Protecting investors in limited partnership PE funds

By Lai Jihong and Yan Juntao, Zhong Lun Law Firm
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A private equity (PE) fund organized as a limited partnership operates as follows: The investor and the general partner jointly set up a partnership. The investor as the limited partner contributes capital, while the general partner as the manager of the PE fund manages the partner’s external investments. For fundraising, the fundraiser will provide credit enhancement/guarantee arrangements by itself or through related parties to attract capital contribution from the investor, so as to assure the investor a minimum income upon expiration of the term of investment.

Disputes will arise if the partnership fails to refund the principal of investment, or pay the earnings to the investor. For disputes over the investor’s recovery of investment, the adjudicative body will award various judgments considering such factors as product structure and contract performance.

partnership
Lai Jihong
Managing Partner
Zhong Lun Law Firm

First, what is the underlying legal relationship for the investor’s recovery of investment? The underlying legal relationship in a PE fund organized as a limited partnership should be determined as a partner-to-partner relationship intended for investment purposes. The investor, as the limited partner, and the general partner jointly establish a partnership to invest externally, which constitutes a partner-to-partner relationship. Meanwhile, the investor, as limited partner, is in a legal partner-to-partner relationship with the partnership.

However, the specific risk-taking and operation/management arrangements under the fund agreement may lead the adjudicatory body to determine the legal relationship as a private lender-borrower relationship. Examples of such arrangements include the following: The agreement stipulates that the investor is entitled to fixed income without participating in the operation/management activities of the partnership; the investor pays the investment money to the general partner other than the partnership; several guarantee measures provided by the general partner and a third party shield the investor from investment risks in reality.

partnership
Yan Juntao
Partner
Zhong Lun Law Firm

Second, if the relationship is determined as a legal partner-to-partner one, will the adjudicatory body affirm the investor’s claim for investment recovery and payment of earnings, as well as the guarantor’s liability for credit enhancement/guarantee?

Generally, as the partnership agreement does not guarantee the investment principal or minimum return, the investor’s failure to recover the investment and receive earnings should be deemed an investment risk, and the investor should assume the loss itself.

However, the investor can still be compensated by investigating the general partner’s liability for breach of contract. If the general partner is the executive partner or fund manager, when failing to perform the partnership agreement and/or fulfil the obligations imposed by the regulator, which leads to the result that the contractual purposes set out in the agreement cannot be achieved, the adjudicatory body may affirm the investor’s claim for rescinding the partnership agreement and the general partner’s liability for breach of contract, enabling the investor to recover its investment indirectly.

In practice, the following circumstances may affect the adjudicatory body’s affirming the investor’s claim for the general partner’s liability for breach of contract: Whether the investor has been registered with the industrial and commercial administration as a limited partner in a partnership; whether the general partner has completed the registration and filing procedures with the Asset Management Association of China (AMAC); and whether the partnership invests in any particular project.

Additionally, credit enhancement and guarantee arrangements often exist in the legal relationship regarding partnership investment. Such arrangements include the commitment to guaranteed principal and earnings, pre-arranged transfer/buyback of partnership share, deficiency payment commitment, and liability of guarantee.

The commitment to guaranteed principal and earnings refers to the partnership agreement that all profits or losses shall be distributed to, or borne by, selected partners. Pursuant to the “principle of shared risk”, established by article 33 of the Partnership Law, the adjudicatory body may consider it invalid for “violating mandatory requirements set out by laws or administrative regulations”.

In the legislative hierarchy, however, the Interim Measures for the Supervision and Administration of Private Equity Funds is just a ministerial rule, so the violation of its article 15 does not constitute a violation of the mandatory requirements set out by laws or administrative regulations, and thus does not certainly render the commitment to guaranteed principal and earnings invalid.

As for pre-arranged transfer/buyback of partnership share, if the general partner or a third party enters into a pre-arranged transfer/buyback agreement with the investor, the general partner or the third party shall accept the transfer of the investor’s share in the partnership, as long as the investor fails to recover the investment principal or receive agreed earnings. In judicial practice, the agreement on acquisition of the partnership share at a premium is a partial sharing of the investor’s risk, and should be considered valid. As for the acceptance of pre-arranged transfer provided by the third party, it is generally considered valid, as the third party is not a party to the partnership.

Deficiency payment commitment refers to an agreement between the investor and the general partner/third party, or the commitment letter issued by a single party, under which the investor is entitled to require the general partner or the third party to compensate the deficiency regarding the investor’s loss when the investment term expires. In judicial practice, the general partner’s deficiency payment may be held invalid pursuant to the “principle of shared risk”, but the deficiency payment by the third party will be immune from the principle of shared risk.

The liability of guarantee refers to the guarantee provided by the general partner or the third party for the investor’s investment. The general partner’s guarantee may be held invalid for violating the shared risk principle, but the third party’s guarantee will not be invalidated.

Besides, if the legal relationship is determined as a private lender-borrower relationship, the lender is entitled to claim principal repayment and interest payment from the borrower, and to claim the guarantor’s liability for credit enhancement/guarantee.

So, it can be seen that the adjudicatory body, in trying a case, will determine the legal relationship based on numerous factors. Relatively, the pre-arranged transfer and deficiency payment commitment provided by a third party can skirt the fund regulation and the restrictions imposed by the Partnership Law, and thus are likely to be held valid.

Lai Jihong is the managing partner and Yan Juntao is a partner at Zhong Lun Law Firm in Shenzhen. Xue Bingran, an associate at the firm, also contributed to this article

private funds

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