"In war, the first guy who understands the terrain takes the high ground. In investing, the first guy who understands the territory gets the best prices. -- Eileen Shapiro and Howard Stevenson "
While there has been too much money in China chasing too few deals, making smart PE and VC investments is like a car race. Not only you need enormous horse power (i.e., size of your fund), but also you need speed - in grabbing and closing deals, and then hopefully, exit in a timely fashion.
Unfortunately, almost everything in China now seems to be against "speed", whether it being the macroeconomic measures to slow down the economy and thwart hot money, or the time-consuming government approval process.
Now for those non-Chinese private equity and venture capital investors, there may be one option to ease such problem, setting up an onshore RMB fund. A RMB fund has at least six appealing attributes:
1. No more individual approval for each onshore portfolio investment. A RMB fund is an entity established under the PRC law, it is therefore deemed as a Chinese entity. As a result, its onshore portfolio investments would not require government approval that would otherwise be required for all foreign investments, unless such investments fall into industries that are not fully open for foreigners.
2. Faster speed to close deals. Because of having no requirement for government approval, transactions can therefore be processed and closed much faster, with much more certainty. This is particularly important in a fast changing market with so much competition for deals.
3. More room for protective provisions and creative arrangements. So long the government approval is not required, pro-investor, Silicon Valley style provisions can be more painlessly and creatively adapted under the PRC law - without fear of being second-guessed and challenged by the approval authority.
4. Faster exits through A-share listing. Under the PRC law, a limited liability company must first convert to a joint stock company before it can be considered for a domestic IPO. The element of "foreign investment" in a joint stock company will make the process longer due to added layers of approvals. For a company looking to list on domestic A share market, the earlier an investor can close a deal of VC or PE financing, the shorter lock-ups and better multiples such investor might end up having.
5. Tax efficiency. If structured properly, a RMB fund can become a pass-through entity for tax purposes. Under the Administrative Measures on Establishing Foreign Invested Venture Capital Funds (2003), a fund can be set up in the form of either a "legal person" (incorporated), or a "non-legal person". If the fund is structured as a "non-legal person" (akin to LLP) with appropriate arrangement, there will be no enterprise income tax at the fund level, the distributions to the fund investors will be only subject to a withholding tax (10% or lower depending on the available tax treaty). If the fund is structured as a "legal person", i.e., a limited liability company, there could be double taxation on capital gains, while dividend payment would be exempted under the new PRC Enterprise Income Tax Law.
6. Reducing currency exchange losses. With a RMB fund, the fund investors can inject the capital in foreign currency as fund’s capital, and convert it into RMB (up to a limit set by the foreign exchange administration) without having to wait until each of those individual portfolio investments closes. By having the ability to convert certain amount of foreign capital RMB and save in an onshore bank account, a RMB fund could therefore mitigate currency losses in light of the increasingly stronger RMB. If the investment is being made by an offshore fund, in contrast, the foreign capital may not be injected and converted into RMB until the individual investment into a Chinese portfolio company has been approved, business license issued and foreign currency bank account opened.
The advantages of forming a RMB fund are apparent. However, for legal and regulatory reasons, fund formation is much more complex in China as compared to Cayman Islands and Delaware. Again, it is the regulatory maze that investors would need to navigate through. It takes guts and hard work to be the early birds, but the early birds will have better chances getting the worms.