The Hong Kong Securities and Futures Commission (SFC) issued a circular (Circular) on January 7, 2020, which clarifies that private equity firms conducting, or holding themselves out as conducting, regulated activities in Hong Kong would be required to be licensed by the SFC under the Securities and Futures Ordinance (SFO)1. This is a significant development for the private equity industry in Hong Kong, as a number of private equity firms that are based in Hong Kong have taken the view that they need not be licensed by the SFC. Nonetheless, unlicensed private equity firms that currently operate under a licensing exemption may continue to do so, provided their activities in Hong Kong fall squarely within the exemption.
In addition to the licensing requirements, the Circular provides guidance as to: the definition of discretionary investment authority; licensing of investment committee members; interpretation of the private companies securities exclusion; and industry experience requirements applicable to responsible officers (ROs).
Fund Management Business
Under the Circular, the general partners of a private equity fund that conducts fund management business in Hong Kong are required to be licensed for Type 9 regulated activity (asset management). However, in practice, most general partners are set up only with a non-executive board and do not conduct fund management business (as they typically outsource various activities to service providers) or otherwise operate in a way that would be deemed to be carrying on business in Hong Kong.
In relation to those general partners that do conduct fund management business in Hong Kong, the SFC has clarified that such general partners do not need to be licensed, if they have delegated fully all of the asset management functions to an entity that is licensed or registered to carry on asset management business in Hong Kong (i.e., an entity that is licensed to conduct Type 9 regulated activity). The logic behind this is not clear, as general partners that have fully delegated fund management business to another entity presumably would not be carrying on any fund management business.
The conduct of a fund management business is to be distinguished from the conduct of an advisory business, as a person or entity that conducts a fund management business must be given full discretionary investment authority in respect of the funds it manages, whereas a person or entity does not require full discretionary investment authority to conduct an advisory business. In the context of private equity, in making a determination as to whether a license is required, the SFC will consider: the investment decision-making process; the roles of the licensed individuals and their involvement in the process; and whether the delegation of investment authority has been properly documented.
In addition, there is a requirement that the each of the members of an investment committee (if the investment committee is established at the level of the SFC-licensed entity) who have a dominant role in making investment decisions (in particular, with voting rights or veto power) must be licensed as a representative accredited to a licensed corporation. Members that do not have voting rights or veto power with respect to making investment decisions (for example, observers) would not need to be licensed.
Offering of Co-investment Opportunities
The Circular further clarifies that the offering by a private equity firm to another person to co-invest alongside the private equity firm would be required to be licensed for conducting a Type 1 regulated activity (dealing in securities), unless otherwise exempt, since the act of offering co-investment opportunities likely would constitute the act of inducing or attempting to induce another to enter into a transaction relating to securities.
Fund Marketing Activities
Similar to offering co-investment opportunities, the act of marketing a private equity fund in Hong Kong (which is regarded as interests in collective investment schemes) would be regarded as an act of inducing or attempting to induce another to enter into a transaction relating to securities, and therefore would fall within the definition of conducting a Type 1 regulated activity. Accordingly, private equity firms that conduct fund marketing activities in Hong Kong would be required to be licensed for conducting a Type 1 regulated activity, unless otherwise exempt.
Investments in Securities of Private Companies
Under the definition of “securities” in the SFO, shares and debentures of a company that is a private company within the meaning of the Companies Ordinance2 are excluded from such definition3. In assessing whether the assets managed by a private equity firm are “securities” for this purpose, the SFC will consider the composition of the entire investment portfolio of the managed fund. Where the underlying investments are held through special purpose vehicles set up for investment-holding purposes, or the special purpose vehicles themselves fall within the definition of “securities,” the management of the portfolio will constitute “asset management” and the private equity firm will require a Type 9 license. This approach demonstrates the wide scope of portfolio management activities that can fall within the ambit of the licensing regime.
RO Industry Experience Requirement
When an RO applies for a license4, the SFC adopts a pragmatic approach and considers the following experience as relevant industry experience for the purpose of assessing competency:
- Conducting research, valuation and due diligence of companies in related industries;
- Providing management consulting and business strategy advice to companies in related industries;
- Managing and monitoring a private equity fund’s underlying investments for the best interests of fund investors;
- Structuring corporate transactions (e.g., management buyouts and privatizations); and
- Private equity experience in non-regulated situations (including experience in an overseas jurisdiction where the related private equities are not regulated), or relevant experience in a Hong Kong private equity firm that is exempted from the licensing requirement (e.g., conducting research in Hong Kong solely for use by the private equity firm’s holding company).
The Circular was published a few months after the SFC took enforcement action against a private equity firm for employing or appointing unlicensed persons to perform regulated functions for the firm’s asset management business.5 The Circular, together with this enforcement action, makes a case for private equity firms to reassess whether they have complied with the applicable licensing requirements. The Circular also has come in time before the introduction of the new Limited Partnership Fund Regime (LPF regime)6 which is a part of the shifting trend of funds from offshore to onshore. Private equity firms that are not licensed in Hong Kong, or wishing to capitalize on the LPF regime and its associated commercial, operational and tax benefits, should consider whether their activities in Hong Kong would require them to be licensed in the SFC and, if so, whether they should obtain a license or otherwise restructure in a way that would fall outside the licensing requirements under the SFO.