The Chinese private equity market is one of the fastest changing in the world. Significant private equity activity in China has been going on for scarcely a decade, and in that short time there have been dramatic changes in the way that the market is regulated and in the way that it functions. Debevoise has been active in this market since its inception, and in this article we continue our examination of topics of interest to Chinese and non-Chinese fund sponsors and investors interested in the Chinese private equity market. In the discussion below we examine the rules governing investment by Chinese insurers in renminbi-denominated private equity funds organized in China1 (“RMB funds”), including recent new revisions to the rules that would greatly expand the ability of Chinese insurance companies to make such investments.
RMB fund sponsors, whether organized under Chinese law or the laws of another jurisdiction, often complain about the scarcity of institutional limited partners in China. Insurance companies organized in China, which are subject to supervision by the China Insurance Regulatory Commission (the “CIRC”), have recently attracted much attention because they are seen as potentially an important source of institutional capital for RMB funds. According to the CIRC, as of the end of August 2012, the total assets held by Chinese insurance companies stood at RMB 6.64 trillion (approximately US $1.06 trillion).
The 2010 Temporary Rules and the 2012 Liberalization
Like insurers in many other jurisdictions, the insurance industry in China is highly regulated, and the types of investments that Chinese insurance companies may make are limited. Only two years ago, the CIRC issued the first set of temporary rules governing investment by Chinese insurance companies in private equity (the “Temporary Rules”). The Temporary Rules authorize Chinese insurance companies to invest their assets in the equity of non-publicly traded companies in China, either directly in private equity transactions or indirectly through RMB funds. However, under the Temporary Rules such investments are subject to significant conditions that may be difficult for some investors to satisfy. To date, only a handful of investments by Chinese insurance companies in RMB funds have been reported.
In July 2012, the CIRC issued a new notice (the “2012 Notice”) containing a series of changes to the Temporary Rules, as well as changes to rules governing investment by Chinese insurance companies in real estate. In general, the 2012 Notice relaxed some of the restrictions in the Temporary Rules, including with respect to the types of Chinese insurance companies that are allowed to make private equity investment, the types of RMB funds in which eligible insurers may invest, and the types of investments that such RMB funds may make. Below is a summary of several key aspects of the rapidly evolving insurance regulations relating to Chinese insurance companies’ investment in RMB funds.
Which Chinese Insurance Companies Are Permitted to Invest in RMB Funds?
Not all insurance companies in China may invest in RMB funds.2 For an insurance company to be qualified to invest in private equity, it must, among other things:
- have net assets of no less than RMB 100 million (approximately US $16 million) as of the most recent fiscal year-end;
- have a solvency adequacy ratio of no less than 120% as of the end of the last quarter before the time of investment; and must adjust its investment strategies if the ratio falls below 120% after any private equity investment is made;
- have at least two employees, with at least three years’ experience each, in private equity investing; and
- meet certain additional requirements, such as having sound corporate governance, management systems, decision-making processes and internal controls, having established asset custody arrangements and not having violated applicable law in any material respect in the most recent three-year period.
What Approvals Are Required Before a Chinese Insurance Company May Invest in an RMB Fund?
Until recently, it was not clear whether CIRC approval was required before a Chinese insurance company could invest in an RMB fund. The Temporary Rules did not expressly require prior approval; although the Temporary Rules did provide that a filing must be made within five business days after the execution of a subscription or other investment agreement. However, in practice it had been widely reported and understood that a “private equity license” of some kind was required for a Chinese insurance company to invest in an RMB fund—and that it could take a substantial period of time to obtain such a license. For example, in 2011 it was reported that it took one prominent insurer about one year to obtain such a “private equity license.”
