Private equity funds are banned from investing through “debt investment approach” in “ordinary residential projects in cities where the housing market is red hot” by the Administrative Guidelines Concerning Filing of Private Asset Management Plans of Securities and Futures Firms No. 4: Investment by Private Asset Management Plans in Real Estate Developers and Projects (No.4 guidelines) issued by the Asset Management Association of China (AMAC) on 13 February 2017, which set out regulatory requirements in relation to underlying assets and investment approaches.
According to the No.4 guidelines, no restrictions are imposed on equity investments that are authentic, i.e., of good faith. However, the guidelines do not clarify whether an investment that combines authentic equity investment with a loan is allowed for filing. In some funding arrangements for real estate projects, the investments are structured in such a manner that PE funds hold both equity and shareholder loan in the fund seekers. On most occasions, equity holding is designed for credit enhancement so that risks are brought under control, or an equity repurchase arrangement is in place as an alternative, so they are not authentic equity investments. The practice is known as “fake equity, real debt”.
The “equity plus debt” structure is also adopted by some real estate acquisitions. Typically, the acquiring fund establishes a limited liability company as the acquirer (usually a special purpose vehicle), in which the capital raised is invested partly as capital contribution, and partly as loan. Such a structure is designed mainly for tax planning considerations. Income of the special purpose vehicle (SPV), generated from operations of the real estate, is distributed to the fund by way of principal and interest payment under the loan. The remaining income, if any, is distributed as after-tax dividends. In this way corporate income tax of the SPV is reasonably minimized during its term of business.
This structure should not be considered “fake equity, real debt”, because equity is held in good faith, and debt is designed for tax planning purpose only. However, fund managers should take note that the AMAC is not able to distinguish “authentic” equity from “fake” equity. Therefore, when investing in ordinary residential projects in hotspot cities, it is not advisable to use the “equity plus debt” structure, because it is highly likely to be considered a breach of the No.4 guidelines and hence result in failure to pass the filing procure.
If the “equity plus debt” structure is used by PE funds for investment in commercial real estate projects, however, filing will be allowed, given that the underlying assets are not subject to the restrictions set out in the No.4 guidelines. For example, according to information on the AMAC website, a fund managed by Zhongcheng Yongkun Investment Centre (Limited Partnership) in Meishan Free Trade Port Area of Ningbo invests in Shanghai Ruiyu Industrial (as the SPV) by holding both equity and shareholder loan in the same, while the SPV acquires and holds Zhuzong Vanke Plaza (a commercial office building) located in Beijing through asset transaction. The fund was registered in April 2017.
In the Response to Questions Concerning Registration and Filing of Private Equity Funds (No. 13) issued by the AMAC on 31 March 2017, mandatory requirements are set out that highlight specialized operation of PE fund managers. The requirements only allow a manager to register one business category and merely file PE funds that are consistent with the registered business category. It raises concerns among managers of funds that are registered as equity investment funds, who are uncertain whether they will be allowed for debt investments. There is a rumour that a fund involving debt investment to any extent must be filed as “other investment funds”, and the manager of the fund must register itself as engaging in “other categories” of business.
According to the AMAC’s Explanations Concerning Business Category/Fund Category and Product Category of Private Equity Funds, “real estate funds” as a sub-category of “equity investment funds” include those that focus on mezzanine investment. It is generally understood that an investment in a project is deemed “mezzanine” if it combines both equity and debt investments, or if it is somewhere between pure equity investment and pure debt investment in nature.
Therefore, filing is allowed for equity investment funds investing in real estate projects (excluding ordinary residential projects in hotspot cities) by using the “equity plus debt” structure that is under management of equity fund managers. As for the percentages that equity and debt are allowed to account for in the portfolio, the 80% threshold used for categorizing funds stipulated by the Measures for the Administration of Operations of Public Securities Investment Funds, issued by the CSRC, must not directly apply to private non-securities investment funds. Nor has the AMAC set upper limits on percentages of equity and debt held by private non-securities investment funds. Moreover, there was a case where filing is allowed for an equity investment fund under management of an equity fund manager with debt investment accounting for over 80% of its portfolio.
According to the AMAC, regarding investment focus of CITIC Jinxiu Yongye Development – No. 1 Specialized Private Equity Fund, “manager of the PE fund will make equity or debt investment in Ningbo Jinxiu Capital Management with assets of the PE fund … with debt investment accounting for 0% to 86.67% of the fund’s total assets”. The manager of the fund is categorized as an equity and venture capital investment firm, and the fund is categorized as an equity investment fund. The fund was registered in May 2017.
In addition to the AMAC regulation, fund managers should pay attention to special requirements of banks and trusts in relation to the “equity plus debt” structure. When the PE fund is put in custody of a bank, direct lending from shareholders is generally not acceptable to the custodian, since private lending is likely to be rendered invalid. Nor is providing entrusted loans via banks feasible, given the impact of the Measures for the Administration of Entrusted Loans of Commercial Banks (Exposure Draft) and the rigorous controls imposed over the housing market that almost went wild.
If trust loan is adopted, according to the Guidelines on the Risk Management of Merger & Acquisition Loans of Commercial Banks, an M&A loan should account for not higher than 60% of the price of the M&A transaction, which means that the percentages of equity and debt and tax planning programme need to be adjusted accordingly.
Dai Tianxiao is a partner at Boss & Young