The Licensing of PE Fund Managers in HK

Introduction

On 7 January 2020, the Securities and Futures Commission (the SFC) issued a circular to private equity (PE) firms seeking to be licensed (the Circular), finally providing clarity to questions surrounding an issue that has been traditionally uncertain - whether PE fund managers require licensing under the SFC.

The Circular follows the February 2019 update of the SFC's Licensing Handbook which had stated that PE firms may be required to be licensed for one or more types of regulated activities depending on the type of business they conduct in Hong Kong¹. In response to the recent queries received by the SFC, it has now published the Circular to address various questions that have been traditionally "grey" areas. These include:

• licensing requirements of a general partner of a PE fund structured as a limited partnership (a General Partner);

• licensing requirements of investment committee member (the IC Members);

• requirement for Discretionary Investment Authority;

• investments in securities of private companies;

• offering of co-investment opportunities and fund marketing activities; and

• industry experience requirement for responsible officers (ROs).

Clarified "grey" areas

Licensing of General Partner

Traditionally, many PE funds have been structured as offshore limited partnerships in the Cayman Islands. Under the partnership vehicle, the General Partner of the partnership manages and controls the fund and often receives remuneration (whether through management fees, carried interest, or both). Under the Circular, the SFC has stated that the General Partner is generally required to be licensed for Type 9 regulated activity (RA9) if it conducts fund management business in Hong Kong, provided that the relevant fund management activities fall under the definition of "asset management" in the SFO, which includes "real estate investment scheme management" or "securities and futures contracts management"².

Individuals performing asset management activities for the General Partner in Hong Kong are also required to be licensed as representatives or Responsible Officers (as the case may be) accredited to the General Partner.

However, the General Partner does not need to be licensed in situations where it has delegated all of the asset management functions to another entity which is licensed or registered to carry on regulated activity (such as another entity with an RA9 licence). This means that where a General Partner has appointed an RA9 licensed investment manager to undertake all regulated activity in Hong Kong (and it does not, itself perform any of those activities in Hong Kong), it is not required to be licensed. In this case scenario, the General Partner should also refrain from representing to any prospective investors that it manages a PE fund in Hong Kong³.

Licensing of Investment Committee Member

It is common for PE Funds to form an investment committee to, among other things, vet investment and divestment decisions. Traditionally, IC members are appointed by the General Partner and the IC Members are affiliated persons of the General Partner, the investment manager and at times, significant limited partners. The SFC has now clarified that if the investment committee is established in Hong Kong by the SFC-licensed entity, then IC Members who play a dominant role in making investment decisions for the fund in Hong Kong are required to be licensed as representatives, and where appropriate, approved as ROs. These IC Members are differentiated from IC Members who are observers and/or who do not have voting right or veto power over investments. Such members are not required to be licensed. We note, however, that the SFC is silent as to whether IC Members on an investment committee that is not established by an SFC licensed entity are still required to be licensed, although in our view, the issue should be determined by whether, in substance, those members are in Hong Kong carrying on a regulated activity - in this case, making investment decisions or carrying out other activity that constitute "asset management" under the SFO. If they are, then it makes sense that they would need to be licensed by the SFC for RA9 asset management activity.

Importance of Discretionary Investment Authority

The SFC Circular has also provided clarification on the differentiation between RA9 asset management activity and advisory regulated activities, such as "advising on securities" or "advising on futures" (which would require a Type 4 "advising on securities" (RA4) licence).

The main difference is that RA9 licensed managers must be granted full discretionary investment authority in respect of the funds they manage⁴. In assessing whether the RA9 licensed manager has full discretionary investment authority, the SFC will assess on a case-by-case and factual basis, and assess factors such as: the proposed investment decision-making process, the role of the proposed licensed individuals and their involvement in the process, and whether the delegation of investment authority to the licensed manager is properly documented. As such, General Partners wishing to delegate all management function to an RA9 licensed manager should ensure that the investment management agreements are drafted appropriately so that they document the proper delegation of regulated activity to the investment manager and provide the investment manager with full discretionary investment authority, especially where the General Partner is not licensed. On the other hand, if it is contemplated that the delegatee will only be performing advisory functions in Hong Kong (but will not have the ability to exercise investment discretion or have investment decision making authority), then that delegatee should only need an RA4 licence (as opposed to a full RA9 licence).

