Introduction
Whether it is for the purposes of resisting the pressure of inflation, choosing a more sound investment channel with lower costs, or seeking funds with a higher rate of return and greater potential, private equity managers in mainland China are now confronted with urgent but hard-to-satisfy demand for “going abroad plans” to provide enterprises and high-net-worth clients with global wealth configuration schemes.
Plans for “going abroad” developed by private equity managers may be based on overseas financial products like Shanghai-Hong Kong Stock Connect, Shenzhen-Hong Kong Stock Connect and Qualified Domestic Institutional Investor (QDII). Due to the shortage of channels, limited quotas, higher costs and other restrictions, however, these plans cannot satisfy the general demands of customers. The US dollar, which maintains a strong position and a stable outlook, has become a universally favored international currency. Therefore, obtaining the qualification to set up US dollar funds by acquiring an international service license has become a better alternative for private equity managers to take part in overseas markets.
Among all major international financial centers, Hong Kong, due to its unique geographical relationship and favorable policies, has attracted a great number of private equity managers from mainland China to apply for financial licenses. The Securities and Futures Commission (SFC) of Hong Kong issues ten major types of licenses, the ninth type of which is for “Asset Management”. Holders of such licenses are qualified to manage securities, portfolios of futures contracts, or funds for their customers with complete discretion. It is usually called “Hong Kong Type 9 License” in mainland China. This license is most in line with the main business requirements of the private equity fund manager. Around 2016 was a peak period for institutions from mainland China to apply for the Hong Kong Type 9 License. However, the strict application requirements scared off some applicants and also brought those institutions whose applications were approved considerable benefits.
The destination for setting up a US dollar fund is another important choice after the license is obtained. In terms of the distribution of global wealth management centers, Luxembourg, as the largest center for investment funds in Europe and the second largest in the world, has become the first choice to set up funds in Europe. While Boston, a wealth management center featuring fund management and the largest fund management center in the US, is favored by the US dollar fund. Most private equity managers from mainland China set up offshore funds. The Cayman Islands, an important global offshore financial center, has become a favorable destination for most privately offered funds that are managed via Hong Kong for tax planning reasons.
In view of the analysis above, this article focuses on the practices of setting up US dollar funds in the Cayman Islands via Hong Kong, namely by applying for a Hong Kong Type 9 License, which can be used by private equity managers in mainland China for reference.
There are mainly two approaches available for institutions from mainland China, including private equity managers, to obtain a Hong Kong Type 9 License. The first is to file an application by a company incorporated in Hong Kong, or to acquire an institution possessing a Hong Kong Type 9 License. For the purpose of saving costs, the other alternative is to set up a fund in the Cayman Islands independently and to manage such a fund by borrowing a Hong Kong Type 9 License from another company. Acquiring a company or borrowing a license seems to be convenient, but it usually results in high costs and a number of uncertain factors, and is detrimental to the unified overall structure of enterprises. To ensure long-term development, therefore, many institutions choose this approach to apply for a license.
The requirements for the application for a Hong Kong Type 9 License are summarized as follows:
1. Incorporation: You must be a company incorporated in Hong Kong or an overseas company registered with the Companies Registry of Hong Kong;
3. Responsible officers: You should appoint not less than two Responsible Officers (RO) to directly supervise the conduct of each regulated activity you apply. At least one of your proposed responsible officers must be an executive director (in relation to a corporation, an executive director refers to a director actively involved in or directly supervising the operation of a corporation) as defined under the SFO. Besides possessing three years of relevant industry experience over the six years immediately prior to the date of application, responsible officers must pass one of the recognized Hong Kong industry qualifications;
4. Executive director: All your executive directors must seek the SFC’s approval as responsible officers accredited to your corporation. Substantial shareholders and officers shall be fit and proper (based on qualification and experiences);
5. Capital requirements: In case you do not need to hold client assets, the minimum paid-up share capital is not applicable, but the minimum liquid capital is 100,000 Hong Kong dollars. In case you need to hold client assets, the minimum paid-up share capital is 5,000,000 Hong Kong dollars, the minimum liquid capital is 3,000,000 Hong Kong dollars, and you should have a strict risk control mechanism.
6. Processing time: if all the requirements above are met, the SFC shall have the following: financial status or solvency; educational or other qualifications or experience with regard to the nature of the functions to be performed; ability to carry out the regulated activity concerned competently, honestly and fairly; and reputation, character, reliability and financial integrity of the applicant and other relevant persons as appropriate. To process an application normally takes at least 15 weeks.
