As the regulatory policy tightens, fundraising gets harder. However, many investors are still expecting too much for full payments of principal investment and expected return. Under this background, part of the investment funds are fake equity, invested in the underlying assets of creditor's rights or similar creditor's rights in the name of private equity
Although the investment is made in the target enterprise in the form of equity, it is a capital-guaranteed contractual investment mode with rigid repayment in essence. Compared with the real equity investment, investment in fake equity usually reflects that investors require a promise of principal investment return through various ways and obtain fixed or clear guaranteed investment income. The principal and investment income above shall be obligated to pay to investors and shall not be affected by the operating conditions and actual profits of the invested target enterprise. In addition, investors of the investment in fake equity rarely have high enthusiasm to participate in operation and management of the invested target enterprise.
Strictly speaking, although the funds invested in fake equity can still be filed and pass the review by the Asset Management Association of China, there are inevitable compliance defects in them. This article will hereby thoroughly analyzes the reasons, common transaction modes and legitimate risks, further predicting future policy trends for the existence of fake equity in private equity investment funds.
Ⅰ. Origins of the Investment in Fake Equity
1. Fund managers’ preference to rigid repayments
Equity investment is an investment with certain risks which are likely to yield less return than expected and even lead to the loss of investment principal. Although it has been explicitly promulgated to break the rigid repayments in the <Guidance on regulating the asset management business of financial institutions> (abbreviated as the “New Guidance of Assets Management Regulation”) issued on April 27th, 2018 by the People’s Bank of China, China Banking and Insurance Regulatory Commission, China Securities Regulatory Commission. Considerable investors still inevitably have high expectations and requirements to be fully paid of investment principal and expected return in the current asset management market, and few irrational investors even require managers to take responsibilities in radical ways when expectations fail to be reached.
In the face of the steady investment requirements by investors, many managers still hope to prevent from getting loss due to inevitable risks by investment in equity, and finally choose to make investment through trading patterns with relative stable income to better secure the investment principal, although the fundraising process is legal and compliant and the risk has been fully revealed to investors. Even though the investment in fake equity may fail to receive higher investment return that may be brought by IPO and other exit methods, it strengthens the guarantee of the investment principal and the expected fixed income, which can meet the needs of stable operation of managers.
2. Harder fundraising for long-term investments
Equity investment is an investment mode with longer term. Equity investment at any stage needs time to wait for the growth and appreciation of the invested target enterprise, and finally realizes the potential value of the enterprise and obtains investment income through reasonable exit whether it is at seed round, angel round or even pre-IPO stage. However, current private equity investment market shows that a considerable number of investors (especially natural person investors) are more willing to accept funds with a short operating period, compared with funds with a few years or longer operating period and weak liquidity.
On the one hand, for investment in equity, it does have difficulties to complete the whole process of fundraising, investment, management and withdrawal within a relatively short period of time and obtain investment returns. On the other hand, it is also not easy for small and medium-sized managers to raise sufficient long-term funds. Time waits for no man. As a result, some managers are afflicted with lacking of enough time to wait for the invested target enterprise to grow up. Instead, the investment in fake equity can control the time period of repayment cycle by making agreements with invested target enterprises to pay back before their growth and development, which is one of the most important reasons why many managers choose to invest by the so-call investment in fake equity mode.
3. Can be disguised to increase credit or optimize the financial statement of invested target enterprise
In addition to being relatively easy for investors to guarantee the investment income and control the investment cycle, the investment in fake equity can also bring some hidden benefits to the invested target enterprises. For example, some powerful investors’ (such as state-owned assets or group background, etc.) nominal shareholding in the invested target enterprise can also enhance its credibility in a disguised form.
Besides, the trading mode of investment in fake equity with debt essence can help to optimize the financial statements by reducing debts and finally avoid the financial data from showing a high asset-liability ratio, poor operating conditions or other detrimental information of the invested target enterprise.
4. Private equity funds are prohibited from investing in loan-making assets
After the Asset Management Association of China (abbreviated as “AMAC”) promulgated the <Instructions of private equity investment registration> on January, 2018 in the Asset Management Business Electronic Registration System, the loan-making assets, as well as the income rights are prohibited to be invested by private equity funds. As a result, more and more capital aiming at investing in loan-making assets are lacking in legitimate and effective ways of making investment.
Moreover, the filing of funds registration by the “AMAC” is still based on the principle of formal review, and it is difficult for auditors to penetrate to the real underlying investment objects. Therefore, most funds that invest in fake equity can still pass the review. Under the current background that creditor's rights funds are not allowed by the regulatory authorities, the investment in fake equity with debt essence has become a "byway" for private equity funds to invest in underlying assets of creditor's rights and gradually grows stronger.