This uncertainty concerning the CIRC filing and approval process was significantly reduced by a September 20, 2012 document issued by the CIRC and titled “Certain Explanations re: Filing by Insurance Companies Relating to Equity Investments and Real Estate Investments” (the “Filing Guidance”). The Filing Guidance makes clear, for example, that a Chinese insurance company may only invest in an RMB fund after it has made a filing with the CIRC, and the CIRC has reviewed and accepted the filing. This filing most likely will need to include copies of documents relevant to the insurer’s decision to invest, which could potentially include key fund documents such as the partnership agreement and subscription agreement, but the Filing Guidance is not clear on this point. The Filing Guidance also makes clear that the CIRC may reject any such filing if it determines that the Chinese insurance company does not meet all the qualification requirements outlined above.
Interestingly, the Filing Guidance also seems to suggest that an insurance investor may be able to obtain a “blanket” private equity license, which presumably would reduce the burden of obtaining a separate approval in connection with each private equity investment. However, further clarification on this point is needed. How this will play out in practice remains to be seen.
In What Kinds of RMB Funds May Chinese Insurance Companies Invest?
A Chinese insurance company may not invest in an RMB fund unless both the fund sponsor (the fund manager or adviser) and the fund itself meet certain tests
Qualified fund sponsors. The fund sponsor generally must (1) have adequate capital, i.e., at least RMB 100 million in either registered capital or capital commitments, (2) employ a stable and experienced management team that satisfies certain tests, e.g., a team that includes at least ten professionals with relevant experience and that has made and exited at least three prior investments, (3) have at least RMB 3 billion in assets under management and (4) satisfy a number of additional conditions.
According to the 2012 Notice, for purposes of the test in clause (3) above, “assets under management” refers only to amounts of capital or assets in China, denominated in RMB and having been paid in. This test could prove very difficult for most private equity firms to satisfy, and it remains to be seen how the CIRC will interpret this requirement and apply the test.
Qualified funds. As for the RMB fund itself, in addition to being sponsored by a qualified sponsor, it must also satisfy a list of requirements relating to, among other things, fund size (no less than RMB 500 million), custody arrangements and disclosure.
Approved investment strategies. RMB funds also must have investment strategies approved by the CIRC. Approved investment strategies include growth capital investing, investing in buyouts, investing in “upcoming industries” (such as financial services, senior care and health care) and investing in modern agriculture and low-income housing. Another approved investment strategy is investing (through a fund of funds) in funds pursuing the approved strategies described in the preceding sentence. On the other hand, Chinese insurance company money may not be invested in “start-up, venture” funds, or in fund sponsors.
Approved securities. The types of securities in which RMB funds with Chinese insurance company investors may invest are also regulated. Prior to the 2012 Notice, under the Temporary Rules a Chinese insurance company was permitted to invest, directly or indirectly through qualified RMB funds, only in the equity of non-public (unlisted) companies. The 2012 Notice, however, expanded the types of permitted investments so that, today, Chinese insurance money also may be invested in RMB funds (with buyout strategies) that have the ability to invest not only in unlisted companies, but also in shares of listed companies; however, these investments in shares of listed companies may only be made in certain ways that generally do not constitute “trading.” It is not clear whether RMB funds that have Chinese insurance company investors may invest in debt or debt-like securities issued by Chinese companies.
Requirement regarding target portfolio companies. Finally, the CIRC has authority to restrict the types of portfolio companies in which RMB funds with Chinese insurance company investors may invest. Thus far, in general, the main requirement in this respect seems to be that target portfolio companies should have the potential to generate favorable returns to the insurance company investors. This vague standard could be clarified, and additional requirements could be imposed, by the CIRC in the future.
General Private Equity and Fund-Specific Investment
A Chinese insurance company may invest up to 10% (but not more than 10%) of its total assets, calculated as of the most recent quarter-end, in private equity, including direct investments and investments in RMB funds. The rules do not specify what happens if, at any point in time, a Chinese insurance company’s investment exceeds this 10% limitation due to, for example, a reduction in the value of the company’s non-private equity assets.