Investment in Securities of Private Companies

As discussed earlier, the definition of "asset management" under the SFO includes "securities and futures contract management"⁵. The meaning of "securities" has been discussed in detail in our previous publication Oversight Article published on 9 May 2019⁶ (the May 2019 Publication) and, among other things, does not include the shares or debentures of a company that is a private company within the meaning of section 11 of the Companies Ordinance (Cap 622) (the CO), which include private Hong Kong companies, as discussed in detail in our May 2019 Publication.

Under the Circular, the SFC now provides further guidance on whether the assets managed by a PE firm are "securities" (which therefore determines whether the asset manager falls within the ambit of undertaking regulated activity in the management of such assets). The SFC will consider the composition of the entire investment portfolio of the fund when assessing whether the assets are considered "securities". If underlying investment held through special purpose vehicles (the SPVs) fall within the definition of "securities", or if the SPV itself fall within the definition of "securities", then the SFC will regard the management of the portfolio as "asset management" and would require the relevant asset manager to be licensed.

This clarification is significant for the following reasons:

First, as the prevailing market view has been that any fund that does not invest in or trade public securities is a PE fund that does not need an RA9 or RA4 licence, the Circular now makes it clear that this approach is demonstrably wrong. Any manager or General Partner managing a fund whose portfolio consists of shares in private companies incorporated outside of HK (for example, BVI, Cayman Islands, or WFOEs) may be regarded as undertaking "asset management" and therefore need a licence to conduct such regulated activity in Hong Kong.

Secondly, it is clear that the SFC will apply a "look through" approach, such that if a portfolio consists of assets that are clearly "securities or futures contracts", AND they are held under holding structures (ie SPVs) that may or may not be securities (for example, a Hong Kong private company acting as an SPV), that portfolio would still be considered one comprising "securities or futures contract", management of, or advising in relation to, which will be considered regulated activity. What is less clear is a situation where the SPVs themselves may be "securities" (for example, BVI or Cayman Islands companies), but where the ultimate underlying assets are not "securities". A typical example of this would be real estate funds, where the portfolio will ultimately consist of land or development projects, held under a number of Cayman Islands or BVI SPVs. In that case, would the relevant "portfolio" comprise "securities", or should the proper approach be to "look through" to the underlying assets (being real estate, which itself is not a "security"?). It is submitted, in such a case, that the proper approach should be to consider where the "management" of the portfolio is taking place - that is, whether management is at the level of the SPVs, or only at the level of the underlying assets. 

"Management", in this case, is not defined under the SFO, but a plain English reading of the term would include activities such as the exercise of "executive, administrative, or supervisory direction"⁷ or acts to "exert control over, regulate or limit towards a desired end"⁸. In other words, "management" of a portfolio requires the taking of positive / pro-active steps, as opposed to the mere passive holding of assets comprising that portfolio.

Continuing with the example of a real estate fund that uses SPVs to hold certain real estate assets or developments, the determinative factor would be whether there are any active or positive steps of "management" being undertaken and at which level. If the SPVs are mere passive holding structures, and the manager directly or indirectly deals with the underlying real estate assets (eg arranges for development, sub-division, sale, acquisition of such assets), then it would be difficult to see how it is "managing" a portfolio of "securities", since the real estate assets themselves are not "securities". Conversely, if the manager is actively mortgaging, charging, trading, or exercising voting rights attached to the shares of the SPVs themselves, then an argument could conceivably be made that it is "managing" a portfolio of private shares that amount to "securities" (assuming those are not private Hong Kong companies).

What is clear from the above analysis is that there is no "one size fits all" answer to the question of whether a PE fund manager needs to have a regulated activity licence in Hong Kong. The answer requires a "deep dive" into the ultimate underlying assets comprising the portfolio, whether there are any intermediate holding companies, and what kind of actual activity amounting to "management" is taking place, and at which level.

