Investor protection in funds with project-based return distribution model

In recent years, private equity investment has witnessed impressive growth in China. The means of distributing private fund returns commonly seen in current private equity fund operational practice are distribution based on the overall returns of the fund and distribution based on the returns on a project-by-project basis (By Project Fund). Generally speaking, more private funds whose investment scale is relatively small, whose risk appetite is relatively high and whose invested projects are relatively numerous will opt for distribution of overall returns, whereas those that have a relatively large investment scale and a smaller number of invested projects will lean towards the distribution of benefits on a project-by-project basis.

As the returns from each project in a By Project Fund product will vary, the fund manager can reap an excessively high performance fee that is incompatible with the overall returns of the fund due to a drop in the returns from or a loss in other projects in the fund, even resulting in the investors losing principal. Accordingly, there is a greater requirement for comprehensive and sound protection of the rights and interests of the investors in such a fund product.

With a view to duly protecting investors’ principal and returns, a By Project Fund contract will usually provide for a mechanism for adjusting the fund manager’s performance fee in the returns distribution clause. The following are the commonly seen clauses:

Retained deposit clause. The retained deposit system is one wherein, in order to prevent the investors incurring a loss due to a loss arising in other projects invested in by the fund after the fund manager has distributed the project returns, the fund manager retains a portion of the performance fee payable to it in the fund as a deposit, and in the event that a loss arises in another project, the deposit is used to cover the loss incurred by the investors.

Generally speaking, the percentage of the retained deposit may be provided for by the fund manager and the investors in the fund contract or the limited partnership agreement. Usually, based on typical practice in the industry, the amount of the retained deposit is, in most cases, approximately 50 percent of the performance fee payable for the project in question.

Performance fee recovery clause (i.e. a clawback clause). Based on the performance fee recovery system, in the event that the performance fee to be received by the fund manager exceeds the specified amount or percentage, or in the event that the fund manager is unable to refund the investors’ investment principal (in some clauses, the investment principal and specified priority returns), the fund manager is required to refund part of the performance fee to the investors.

The recovery system is usually triggered when subsequent projects in the fund show a loss or the returns show a marked decrease after the investors have already received the performance fee. Common forms include the following: (1) once the entire project is divested from, the fund manager refunds to the investors its returns that exceed the prescribed distribution percentage; (2) when distribution for each of the projects is carried out, the fund manager refunds part of the performance fee that it has already received, to serve as makeup when other projects produce a loss; (3) the parties specify that once the allocation of such expenses as the fund management fees, investment costs, makeup of loss making projects, etc. from the project returns is completed, the fund manager and the investors carry out the distribution of returns in the specified percentages.

The performance fee recovery clause may be triggered when operation of the fund terminates or at a time during the operation of the fund. With a view to ensuring the solvency of the fund manager, the investors may require the fund manager to provide security or open a returns deposit account so as to ensure that distributed returns are not diverted by the fund manager and that rights are realized without hindrance.

Priority refund of principal. Priority refund of principal means that it is specified in the fund contract or limited partnership agreement that the fund manager may receive the performance fee in respect of genuine returns beyond the investment principal only once all of the investment principal of the fund has been fully recovered. This model places greater weight on the interests of the investors, making it difficult for the fund manager to obtain a performance fee during the early or middle period of the operation of the fund. It must wait until late in the operation of the fund before it can receive the performance fee based on the genuine returns of the fund.

The priority refund of principal method, in essence, approaches the method of distribution based on the overall returns of a fund. Although this model markedly extends the period for the fund manager to receive returns, because it offers greater protection to investors, it is favoured by many of them and is applied in the contracts for many fund products.

In summary, the nature of private equity investment determines that not all projects invested in by a fund will be profitable. If, in a situation where the future returns from an invested project are impossible to predict, distribution is first effected in respect of existing returns and later the project produces a loss or the rate of return decreases, the result could be a loss in the investors’ investment principal or an excessively large difference in the percentage of the returns going to the fund manager and the investors.

The clauses described above can protect the interests of investors and reduce investors’ losses to a relatively large extent, and when there is a relatively large difference in the returns generated by the projects in one fund, giving priority to ensuring that investors recover their original capital investment and any specified priority returns, thereby avoiding a situation where the fund manager receives a performance fee that far exceeds the overall returns of the fund, better protects the lawful rights and interests of the investors.

Jiang Fengtao is the founding partner and Yuan Shuyang is a capital market associate at Hengdu Law Firm