The Cayman Islands adopts a relatively flexible and comprehensive legal system that takes the best of other legal systems and advances with the times. One important manifestation of this is that Cayman Islands law is based on the legislative experience of developed countries such as the United Kingdom and the United States, combined with the actual situation of the Cayman Islands. The organization of the fund is a key element that the founder of an investment fund needs to consider and decide at the very beginning when he or she designs the structure of the fund. Different organizational forms and structures lead to different underlying legal relationships between participants of a fund, and impact the raising, investment, management, withdrawal and all aspects of the investment fund.
Generally speaking, funds set up in the Cayman Islands mainly adopt two structures: Segregated Portfolio Company (SPC) and Exempted Limited Partnership (ELP).
At present, SPC is the most popular structure for building an umbrella-type structure. A number of segregated portfolios can be created under the “umbrella” of SPC. Each segregated portfolio runs like a subsidiary of the SPC and has a segregated asset pool and segregated liabilities. Each sub-fund may have its own manager and segregated asset pool, and abide by its own investment policies. It is worth noting that liabilities arising from trading activities of each sub-fund may be segregated and only relate to the assets under this sub-fund. Such a structure eliminates the need for establishing a new company for each new fund, reduces the cost, and makes the set-up more effective.
SPCs are divided into the open type and the closed type. The open type is generally used to be engaged in secondary securities market, while the closed type is generally used to be engaged in private equity funds.
The schematic diagram of the establishment of a fund through a SPC is below:
ELPs are generally used for a closed type fund and also mainly used to set up private equity funds. Investors, as limited partners, hold interests and shore the profits or losses of the fund according to their investment proportions. As limited liability partners, their risk exposure is limited by their investment amounts. General partners bears unlimited liability, but normally it is a limited liability company. For the sake of improving tax efficiency, American investors embrace these structures. Meanwhile, it offers greater flexibility in terms of negotiation conditions. However, investors cannot benefit from the profits tax exemption that is unique to corporate funds. If the core investor has to go through a lot of negotiations on the limited partnership agreement, the cost may be much higher.
The schematic diagram for setting up a fund by ELP is below:
As discussed above, to set up US dollar funds via Hong Kong involves two major steps, namely applying for a Hong Kong Type 9 License and setting up funds in the Cayman Islands. Due to major differences in the legal system, economic system, and cultural environment between the two regions and China, only highly professional practitioners with extensive practical experience and overseas backgrounds can accomplish this. Generally speaking, private equity managers from mainland China cannot handle it independently and require full assistance from a corresponding service provider.
An appropriate service provider, while applying for a Hong Kong Type 9 License, should first evaluate the applicant’s competence for possessing an SFC license, including reviewing the resume and other data of responsible officers and conducting preliminary assessments of the project feasibility. If the responsible officers proposed by the applicant are not qualified for this application, the service provider shall seek appropriate responsible officers for the applicant via its partners. In addition, the service provider shall, in view of the business demands of the applicant, design a tailored scheme for the license application and put forward the proposed rationale for the equity structure and management structure.
Upon signing the agreement, the service provider shall assign the applicant a licensed consultant, who will be responsible for communication with the applicant and SFC and preparations of project documents, and assist the applicant in filing application forms and drafting other application documents, including but not limited to business plans, compliance manuals, risk management policies and a continuing business plan. The time spent during the preparation of application materials depends on the structural complexity of stock equities and the board of directors, as well as the response speed of the applicant, and is normally about 2-4 weeks.
Once all application materials are ready, the service provider shall send scanned copies of the whole set of application documents to the applicant for review and approval, and after such approval is obtained, submit the application documents to Hong Kong SFC. Within about three days after the application is submitted, the licensed consultant shall get in touch with Hong Kong SFC, consult a staff member in the Licensing Department who takes charge of this application, and follow up the application. During the application, the service provider shall assist the applicant in drafting replies to a series of questions raised by SFC about the application. Only with a licensed consultant who has sufficient experience in replying to such questions can such an application be smoothly advanced.
As for setting up a fund in the Cayman Islands, an appropriate service provider shall provide all-round services covering all processes before and after investment, and the fund settlement. Services before investment include building a structure, employing a lawyer in the Cayman Islands to draw up a Private Placement Memorandum (PPM), accounting of the initial incorporation cost and annual operation expenses, administration of the fund, auditing, tax consultations, bank account opening, Know Your Customer (KYC), Anti-Money Laundering (AML), etc. Services after the investment include monthly reports, monthly follow-ups after investment, annual KYC and AML. The fund settlement services include communication with an auditor, provision of an auditor’s report, fund settlement or liquidation, and provision of a customer report on fund settlement.