Offering Co-investment Opportunities and Fund Marketing Activities

Finally, the SFC has clarified its position in relation to the offering of co-investment opportunities and the licensing requirements related to such activity. Where a firm provide investment opportunities to investors to enter into securities transactions alongside the PE fund (eg, acquiring the shares of a private BVI company), such firm is generally required to be licensed for Type 1 regulated activity (RA1), provided that it is not otherwise exempted under existing exemptions (including incidental exemptions), since offering a co-investment opportunity will be regarded by the SFC as inducing another person to acquire, or enter into an agreement with a view to acquiring, a security. Where an exemption would arise would be a situation where, for example, the firm is already licensed for RA9 activity, and the offering of co-investment opportunities to investors forms an indispensable, or is an integral, part of the fund raising activity for the fund that the manager is also managing under its RA9 licence. In such case, the manager should be able to rely on the general exemption from obtaining an RA1 licence (since it is clear that fund managers are able to carry out RA1 activities as an incident of managing a fund under their RA9 licence). 

In similar fashion, the SFC has confirmed that fund marketing activities would also generally constitute "dealing in securities" as defined in the SFO, since the marketing activities also induces other persons to enter into security transactions (being inducement of a person to enter into an agreement with a view to the acquisition or disposal or securities -- being interests in collective investment schemes). Accordingly, marketing a PE fund in Hong Kong will require an RA1 licence, unless the marketing is being carried out by the party that is also managing the fund under its RA9 licence.

RO Industry experience requirements

Lastly, the SFC has discussed the industry experience requirement for RO applicants and has stated that it will adopt a pragmatic approach to recognise a broad range of experience so long as the applicant can demonstrate that it is relevant to his/her duties as a responsible officer. Among other things, the SFC will consider experience in:

• conducting research, valuation and due diligence of companies in related industries;

• providing management consulting and business strategy advice to companies in related industries;

• managing and monitoring a PE fund's underlying investment for the best interests of fund investors; and

• structuring corporate transactions, such as management buyouts and privatisations.

The SFC will also consider non-regulated private equity experience, including experience in overseas jurisdictions that does not require licensing, as well as relevant private equity experience in Hong Kong that is exempted from a licensing requirement.

To conclude

In light of the new guidance issued by the SFC, PE fund managers and other parties mentioned in the Circular (including any General Party entities, and IC Members) should reassess whether licensing is required for the activity they plan to undertake, or are undertaking. In particular, PE fund managers who have been relying on general market practice should reassess the nature of their investments (whether these amount to "securities" as described above), whether they are offering any co-investment opportunities, and whether any work undertaken amounts to "fund marketing activities". General Partners who have delegated all regulated activity to licensed entities are encouraged to revisit the agreements providing for such delegation and ensure that all of the requirements are met.

This Circular was issued only one day after the SFC's publication of the findings of the Eastern Magistrates' Court convicting an unlicensed individual for holding himself out as carrying on a business in asset management without a licence⁹. Together, these two publications show that the SFC will scrutinise the licensing requirements of PE fund managers much more closely and clearly demonstrate a far greater willingness on the SFC's part to extend its governance and oversight into a space that it has traditionally always left unregulated. This is a clear “shot across the bow” for industry players from the regulator, and they would be well advised to pay heed going forward.

¹ Paragraphs 1.4.18 and 1.4.19 of the Licensing Handbook
² Paragraph 1.4.24 of the Licensing Handbook.
³ Section 114 of the SFO prohibits any unlicensed person from holding himself out as carrying on a business in a regulated activity. See also SFC Enforcement News published on 6 January 2020 where the SFC convicts an unlicensed fund manager who represented to investors that he was the manager of a fund.
⁴ Paragraph 1.3.24 of the Licensing Handbook.
⁵ Part 2, Schedule 5 of the SFO.
⁶ Our Oversight Article dated 9 May 2019 is available here
⁷ "Manage." Merriam-Webster.com. 2020. (17 March 2020)
⁸ "Manage" The American Heritage Dictionary of the English Language, Fifth Edition. 2020. (17 March 2020).
⁹ SFC Enforcement News published on 6 January 2020 where the SFC convicts an unlicensed fund manager who represented to investors that he was the manager of a fund.