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.

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