The Hong Kong Financial Secretary announced in his 2019-20 Budget speech1 that the government was seeking to establish a limited partnership regime for funds (LPF), in order to facilitate industry development while maintaining market integrity and investor protection. This development is timely and could (with some caveats described below) prove to be transformational for private equity firms headquartered outside of Hong Kong, as well as other Asia-focused managers with Hong Kong operations.
The Financial Services and the Treasury Bureau published a consultation paper setting out the key features of the proposed LPF regime in July 2019 (Consultation Paper), and put forward the proposals (with certain amendments to those in the Consultation Paper) for consideration by the Legislative Council in December 2019 (Proposals)2.
Given the strength of the industry in Hong Kong, it has long been somewhat perplexing that there has not been a viable local fund structure for establishing private equity funds. The key beneficiary of this has been the Cayman Islands, where most Asia-focused private equity funds have been established, particularly through the use of Cayman Islands-exempt limited partnerships. For fund managers focused on South and Southeast Asia (and which have investment executives on the ground in Singapore), there has been some chipping away at this in recent years as the Singapore limited partnership, established in 2009, has increasingly been utilised as an alternative fund vehicle. Singapore has continued to innovate in this area with the impending introduction of the Variable Capital Company. For further information, please refer to Dechert OnPoint, A New Fund Vehicle for Singapore.
From the perspective of firms with a Singapore nexus, the biggest “game changer” probably has been the introduction of economic substance requirements in the Cayman Islands3, which have made it more challenging to operate a Cayman Islands limited partnership solely offshore. As more of the management functions have needed to be moved onshore, the rationale for using onshore fund vehicles has itself been bolstered. Accordingly, it is somewhat opportune that the introduction of what appears to be a viable Hong Kong structure comes at a time when Asia-based fund managers are considering alternate ways of structuring their operations in response to these substance requirements. This is in line with a more general shift across the globe within the industry away from offshore structures towards onshore ones.
Key features of the proposed LPF regime are described below.
The existing Limited Partnerships Ordinance4 (LPO) was enacted more than a century ago, before the development of the investment funds industry5, and contains provisions that made the structure unwieldy for fund managers seeking to establish private equity funds in Hong Kong in the form of a limited partnership.
A stand-alone piece of legislation now is being introduced to put in place a limited partnership regime specifically for funds, which is designed to accommodate the needs of funds and the fund industry. It is not intended that the LPO itself will be amended, in order not to inadvertently affect non-fund limited partnerships (such as consulting firms and restaurants).
An LPF would be a limited partnership “fund” (i.e., a “collective investment scheme” as defined under the Securities and Futures Ordinance6) used for the purpose of managing investments for the benefit of its investors. The LPF regime would be a registration regime. The LPF is proposed to be constituted by at least two partners (one general partner (GP) and one limited partner (LP)) under a limited partnership agreement (LPA) with a registered office in Hong Kong and a business registration certificate. Each LPF will be governed by its LPA under the terms and conditions set out therein.
As currently proposed, a GP may be: a private company limited by shares incorporated in Hong Kong; a non-Hong Kong company registered with the Companies Registry of Hong Kong; a limited partnership (domestic or foreign); or an individual (domestic or foreign). The types of entities that are permitted to be a GP are much broader and flexible compared to the original proposal in the Consultation Paper, which would have allowed only a private company limited by shares incorporated in Hong Kong to be a GP. This revision allows fund sponsors the freedom to choose among a range of tax-transparent and tax-opaque entities that best suit the sponsor’s business needs.
The GP would be required to appoint an investment manager to carry out the day-to-day investment management functions. The investment manager should be either a Hong Kong resident at least 18 years old or a corporation registered in Hong Kong. A Hong Kong-based fund manager would conduct the day-to-day investment management functions and would need to be appropriately licensed by the Securities and Futures Commission of Hong Kong (SFC) to conduct such business. This is a significant feature of the proposed legislation, as a number of Hong Kong-based private equity firms have taken the view that they need not be licensed by the SFC7; firms that have been averse to being licensed are likely to take this into consideration when deciding whether to structure any of their funds as an LPF.
The Proposals require the GP to ensure that there are proper custody arrangements for the assets of an LPF. However, the Proposals do not provide any detailed requirements, including whether there would be a requirement to appoint a custodian (which is unusual in the private equity context).
LPFs would need to be registered with the Registrar of Companies (RoC, which would serve as a registrar for the LPFs and maintain and publish a register of LPFs)8.
