Property attribution disclosure in contractual PE funds

Private equity (PE) funds come in three organisational types: corporate, partnership and contractual. Unlike the first two, contractual PE funds do not establish a company or partnership entity. Typically, they involve a fund contract signed by investors, fund managers and custodians outlining that the funds gathered by investors will be managed and utilised by the fund manager, with the custodian overseeing capital custody.

Advantages and disadvantages

Compared to corporate and partnership PE funds, contractual funds have unique advantages. They bypass the need to establish a physical entity, avoiding business and tax registrations, making fund establishment more convenient and exempt from double taxation. The limit on the number of investors is relatively minimal, catering to the anonymity preferences of some investors. Additionally, investor withdrawal is more convenient.

However, contractual funds also have some drawbacks. Because of the absence of a physical entity, they cannot independently assume civil liability, and they face various restrictions in investment activities. One significant limitation is the insufficient display of the independence of fund assets, meaning it fails to meet the disclosure requirements for property ownership.

The independence of fund assets from fund managers is a fundamental principle in PE funds. The Interim Measures for the Supervision and Administration of Private Investment Funds of 2014 stipulated that fund managers must not commingle fund assets with their inherent assets or those of others for investment activities.

The Regulation on the Supervision and Administration of Private Investment Funds of 2023 specifies in article 4 that “PE fund assets are independent of the inherent assets of PE fund managers and custodians. The debts of PE fund assets are borne by shareholders of the fund, except as otherwise provided by law.”

Public disclosure efficacy

In China, where property ownership in the civil law system is closely tied to disclosure mechanisms, even when laws explicitly state the independence of fund assets, without a corresponding disclosure system, the independence of fund assets may struggle against bona fide third parties. If fund assets are commingled with the inherent assets of the manager, this can jeopardise the interests of investors.

Corporate and partnership PE funds have the efficacy of public disclosure since companies and partnerships alike are recognised as legal entities under the Civil Code, granting them the right to engage in civil activities and exercise various rights.

However, contractual PE funds currently do not fall under the legal definition of legal entities. They are particularly constrained by various registrations and often cannot engage in civil activities in their own name.

For instance, if the investment target is the equity of a limited liability company, current business registration norms dictate that the equity can be registered only under the manager’s name, and cannot be registered under the contractual private equity fund.

Therefore, when the manager’s creditors seek to enforce against property registered in the manager’s name, if the manager objects on the grounds that the property is fund assets and not the manager’s, the court may dismiss the objection based on the public disclosure of the property being under the manager’s name.

Naming regulations

In response to this situation, relevant authorities are exploring the establishment of a public disclosure system and information sharing mechanism for contractual PE fund assets to affirm their independence.

To meet practical demands, article 21 of the 2023 regulations stipulates: “When a PE fund manager uses the fund’s assets for investment, when opening an account or entering the shareholder registry of the invested enterprise, or holding other PE fund assets in the name of the fund manager, the name of the PE fund should be specified.”

Contractual PE fund managers, during routine duties and external investments using fund assets, can now specify the actual investor as the PE fund managed by the manager when opening accounts or entering the shareholder registry with banks or securities companies. According to article 21, when the invested enterprise includes the manager in the shareholder registry, it is necessary to specify the name of the PE fund that made the actual investment. This disclosure aims to reveal the identity of the contributor as the PE fund, not the manager.

For other asset investments, including the purchase and sale of shares in limited liability companies, equity in limited liability companies, bonds, fund units, other securities and their derivatives, and investments specified by the China Securities Regulatory Commission (CSRC), the PE fund’s name, if publicly disclosed, enables third parties to identify the true rights holder as the fund and not the manager.

This provides the manager and investors with reasonable grounds to contest enforcement actions by third parties when assets nominally held by the manager but owned by the PE fund are being executed. The implementation of such disclosure mechanisms will strengthen the protection of investor rights.

Commercial registration pilot

Given this context, the Shenzhen office of the CSRC has introduced the Shenzhen Pilot Implementation Plan for Commercial Registration of Contractual Private Equity Fund Investments in Enterprises, along with supporting operational guidelines. This initiative aims to facilitate the implementation of a pilot programme for commercial registration of contractual private equity fund investments in enterprises.

It allows registration in the form of “the names of companies or partnership enterprises acting as PE fund managers (representing ‘the name of the contractual PE fund product’)” when registering as shareholders of invested companies or partners in partnership enterprises.

If the pilot programme proves successful and is widely adopted, it will, coupled with improvements in various registration and filing norms such as business registration, clarify the business entity status of contractual PE funds, potentially significantly enhancing the disclosure efficacy of contractual PE funds and better protecting the interests of investors and third parties.

Jia Yipeng is the managing partner and Zhuo Yiwei is an associate at Hylands Law Firm