Hong Kong: Venture Capital Sector

Hong Kong is the largest venture capital centre in Asia, having the second largest concentration of venture capital professionals in the region and managing about one-fifth of the total capital pool in the region (at the time of writing).

The Hong Kong Private Equity and Venture Capital Association is a long-standing Hong Kong Association representing Hong Kong private equity or venture capital managers. The firms represented by the HKVCPEA are responsible for managing funds totaling approximately USD60bn and directly employ around 750 professionals in Hong Kong.

Total funds under management by Hong Kong venture capital firms grew to USD30bn by early 2005, outstripping Japan and Singapore, although only a small proportion of this money is actually invested inside the SAR, which acts as a regional entrepot rather than as a destination for investment.

Total capital under management (CUM) in private equity in Asia has been rising steadily, with data provided by the Asian Venture Capital Journal showing that the total CUM in private equity reached USD290bn in 2010, representing an increase of 14.6% over 2009, and that total CUM in just the first half of this year had reached over USD310bn.

Within that market, in terms of total CUM in 2010, Hong Kong was ranked second, accounting for 21.6% of the Asian total, only slightly behind mainland China's 22.6% and ahead of Japan's 14.2%. Therefore, China and Hong Kong together manage nearly half of the total private equity in Asia.

Furthermore, of the USD33bn raised in Asia in 2010, Hong Kong accounted for 15.2%, ranking second in Asia, behind China (43.9%) and ahead of South Korea (11.8%). As at end of June 2011, 259 out of Hong Kong's 375 private equity firms had chosen Hong Kong for their Asia regional headquarters.

Implementation of the Mandatory Provident Fund (MPF) scheme (which began collecting contributions in December 2000) provides ample supply of funds to the industry. The MPF scheme will inject an estimated HKD30bn a year of retirement funds for the next 30 until the system matures. Insurance companies and pension funds, which will play a vital role in directing MPF funds to various investment opportunities, represent a significant source of funds for Hong Kong's venture capital industry.

EU AIFM

In June 2010, the Hong Kong Private Equity and Venture Capital Association (HKVCA) wrote to the Hong Kong government asking that it protect Hong Kong's with the respect to the EU Alternative Investment Fund Managers Directive, particualry with regards the need for non-EU investment firms to obtain a 'passport' before being allowed to offer investment services to EU residents.

"The EU’s stance towards regulating Alternative Investment Managers has created significant concerns in third countries regarding protectionism and unilaterally restricting market access to European capital. In our view, improving regulatory oversight is essential for the industry and this is best carried out by local regulators working within consistent but individual standards," the letter stated.

"We would like to ask the Hong Kong government to represent to the relevant parties in Europe that the European Community is best served by allowing its investors to commit capital to regulated funds in other parts of the world. Hong Kong’s regulator is best placed to determine the appropriate regulation of private equity investors based in Hong Kong and European regulators should work with the SFC to establish conditions under which Hong Kong based firms can continue to have access to European capital," the letter concluded.

Under the directive, as agreed by the European Parliament and the European Council in October 2010, a European AIFM with a portfolio of more than EUR100m (USD140m) will be required to obtain an authorization from national authorities to operate. This permit will entitle them to market funds throughout the EU single market.

The most controversial proposal in the directive has been that AIFMs from 'third countries' would be able to obtain that EU permit, or ‘passport’, to sell their funds within the EU without first having to seek permission from each member state and comply with different national laws. However, AIFMs will obtain passports only if the non-EU country they are located in meets minimum regulatory standards and has agreements in place with member states to allow information sharing.

There are also rules in the final text to deal with asset stripping, and the agreement includes a number of provisions to this end, relating primarily to limits on the distribution of capital within the first years that a company is taken over by a private equity investor. This, it was said, is intended to deter private equity investors from attempting to take control of a company solely in order to make a quick profit.

Tax Treatment

Hong Kong is largely an administrative hub serving the region. Over 90% of the venture funds are sourced from overseas and then disbursed to overseas companies, based on beneficial tax treatment. However, this favourable situation seemed to come under threat in 2003 when the government planned to tighten the rules governing 'offshore' funds based in Hong Kong.

The Financial Secretary's Budget Speech on March 5, 2003 proposed to amend the IRO to exempt offshore funds from profits tax to bring Hong Kong in line with other major financial markets such as New York and London. The detailed rules as set out in a consultation paper seemed to be more threatening than helpful, but after much to-ing and fro-ing, in June, 2005, the Revenue (Profits Tax Exemption for Offshore Funds) Bill 2005 was gazetted.

"The proposed exemption will help attract new offshore funds to Hong Kong and to encourage existing ones to continue to invest here," noted a government spokesman, continuing that: "Anchoring offshore funds in Hong Kong markets could also help maintain international expertise, promote new products, and further develop the local fund management industry. The proposal would lead to an increase in market liquidity and employment opportunities in the financial services and related sectors.

"Hong Kong is facing keen competition from other major IFCs in attracting foreign investments. Major financial centres such as New York and London as well as the other major player in the region, Singapore, all exempt offshore funds from tax. The financial services industry has expressed the view that it is vital for us to provide tax exemption for offshore funds, or otherwise some of these funds may relocate away from Hong Kong, leading to loss of market liquidity and a negative read-across impact on other financial services, including downstream services such as those provided by brokers, accountants, bankers and lawyers."

Under the legislation, offshore funds, i.e. non-resident entities (which can be individuals, partnerships, trustees of trust estates or corporations) administering a fund, are exempt from tax in respect of profits derived from dealings in securities, dealings in futures contracts and leveraged foreign exchange trading [as defined in the Securities and Futures Ordinance (Cap. 571) (SFO)] in Hong Kong carried out by specified persons such as corporations and authorized financial institutions licensed or registered under the SFO to carry out such transactions.

The exemption applies with retrospective effect to the year of assessment commencing on 1 April 1996, in order to provide legal certainty on the tax liability of offshore funds in respect of past years, which was much called for by the industry as otherwise there would be huge problems for offshore funds to finalise their tax liabilities for past years.

The Revenue (Profits Tax Exemption for Offshore Funds) Bill 2005 was passed by the Legislative Council in March 2006.