On March 1, 2018, the Administrative Measures for Outbound Investments by Enterprises (企业境外投资管理办法) (“Circular 11”) issued by the National Development and Reform Commission (the “NDRC”) went into effect. In addition to regulating direct outbound investments by Chinese companies in general, Circular 11 introduces a new regulatory framework administered by the NDRC governing Chinese companies’ sponsorship of, and investment in, offshore private equity investment funds.

In summary, Circular 11 requires a Chinese company that is sponsoring or investing in:

  • an offshore private equity investment fund with pre-identified portfolio investments that are not “sensitive projects”[1] to submit regulatory filings or reports to the NDRC or its local counterparts, unless such sponsorship or investment is made through a Controlled Entity (as defined below) and the aggregate amount of investments from Chinese companies, directly or through Controlled Entities, in the relevant fund is less than US$300 million; and
  • an offshore private equity investment fund either (i) with pre-identified portfolio investments that are “sensitive projects” or (ii) without any pre-identified portfolio investments, regardless of the industry or project in which it intends to invest (each of (i) and (ii), a “Regulated Fund”) to obtain prior approval from the NDRC.

A. Casting a Wider Net

Domestic Chinese companies, as well as any offshore entities controlled[2] by such companies or by Chinese individuals,[3] are subject to Circular 11’s regulatory regime. Circular 11 applies to two important groups of Chinese investors that have been active in the private equity investment funds space but were not previously covered:

  • Chinese insurance companies, which were previously required to comply only with regulations issued by the China Insurance Regulatory Commission; and
  • Offshore entities controlled by Chinese companies or individuals making outbound investments (each, a “Controlled Entity”), which were generally outside the scope of prior regulations.

B. Seal of Approval

Circular 11 has significant implications for the sponsorship of and investment in Regulated Funds, either by a Chinese company directly or by an offshore entity controlled by a Chinese company or individual:

  • Sponsoring a Regulated Fund requires NDRC approval. Prior to Circular 11, the sponsorship of an offshore private equity investment fund was generally not subject to regulatory approval, and the major regulatory hurdle that Chinese sponsors were facing was the exchange and remittance of funds outside China to fulfill the sponsors’ commitment.
  • Investing in a Regulated Fund is also expected to require NDRC approval, regardless of the size of the proposed investment.

C. Great Uncertainties

Because Circular 11 just went into effect on March 1, 2018, there remains great uncertainty regarding its interpretation, application and impact on market participants:

  • The expected timeline and mechanics of the approval process administered by the NDRC remain uncertain.
  • It remains unclear whether a Chinese investor must obtain approval prior to the execution of any fund documentation with respect to an investment in a Regulated Fund or prior to making any capital contributions.

Because of these uncertainties, Chinese investors are asking fund sponsors to provide solutions in anticipation of their admission into Regulated Funds:

  • Closing Conditioned upon Regulatory Approval: Some Chinese investors are agreeing to submit signed fund documentation to be held in escrow by a Regulated Fund, but the effectiveness of such documentation and its admission to such Regulated Fund is conditioned upon NDRC approval. An even more conservative approach taken by some Chinese investors is to avoid submitting any signed fund documentation until all regulatory hurdles are cleared.
  • Withdrawal from Participation: Some Chinese investors are agreeing to be admitted into a Regulated Fund prior to the completion of regulatory review, on the condition that if such investment does not receive approval, the investor may withdraw from such Regulated Fund using the withdrawal mechanism typically reserved for other regulated investors (e.g., ERISA investors). This approach could potentially be significantly more disruptive for a Regulated Fund, given the commercial and legal difficulties that can arise from processing a withdrawal from a closed-end fund.
  • Exceptions to Confidentiality Restrictions: Chinese investors are requiring fund sponsors to allow them to disclose certain fund related information, such as the investment objective, geographic focus and target size, to the NDRC to obtain regulatory approval. Circular 11 states that such information will be kept confidential by the NDRC.

Until the NDRC issues further guidance on the interpretation and application of Circular 11, or until market participants have had more experience dealing with the NDRC, both fund sponsors and investors will be “crossing the river by feeling the stones” as they consider their approach to outbound investments in offshore private equity investment funds and, in particular, Regulated Funds.