Hong Kong is consistently ranked among the world’s leaders in terms of asset management, stock market capitalization, initial public offering fundraising and banking. As at the end of 2018, the total capital under management by approximately 520 private equity and venture capital (PE&VC) firms operating in Hong Kong reached roughly HK$1.21 trillion (US$154 billion)1.
Exciting Opportunities Lie Ahead for PE&VC Firms
- The Landmark Limited Partnership Regime for Private Funds (LPF Regime): On July 31, 2019, the Hong Kong government issued a consultation on its proposal to establish a limited partnership regime for funds. With the Cayman Islands and many other traditional fund domiciles implementing onerous new requirements in connection with economic substance, licensing, anti-money-laundering and a range of information requirements, this new regime is expected to create a thriving domestic industry for the development of PE&VC funds and a broad range of other private funds in Hong Kong spanning the real estate, infrastructure, credit and hedge fund market segments. The government has indicated that it targets introduction of the bill into the Legislative Council for a first and second reading in the first half of the 2019-20 legislative session.
Sidley has acted as the sole legal adviser in relation to the development of the new limited partnership regime for private funds and its related licensing considerations.
- Hong Kong Unified Tax Regime: Effective April 1, 2019, the Hong Kong profits tax exemption for offshore funds was extended to onshore funds, and flexibility was provided for funds to invest in Hong Kong private companies.
- The Greater Bay Area Potential: The development of the Guangdong-Hong Kong-Macao Greater Bay Area has created a plethora of investment opportunities for PE&VC funds, ranging from high-tech to healthcare startups.
- International Tax Developments: Evolving international tax law and practice, especially in connection with forthcoming base erosion and profit shifting (BEPS) 2.0 package from the Organization for Economic Cooperation and Development (OECD), is likely to see Cayman Islands and other offshore fund structures, and their related tax arrangements, challenged where the fund structure does not align form and substance. This development will require all fund managers based in Hong Kong to evaluate and consider the use of domestic Hong Kong fund structures.
Section 114(1) of the Securities and Futures Ordinance (SFO) effectively provides that a person may not carry on a business in a “regulated activity,” or hold him- or herself out as carrying on a business in a regulated activity, unless that person is licensed by the Securities and Futures Commission (SFC) to undertake such a regulated activity. The trading of financial instruments that are not “securities” or “futures contracts,” or are otherwise covered or authorized by the SFO, will not trigger licensing requirements in Hong Kong.
There is a carve-out under the SFO to the effect that shares and debentures of a private company within the meaning of section 11 of the Companies Ordinance (Cap 622) do not fall within the ambit of the definition of “securities.” The SFC released a new edition of the Licensing Handbook on February 1, 2019, and clarified that only the shares and debentures of Hong Kong incorporated private companies are excluded from the definition of “securities.” Firms that deal in, advise on or manage a portfolio of the shares or debentures of offshore private companies will remain subject to licensing requirements.
For PE&VC firms, the most relevant types of regulated activities are typically Type 1 (Dealing in Securities), Type 4 (Advising on Securities) and Type 9 (Asset Management). There is an incidental exemption available to the effect that Type 9 fund managers are not required to be Type 1 or Type 4 licensed if the Type 1 or Type 4 activities are carried on solely for the primary purpose of the primary asset management business.
The summary below sets forth a general overview of the key advantages and limitations applicable to PE&VC funds in relation to each of the following licensing options. PE&VC firms may also consider a mix of different options:
- Remain Unlicensed: The obvious advantage of remaining unlicensed is the low regulatory/compliance cost the firm needs to bear, as it will not be directly supervised by the SFC. However, unlicensed fund managers in Hong Kong can invest only in products that are not securities or futures contracts as defined under the SFO. In the context of PE&VC firms that manage fund arrangements in Hong Kong, this effectively means investment must be limited to the shares and debentures of Hong Kong private companies or a relatively limited range of other instruments or assets that are not relevant “securities.” In addition, unlicensed firms can distribute funds in Hong Kong only in reliance on the private placement regime, through other licensed fund distributors or in accordance with limited permitted exemptions from licensing. Due to the manager’s unlicensed status, institutional investors may be reluctant to invest in the funds under management. Some service providers, including brokers, custodians and fund administrators, may not provide services to unregulated intermediaries as a matter of policy. Further, there are likely to be significant commercial, legal and taxation advantages that will apply to licensed firms that wish to access the new LPF Regime.
Type 1 (Dealing in Securities): A Type 1 license will permit firms to market their own funds in Hong Kong. They may also act as distributors to funds managed by other fund managers in exchange for marketing and distribution fees. A Type 1 licensed firm will remain subject to SFC supervision, and related compliance costs will continue to apply. Maintenance costs are the highest among the available licensing options as the firm will need to maintain a minimum liquid capital of HK$3 million (US$383,000), together with an additional regulatory “buffer,” and a minimum paid-up share capital of HK$5 million (US$638,000).
- Type 4 (Advising on Securities): The Type 4 license authorizes firms to provide securities advice to their clients. Firms that are licensed in this category may provide investment advice to portfolio companies and other third parties in relation to all types of securities, including the shares and debentures of offshore private companies. Regulated firms are required to maintain a minimum liquid capital of HK$100,000 (US$12,800), together with an additional regulatory “buffer.” In general, a statutory minimum paid-up share capital requirement will not apply.
- Type 9 (Asset Management): Type 9 licensed corporations can manage a portfolio of securities and futures contracts in Hong Kong on a discretionary basis. They may also carry on Type 1 and Type 4 regulated activities pursuant to an incidental exemption from licensing without needing to be additionally licensed in these categories. The incidental exemption allows Type 9 licensees to perform trade execution, fund marketing and securities advisory activities for the funds they manage in Hong Kong but not for other third‑party managed portfolios. Type 9 licensees must at all times maintain a minimum liquid capital of HK$100,000 (US$12,800), together with an additional regulatory “buffer.” There is no minimum paid-up share capital requirement.
PE&VC firms that wish to capture these developing market opportunities should understand the licensing regime that will apply to private fund managers in Hong Kong following the introduction of the new LPF Regime in 2020. If you would like to understand these requirements or discuss your plans, please contact us.
Sidley Austin LLP provides this information as a service to clients and other friends for educational purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client relationship. Readers should not act upon this information without seeking advice from professional advisers.
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