Impact of new rules on PE VAM

With the issuance of the Guiding Opinions on Regulating the Asset Management Business of Financial Institutions (the New Rules) in April 2018, the asset management industry formally welcomed the era of “grand unified” regulation. The provisions of the New Rules on breaking “rigid payment” became the focus of attention from the end of 2017, when the central bank sought public comment. In response to a reporter’s question, a relevant senior official of the central bank stressed that when a financial institution “accepts an appointment to manage wealth on a client’s behalf”, it is additionally required to genuinely realize “seller is to duly fulfill its responsibilities and buyer is to himself bear the liability”, returning asset management business to its original principles. Though the New Rules do not directly address private equity investment funds, nevertheless, against the backdrop of “grand unified” regulation, private equity funds will necessarily feel the effects of the New Rules.

EFFECT ON VAM

Generally speaking, valuation adjustment mechanisms (VAMs) are divided into three types: equity buyback, performance compensation and valuation adjustment, with equity buyback being the most common and the most core type.

Buyback clause at the time of offering of a private equity fund. In one arbitration case in which the authors were involved, the private fund manager had committed to pay the principal and returns to the investors by way of a buyback. Additionally, the private fund had not registered the investors as limited partners and the investors did not bear the investment risks. The award of the arbitration tribunal found that the relationship between the investors and the private fund was a loan relationship.

In terms of the offering of private equity funds, the New Rules expressly restrict or prohibit financial institutions from making such arrangements as dividing product units into classes, nesting asset management products, “rigid payment”, etc. Though the New Rules do not directly address private equity investment funds, what private equity fund offering related buyback clauses embody is clearly a type of commitment to bear the risks on the behalf of the investors, which rubs up against the redline prohibiting “rigid payment”. Although, from the perspective of civil liability, private fund managers are not required to bear any punitive liability as a result, with the issuance of subsequent detailed rules or complementary rules specifically for private funds, they will necessarily be faced with more stringent regulation.

Harry Wu is a partner at Wintell & Co. He can be contacted on +86 21 6854 4599 or by email at harry.wu@wintell.cn

Ashley Lei is an associate at Wintell & Co. She can be contacted on +86 21 6854 4599 or by email at ashley.lei@wintell.cn