Ⅱ.Common Operation Mode of the Investment in Fake Equity
1. Transaction mode
In the trading model of investment in fake equity , the main content is that investors give money in the name of equity investment to the invested target enterprise, and the target enterprise commit to return the investment proposal and pay the profits through investment agreement or supplementary agreement and other legal documents, which shall not be influenced by operating conditions and the amount of distributable profits of the invested target enterprise. The specific methods include signing the debt-for-equity exchange agreements in which equity swap cannot be realized under the conditions, establishing valuation adjustment clauses in equity investment agreements to ensure that the equity repurchase is finally paid rigidly by investors, the project company and its shareholders undertake the long-term equity repurchase commitment, guarantee regular dividends or provide margin compensation by other high-credit subjects, etc.
Please check the basic deal structure as follows:
2. Funds Registration
When producing and distributing funds invested in fake equity , managers shall firstly pay attention to the private equity investment funds that are still nominally managed by private equity fund managers and whose investment targets are equity assets such as equity of unlisted enterprises. Secondly, when filling the information of funds, there’s no need to fully disclose the real intended investment direction and underlying assets of the fund products to the regulatory authorities, it’s enough to report the industry field of the invested target company. Finally, the supplementary legal documents related to the content of investment in fake equity are not disclosed, such as equity repurchase agreement, repurchase commitment and guarantee agreement, etc.
III. Legal Risks of the Investment in Fake Equity
1. Violating the principles of professional operation
According to the requirements of the regulatory authorities for the professional operation of the manager, the private fund manager can only register the private fund that is consistent with the registered business type of the organization, and shall not manage the private fund of other business type. Therefore, the funds filed as private equity investment funds investing in fake equity actually violate the principles of professional operation and may be punished by the regulatory authorities.
2. Risk of default by the other party
Although in the agreement of investment in fake equity , the obligation of the invested target enterprise to repay capital and interest to the investors shall not be affected by its operating conditions, and is not based on the premise that the invested target enterprise makes sufficient profits, the influence on solvency of the invested target enterprise does exist by its operating conditions. Once the invested target enterprise is incapable to perform the contract, and the guarantee provided is also not enough to realize creditor's rights (such as the guarantors’ credit deterioration, the value of equity pledge derogate, pledge bill defects, etc.), the investors will thereby face the risk that rights shall not be achieved.
3.Uncertain risks exist in legal relations
The investment in fake equity is an uncertain state of the legal relations. The legal documents signed by the investor and the investee on the investment behavior reflect two legal relations of equity and debt. If dispute arises and the investment is recognized as equity investment by judicial offices after entering legal procedures, the investor can only claim the rights related to equity, while the right to return the investment principal and investment income is unable to be claimed.
4. Bear the risk of Contributive Funding Obligations
In the investment in fake equity, the investor, as the nominal shareholder of the invested target enterprise, shall undertake the obligation of real investment. Once the invested target enterprise is unable to repay its matured debts or other circumstances, the creditor may require the investor to assume the liability for debt repayment within the scope of the subscribed capital according to the register of shareholders registered in the industry and commerce authorities. After paying off debts, the investor may, in accordance with internal agreements, recover debts from other shareholders of the invested target enterprise.
IV. Regulatory Trend Forecast of the Investment in Fake Equity
1. Enhance the audit intensity of the real underlying assets of the archival funds
In view of the current increasingly strict supervision, private equity funds filing audit is becoming more rigorous and detailed. In order to control the incomplete disclosure of trading structure such as investment in fake equity and the unreal disclosure of underlying assets, the regulatory authorities are likely to increase the audit intensity of transaction structure and penetration of underlying assets.
Meanwhile, it may further clarify the responsibility of the private fund manager in the registration process of funds and stipulate corresponding penalty measures to reduce the incomplete and inaccurate disclosure of the manager in the funds registration process
2. Further clarify the boundaries between investment in fake equity and equity investment
Since there are certain similarities in structures between equity investment and investment in fake equity, whether it belongs to investment in fake equity and the identification criteria still need to be clarified by the regulatory authorities. Questions such as whether performance targets in the valuation adjustment clauses and the debt-for-equity exchange conditions in equity investment agreements are achievable and maneuverable to the target enterprise's true performance expectations, or are simply as an excessively high equity repurchase conditions which are impossible to be implemented need regulators to judge and make criteria to define as much clear as possible.
Conclusion: although there is still a large stock of investment in fake equity and such funds can still be put on record, there are still compliance defects that can’t be covered up in further study and review. In view of its large stock and great influence, it is likely that targeted regulatory measures will be taken in future regulatory policies. Therefore, private fund managers should abide by the principles of professional management and return to the essence of investment in fund operation and management.