This article discusses the latest guidance in the SFC's Licensing Handbook and its impact on licensing for private equity fund managers.
Under the Securities and Futures Ordinance (SFO), persons who engage in regulated activities in Hong Kong must be licensed or registered with the SFC. A corporation that carries on a business in a regulated activity or actively markets services to the public which constitute a regulated activity need to be licensed, while individuals performing a regulated function for a licensed corporation must be accredited as a licensed representative and, if the said individual is also an executive director, approved as a responsible officer. Authorised financial institutions that are supervised by the Hong Kong Monetary Authority, such as banks or deposit-taking companies, must also be registered with the SFC to carry on a business involving regulated activities.
Schedule 5 of the SFO sets out ten categories of regulated activities. These are:
- Type 1 Dealing in securities
- Type 2 Dealing in futures contracts
- Type 3 Leveraged foreign exchange trading
- Type 4 Advising on securities
- Type 5 Advising on futures contracts
- Type 6 Advising on corporate finance
- Type 7 Providing automated trading services
- Type 8 Securities margin financing
- Type 9 Asset management
- Type 10 Providing credit rating services
Notwithstanding the wide scope of regulated activities, the licensing position for PE fund managers has traditionally been uncertain. PE funds generally invest directly in assets or indirectly through holding companies, or make direct investments into the private equity of companies through different investment strategies such as venture or growth capital. Managing or advising such funds could arguably fall within the ambit of Type 4 (advising on securities) and Type 9 (asset management) regulated activities if the “portfolio” (owned by the Fund) which a manager/advisor is managing, or advising, is comprised of “securities”.
Clearly, a PE fund which invests directly in assets that do not fall within the definition of “securities” under the SFO (for example, directly in real estate without the use of any special purpose vehicles) would not require its manager/advisor to obtain a Type 9 or Type 4 licence in order to manage or advise it.
The position is less certain, however, when it comes to PE funds that own a portfolio of private company shares (by extension, a PE fund that invests in real estate through a holding of private company shares may also run into issues).
Definition of ‘securities’ under the SFO
Schedule 1 of the SFO provides a wide definition of ‘securities’ which includes, inter alia, shares and debentures issued by any incorporated or unincorporated body. The definition does not, however, include the shares or debentures of private companies within the meaning of section 11 of the Companies Ordinance (Cap. 622). Technically speaking, therefore, only shares in private Hong Kong companies would not be considered “securities” for the purposes of the SFO. This means that if applied strictly, any PE fund that invests in private companies, or through SPVs, that are incorporated in, say, the BVI, Cayman Islands, etc, or that are WFOEs, would technically be investing in a portfolio of securities. Any fund manager that advises or manages that fund in Hong Kong would therefore be carrying out regulated activity for which a Type 4 and/ or Type 9 licence is needed.
Technicality aside, however, the practical reality in Hong Kong, and the prevailing market view, is that any fund that does not invest in or trade public securities is a PE fund that does not need a Type 9 or Type 4 licence to be managed/advised. For the most part, at least up until recently, the SFC’s position also appeared to be that it would not look too closely at the issue – for example, in one of the SFC’s earlier FAQ on Venture Capital Companies (http://www.sfc.hk/web/doc/EN/faqs/licensing/faq-lic-15.pdf) , the SFC’s stated that dealing in or advising on “private equity” (which does not involve securities) would not, by itself, attract a licensing requirement. However, the SFC left “private equity” deliberately vague as a concept.
The New Position
Pursuant to the guidance under paragraphs 1.4.18 and 1.4.19 in the latest edition of the SFC’s Licensing Handbook, however, the SFC has now confirmed that if a firm deals in, advises on or manages shares or debentures of private offshore companies that fall outside the definition of “private company” under the Companies Ordinance, it is likely that such firm will require a licence for any regulated activities conducted in Hong Kong. (Click on the following link to the SFC’s latest FAQ: https://www.sfc.hk/web/EN/regulatory-functions/intermediaries/licensing/do-you-need-a-licence-or-registration.html#4).
