Paper which merely focus on the investment targets. Article 35 of the Regulations defines venture capital funds from five perspectives, namely (1) the investment scope (limited to unlisted companies, except for the unassigned and allocated shares held by the fund after the portfolio company’s listing), (2) name or business scope (the name includes “venture capital fund” or the business scope includes “engaging in venture capital activities”), (3) investment strategy (the fund agreement must reflect venture capital investment strategy), (4) investment method (no leverage, except as otherwise provided by laws or regulations) and (5) duration (minimum duration in line with relevant regulations), with a catch-all provision “other conditions specified by laws or regulations” to leave room for future additional regulation and support.

Article 36 of the Regulations reiterates the incentivizing policy support for venture capital funds under existing laws and regulations, encourages and guides venture capital funds to invest in growth and innovative venture companies, and encourages long-term capital to invest in venture capital funds. In addition, Articles 37 and 38 of the Regulations further specify the policy rationale of differentiated regulation for venture capital funds under existing laws and regulations in terms of the registration and filing procedures, fundraising, investment operation, risk monitoring, on-site inspection and investment exit, and further emphasizes the support for the development of venture capital funds – reflecting the regulatory approach and policy direction of encouraging “investment in early-stage enterprises, investment in small enterprises and investment in technology”.

3. The Regulations’ Impacts on the Private Fund Sector and Future Prospects

After the COVID-19 pandemic, many industries are awaiting recovery. The private fund sector is facing challenges in fundraising, investing, management and exiting due to the impact of a variety of factors such as the pandemic, economy and geopolitics. Given the important role that private fund sector plays in serving the real economy and supporting technology innovation, it is imperative that it has the support and encouragement from the government.

The promulgation of the Regulations reflects the government’s realization of this and encouragement to the development of the private fund sector, and provides higher-level legal support for sector regulation. It fills the gap between laws, departmental rules and self-regulatory rules, and puts forward higher requirements for the regulation of the private fund industry. This will accelerate the survival of the fittest in the private fund industry and promote its healthy development in the long run.

It is worth noting that as the first administrative regulation in the private fund sector, the Regulations set out high-level principles and rules regarding major issues in the industry and fulfilled its mission for the time being. More practical provisions still need to be further clarified, supplemented, and improved by the departmental rules of CSRC and/or the self-regulatory rules of the AMAC. After the promulgation of the Regulations, it is expected that CSRC and AMAC will amend their existing departmental rules and self-regulatory rules accordingly, such as the CSRC Order 105 and the “Measures for the Administration on Fundraising Behaviour of Private Investment Funds,” and issue relevant follow-up guidelines to the Registration and Filing Measures to ensure a smooth connection between laws, regulations, and regulatory rules, and hopefully translate the good governance of the Regulations into industry practice.