China’s private equity industry is expanding at an unprecedented pace and has now become the world’s second largest and Asia’s largest private equity market in terms of fundraising amount. As of 2016, China has raised USD 75.9 billion in private equity funding. In 2016, 2,438 new private equity funds were established in China. Fundraising amounts reached a record high of RMB 1,370 billion (USD 198.4 billion), nearly tenfold compared to 2006. 
However, due to the lack of a clear regulatory framework governing the private equity sector prior to 2014, numerous concerns have surfaced in this rapidly developing market. In particular, many private equity fund managers have been involved in illegal fundraising activities that caused investors to suffer huge losses. One typical example is where fund managers mislead retail investors to make private equity investments by publishing false information, fabricating non-existent projects and guaranteeing returns that do not materialize. There have also been cases involving misappropriation of funds. 

My forthcoming article in the Berkeley Business Law Journal finds that unlike the US and the EU markets where typical concerns about private equity are excessive leverage, systemic risk and short-termism, the recent market concerns in China have centered around illicit fundraising activities and misappropriation of funds. The evidence of market failure in China challenges conventional views that private equity is a highly competitive market involving sophisticated investors and hence the relationship between managers (general partners- GPs) and investors (limited partners - LPs) requires no regulatory attention. 

Although Chinese regulators are strengthening the regulation of the private equity sector to address managerial abuse, most measures are piecemeal and in the form of temporary provisions. On top of the deficiencies of the current regulatory response, the situation is worsened by the lack of fiduciary duties in Chinese partnership law. Unlike its common law counterparts, Chinese partnership law does not have any equivalent concept of fiduciary duty which can be imposed on partners. Meanwhile, the Partnership Enterprise Law of the People’s Republic of China (PEL) fails to clearly and adequately stipulate the partners’ statutory duties. As a result, GPs’ duties are largely left for partners to specify in the partnership agreement. 

In the article, I use a hand-collected dataset of private equity limited partnership agreements (LPAs) to examine how GPs’ duties are contracted in China. I also supplement the agreements with interviews with numerous industry participants – managers of private equity firms (fund managers), legal counsels of private equity firms, individual investors, representatives of institutional investors, entrepreneurs and lawyers. I find that most of the Chinese LPAs are insufficient in constraining GPs’ conduct. There are legal, institutional and social barriers that hinder LPs from contractually imposing comprehensive duties on GPs in China. I argue that common contractual designs have severe shortcomings and do not function effectively in anticipating and mitigating managerial abuse of GPs in the context of China. This special feature of Chinese private equity market challenges the view that qualified investors are always able to write optimal contracts to protect themselves. 

The article argues that changes in the law are required. Addressing the relationship between fund managers (GPs) and investors (LPs) would be a more effective and less expensive way to achieve regulatory aims. I suggest that the regulatory focus should be on the fund manager. Private equity fund managers play an essential role in the private equity cycle. The proposed specific statutory duties would enhance investor protection in the ever-changing industry.

The article further contributes to the literature on the private equity industry, and on duties of partners by analyzing the duties of GPs in Chinese private equity limited partnerships. It will be helpful in other civil law jurisdictions where there is also no equivalent concept of fiduciary duties on partners. My findings have policy implications for future law reforms in civil law jurisdictions that are considering whether they should impose fiduciary duties on partners to regulate the relationship between a GP and LPs. It would also be helpful to other jurisdictions that are reviewing their regulatory framework to facilitate private equity developments.

Dr. Lin Lin is Assistant Professor at the Faculty of Law, National University of Singapore.