The Licensing Handbook provides further guidance on the type of license that may be relevant based on the PE firm’s business model:
- Firms that are delegated with discretionary power to make investment decisions on securities in Hong Kong for a fund would be required to obtain a license for Type 9 (asset management) activities; and
- Firms that are not granted discretionary investment authority by the fund it serves would need to be licensed for Type 1 (dealing in securities) regulated activity if it markets or distributes a fund or conducts any other securities dealing activities (such as deal negotiation and trade execution) for the fund, or, unless the wholly-owned group company exemption is available, Type 4 (advising on securities) regulated activity if it provides investment advice to the fund.
PE firms may also continue to rely on any applicable incidental exemptions, whereby certain regulated activities will not require a licence to be granted by the SFC if such activities are performed wholly incidental to the carrying out of another regulated activity that the firm is already licensed for. The most relevant incidental exemption for PE managers is where the manager is licensed for type 9 (asset management) regulated activities, it will not require an additional licence to carry out any Type 1 (dealing in securities) or Type 4 (advising on securities) regulated activities provided that these are carried out solely for the purposes of its asset management business.
The latest guidance issued by the SFC represents a significant pivot by the regulator, and signals, in our view, a more rigorous focus on the actual activity that is carried out by PE fund managers in Hong Kong. Gone are the days where a manager in HK can assume that simply because the fund it is managing is a PE fund, that it will not need any sort of regulatory licence. Instead, managers should now carry out a careful analysis of the actual composition of the fund’s portfolio to determine if there are any “securities” within that portfolio.
For many PE funds, the formal investment decision is usually made offshore either by the general partner of the fund (assuming it is structured as a Cayman Islands limited partnership), the Cayman manager (a separate Cayman Islands corporate entity that is usually owned by the fund’s sponsors), or an investment committee established by the Cayman manager. In turn, these entities rely on the research, due diligence and contract negotiations conducted by local onshore staff on behalf of the fund in Hong Kong. While this arrangement should remain unaffected (in terms of whether the domestic entity in Hong Kong would require a Type 9 licence), managers should be careful to ensure that investment decisions and discretion are, as a matter of fact, exercised offshore from Hong Kong, and that there is no management activity taking place in Hong Kong. It is likely that the SFC will examine such arrangements more closely going forward.
For many PE fund managers, the decision whether to get licensed in Hong Kong comes down to their appetite for reputational risk. Increasingly, larger fund houses will seek to get licensed for PE funds in any event, because the reputational risks are too high. With the pivot by the regulators in Hong Kong, it is submitted that this risk has just become even higher across the board for PE fund managers of all sizes.
Regulatory/reputational risks aside, managers should also consider the other costs and benefits of getting licensed. Obviously, having a licence entails the regulatory burden of ongoing compliance (which has become even heavier following the introduction of the revised Fund Managers’ Code of Conduct – which applies to PE funds as well as hedge funds). Applying for a licence is also costly and time consuming (expect up to 6 months now before a licence will be issued).
There are, however, many benefits that come with being licensed. For one, having a Type 9 licence means that the manager can also market the fund in Hong Kong (since a Type 9 licence holder can exercise Type 1 functions as an incidental activity to the management function it is exercising in respect of the fund). This would mean the fund can avoid having to appoint a separate placement agent, and hence save on placement/distribution fees. Being regulated by the SFC may also aid with capital raising since the SFC is a well-regarded regulatory authority in the region.
Finally, our understanding is that Hong Kong will, by the end of 2019, introduce its own limited partnership regime that will be modelled on the Cayman Islands GP-LP structure. Together with the recent introduction of Hong Kong’s unified tax regime (which makes Hong Kong fund structures tax-neutral if they meet certain requirements), this provides an attractive structuring alternative for fund raising in the PE space. One of the requirements for using this structure, however, will be that the manager in Hong Kong is licensed for carrying out regulated activity (which most likely will be for Type 9 (asset management) activities).
In our view, all these factors combine to make obtaining an SFC licence for PE fund management a compelling argument.
This document (and any information accessed through links in this document) is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from any action as a result of the contents of this document.