Furthermore a Chinese insurance company’s investment in any single RMB fund may not exceed 20% of the “total size” of such fund; and if the insurance company is an insurance holding company, the aggregate investments made by the such holding company and its insurance subsidiaries may not exceed 60% of the “total size” of the fund. It is not clear under the rules whether the term “total size” refers to capital commitments, invested capital or some other test.
Reporting Requirements; Inspection
After making an investment in an RMB fund and during the term of the investment, a Chinese insurance company is required to provide certain information (including periodic reports) to the CIRC, and the fund sponsor also is required to submit an annual report concerning the fund to the CIRC. However, these reporting requirements are vague, and it is difficult to be certain how much information must be reported to the CIRC. These reporting obligations—as well as other regulatory requirements, such as investment restrictions concerning a fund’s investment scope and objectives—typically will be requested by Chinese insurance investors to be reflected in the relevant subscription, partnership or other investment agreements or in side letters between the insurance company investor and the RMB fund.
The CIRC has the authority to inspect each RMB fund in which a Chinese insurance company has invested and may impose penalties on non-complying fund managers. Such a penalty could include adding a non-complying fund manager to a “black list” of fund managers with whom insurance companies are prohibited from doing business. It is not clear in practice how these inspections will be carried out. Similarly, the full extent of the penalties that might be imposed for non-compliance also is not clear.
Other Types of Permitted Investments
Real estate funds. Under Chinese insurance regulations, Chinese insurance companies are allowed to invest in real estate and “real estate-related financial products.” The definition of “real estate financial products,” together with other rules issued by the CIRC (including the Temporary Rules and the 2012 Notice), seem to suggest that Chinese insurance companies should be able to invest in real estate funds. However, we are not aware of any specific case where a Chinese insurance company has received CIRC approval to invest in a real estate fund, although this could be due to the unsettled state of the relevant regulations, as well as the recent tight government control of the Chinese real estate industry in general.
Offshore funds. The CIRC has issued separate regulations concerning offshore investments by Chinese insurance companies. (An investment in an offshore private equity fund typically would be considered an “offshore investment” even if the fund invests in China.) Since August 2010, Chinese insurance companies have been permitted to make certain types of offshore investments, such as investments in money market instruments, fixed income products and certain equity products in developed offshore markets as part of the “Qualified Domestic Institutional Investors” scheme.
Chinese insurance companies are not yet expressly permitted to invest in offshore private equity funds. However, it has been reported in recent months that the CIRC is likely to issue more detailed rules on offshore investments that will broaden the scope of permitted investment, and that this permitted investment might include investments in certain qualified offshore private equity funds. And in fact, just as this issue of the Private Equity Report went to press, we learned that the CIRC is likely to issue regulations shortly concerning investment by Chinese insurance companies in qualified offshore private equity funds. We will report on these developments in the next issue.
Asset managers. Lastly, Chinese insurance companies may outsource their investment management functions to specialized asset managers. The CIRC has issued separate rules concerning such asset management arrangements. Based on publicly available reports, a number of major Chinese insurance companies have set up their own asset management divisions. Will third-party asset managers be able to take over a large share of the market or will insurance companies’ asset management subsidiaries dominate the market? It is difficult at this time to predict in which direction the market will move.
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The 2012 Notice and the recent Filing Guidance from the CIRC have provided much needed and long-awaited rulemaking and clarification concerning investment by Chinese insurance companies in RMB funds. However, the rules are still vague in a number of respects. Many important questions remain unanswered. We will continue to monitor development in this exciting and quickly changing market.
1. For purposes of this article, “China” refers to mainland China, i.e., excluding Hong Kong, Macau and Taiwan.
2. The Temporary Rules generally are drafted such that they apply not only to Chinese insurance companies’ investment in RMB funds, but also to their direct investment in unlisted companies. So, for example, the qualification requirements that apply to Chinese insurance companies investing in RMB funds are generally similar to those applicable to their direct private equity investing subscription agreement with respect to the RMB fund being tested. However, again, the rules are not entirely clear on this point.