The registration of an LPF would remain valid subject to the GP’s filing of an annual return with the RoC. Further, the GP would be required to inform the RoC within a specified period of time of any changes in the registration particulars.
An independent auditor would need to be appointed to carry out an annual audit of the LPF’s financial statements.
The GP or investment manager would be required to maintain a proper record of documents or information in relation to the LPF’s operations and transactions (e.g., audited financial account, particulars and beneficial ownership information as to all partners) at the registered office of the LPF or any other place in Hong Kong made known to the RoC. The financial account of an LPF would need to be made available to all partners and, as and when necessary, accessible by law enforcement officers.
Tax and Stamp Duty Treatment
In respect of profits tax, an LPF meeting the definition of “fund” under the Inland Revenue Ordinance9 (IRO) and subject to certain exemption conditions in the IRO could enjoy profits tax exemption in Hong Kong for certain transactions. For further information, please refer to Dechert OnPoint, New Hong Kong Profits Tax Exemption Regime Currently Effective.
In respect of stamp duty, as an interest in an LPF does not fall within the definition of “stock” under the Stamp Duty Ordinance10, an instrument under which the LPF interest is contributed, transferred or withdrawn would not be subject to stamp duty. However, in-kind capital contributions in relation to the transfer of dutiable assets (such as Hong Kong stock or immovable property) would be subject to a stamp duty.
Anti-Money Laundering / Counter-Terrorist Financing Requirements
The Proposals require an LPF to appoint a “responsible person” to carry out anti-money laundering/counter-terrorist financing (AML/CFT) functions for the LPF. The responsible person could be: a person or corporation that is: an “authorized institution”11; a “licensed corporation”12; an “accounting professional”13; or a “legal professional”14. The responsible person would be required to conduct preventive AML/CFT measures as stipulated under the AMLO, including for example, conducting customer due diligence in respect of all investors (including all GPs and LPs as well as their beneficial owners) in the LPF. The name and identification number of the responsible person would need to be made known to the RoC.
Safe Harbour Activities for Limited Partners
The liability of LPs would be limited to their respective commitments to the LPF. While the LPs would not have management rights or control over the underlying assets held by the LPF, they would have the right to participate in certain prescribed safe harbour activities. The Proposals set out examples of safe harbour activities (e.g., serving on a board or committee of the LPF; participating in decisions regarding the admission or withdrawal of partners; and changing the investment scope of the LPF).
The RoC would be authorised with sufficient enforcement powers to enable it to oversee LPFs’ compliance with registration, annual return filing and other requirements. In particular, the RoC would have the power to revoke a registration of LPF under designated conditions15.
The Proposals introduce a straightforward and cost-efficient dissolution and/or liquidation mechanism for LPFs:
- By partners’ agreement – The GP would have the right to have the partners agree to the conditions under which the fund could be dissolved voluntarily. Upon the partners’ agreement to dissolve the fund and receipt of tax clearance, the GP could carry out the dissolution procedures specified in the LPA, and file a notice of dissolution with the RoC to dissolve and deregister the LPF.
- By the court – A court could order an LPF to be liquidated as an unregistered company in accordance with the Companies (Winding Up and Miscellaneous Provisions) Ordinance16. The process could be initiated when any partner or creditor of the LPF or the Financial Secretary or the RoC presents a winding up petition to the court against the LPF under certain conditions, followed by the appointment of a provisional liquidator (and subsequently, a liquidator) to carry out the administration of the liquidation.
The government currently is targeting the introduction of a bill on the LPF regime into the Legislative Council for first and second reading in the first half of the legislative session in 2020.
The proposed LPF regime appears to have taken a streamlined and straightforward approach to the formation and registration requirements of LPFs. This not only seems to offer investment funds a speedy establishment process, but also capitalises on the shifting trend of funds from offshore to onshore. At the same time, historically there has been considerable inertia in the industry with regard to the adoption of new structures, particularly as there is some concern that overseas institutional investors may prefer to invest in the types of vehicles with which they are familiar. Accordingly, to make a compelling case, at the very least the new private equity fund regime must align with industry practice to accommodate the operational needs of both private equity fund managers and the investors, and the new legislation must be sufficiently clear to avoid concerns with regard to regulatory compliance. How the Hong Kong government addresses these issues is of critical importance to a competitive and effective limited partnership regime for funds.