Money Under Sunshine: An Empirical Study Of Trust Contracts Of Chinese Hedge Funds
OF NON-LISTED COMPANIES
Under Sunshine: An
Empirical Study Of Trust Contracts Of Chinese Hedge Funds
Copyright c 2012 by the authors. Fordham Journal of Corporate & Financial Law is produced
by The Berkeley Electronic Press (bepress). http://ir.lawnet.fordham.edu/jcfl
Money Under Sunshine: An Empirical Study
Of Trust Contracts Of Chinese Hedge Funds
This article conducts the very first empirical study exploring the contractual arrangements of
Chinese hedge funds, which are organized not as limited partnerships but as trusts. Using 139 trust
contracts collected by hand, this article sheds light on the structure, covenants, and compensation
mechanisms used by “sunshine funds,” the local name for hedge funds in China. It shows that,
while sunshine funds do have similar contractual arrangements as typical LP-organized hedge
funds, they also possess many undeniable differences due to the jurisdiction-specific
characteristics of China. In particular, because of the direct involvement of trust companies, sunshine
funds include certain covenants and terms that could both narrow the decision-making power and
dampen the incentives of investment advisers. New, but rapidly developing, sunshine funds have
been frequently targeted by regulatory efforts, which, however, come at a low level of
consistency and sometimes lack in-depth consideration. Growing out of gray regulatory areas, Chinese
sunshine fund managers have demonstrated remarkable competence in positioning themselves by
taking advantage of favorable regulations and mitigating the impact of unfavorable ones. Looking
ahead, it is of key importance that a proper balance is reached in terms of what role regulators
should play in dealing with the Chinese hedge fund industry.
Lecturer and Ph.D. Candidate, Department of Business Law at Tilburg University; MPhil. 2008,
Tilburg University; LL.M. 2010, Duisenberg School of Finance; LL.M. 2004, Stockholm
University; and LL.B. 2003, University of International Business and Economics. The author
acknowledges with gratitude Professors Joseph McCahery, Armin Schwienbacher, and Erik Vermeulen,
for the inspirational and insightful comments they had on this article at an early stage.
CORPORATE & FINANCIAL LAW
MONEY UNDER SUNSHINE: AN EMPIRICAL STUDY OF TRUST
CONTRACTS OF CHINESE HEDGE FUNDS
MONEY UNDER SUNSHINE: AN EMPIRICAL
STUDY OF TRUST CONTRACTS OF CHINESE
This article conducts the very first empirical study exploring the
contractual arrangements of Chinese hedge funds, which are
organized not as limited partnerships but as trusts. Using 139 trust
contracts collected by hand, this article sheds light on the structure,
covenants, and compensation mechanisms used by “sunshine funds,”
the local name for hedge funds in China. It shows that, while
sunshine funds do have similar contractual arrangements as typical
LP-organized hedge funds, they also possess many undeniable
differences due to the jurisdiction-specific characteristics of China.
In particular, because of the direct involvement of trust companies,
sunshine funds include certain covenants and terms that could both
narrow the decision-making power and dampen the incentives of
investment advisers. New, but rapidly developing, sunshine funds
have been frequently targeted by regulatory efforts, which, however,
come at a low level of consistency and sometimes lack in-depth
consideration. Growing out of gray regulatory areas, Chinese
sunshine fund managers have demonstrated remarkable competence
in positioning themselves by taking advantage of favorable
regulations and mitigating the impact of unfavorable ones. Looking
ahead, it is of key importance that a proper balance is reached in
terms of what role regulators should play in dealing with the Chinese
hedge fund industry.
TABLE OF CONTENTS
INTRODUCTION ...................................................................................... 63
* Lecturer and Ph.D. Candidate, Department of Business Law at Tilburg University;
MPhil. 2008, Tilburg University; LL.M. 2010, Duisenberg School of Finance; LL.M.
2004, Stockholm University; and LL.B. 2003, University of International Business and
Economics. The author acknowledges with gratitude Professors Joseph McCahery,
Armin Schwienbacher, and Erik Vermeulen, for the inspirational and insightful
comments they had on this article at an early stage.
I. CONTRACTUAL AND GOVERNANCE STRUCTURE OF HEDGE
A. LIMITED PARTNERSHIP AS THE PREVALENT BUSINESS FORM
IN PRIVATE INVESTMENT FUND INDUSTRY ................................ 70
B. COVENANTS IN HEDGE FUND PARTNERSHIP AGREEMENTS –
HOW CAN THE CORRESPONDING LITERATURE ON PRIVATE
EQUITY FUNDS BE HELPFUL?.................................................... 75
II. OVERVIEW OF CURRENT REGULATORY FRAMEWORK FOR
CHINESE HEDGE FUNDS................................................................. 79
A. ALTERNATIVE FORMS FOR HEDGE FUNDS IN CHINA OTHER
THAN SUNSHINE FUNDS............................................................. 79
B. HEDGE FUNDS ORGANIZED AS TRUSTS: STRUCTURE AND
BUSINESS MODELS.................................................................... 86
III. EMPIRICAL ANALYSIS OF TRUST CONTRACTS OF SUNSHINE
A. SAMPLE AND DATA COLLECTION .............................................. 91
B. SAMPLE COVERAGE .................................................................. 94
C. DESCRIPTIVE STATISTICS .......................................................... 97
D. COVENANTS ............................................................................ 109
1. Covenants on the Authority of Fund Managers
Regarding Investment Decisions ..................................... 110
a. Restrictions on Investment Size ................................ 110
b. Covenants on Dividend Payouts................................ 111
2. Covenants on Fund Managers' Capital Contributions.... 113
a. Concerns of Chinese Investors .................................. 116
b. Liability Concerns of Trust Companies .................... 118
c. Legal Restrictions...................................................... 118
3. Covenants on Types of Investment................................... 120
4. Covenants on Fund Operation......................................... 125
5. Limitation of Investment Adviser’s Power....................... 126
E. COMPENSATION ...................................................................... 129
1. Temporarily No Performance-Based Compensation; to
be Resumed if Allowed by Law in the Future .................. 134
2. Trust Companies’ Fixed Fees and Flexible
Compensation Combined Together and Called “Trust
Management Fee,” Investment Advisers’ Flexible
Incentive Fees Received as “Special Trust Interests”
3. Trust Company Designated Together with Investment
Adviser as Special Beneficiary to Share Special Trust
4. Flexible Fees Payable Upon Investors’ Redemption....... 137
Although lacking a legal or regulatory definition, the term “hedge
fund” usually describes a type of alternative investment vehicle that
possesses four general characteristics: (1) it is a pooled, privately
organized fund; (2) it is administered by professional investment
managers; (3) it is not widely available to the public; and (4) it operates
outside of securities regulation and registration requirements.1 Although
many private equity or venture capital (“VC”) funds also share these
characteristics, those funds are distinguishable because they invest in
unlisted portfolio companies for relatively long-term periods for the
purpose of securing lucrative exits afterwards. As a class, however,
hedge funds can embark upon a broad range of investments including
equities, debt and commodities. They are often associated with using
active trading strategies and employing sophisticated instruments (most
notably short-selling and derivatives) to hedge investment risks and
increase returns. Most of the time, hedge funds tend to focus on trading
publicly-listed securities; in recent years, however, they also have
invested through side pockets into those assets that are comparatively
illiquid or hard-to-value, 2 thus indirectly broadening their coverage
further to private markets. Therefore, it is important to bear in mind that
there is a wide range of variations among hedge funds, and while some
hedge funds do share some or all of these characteristics, others do not.
Every hedge fund has its own investment strategy that determines the
type and method of investment it undertakes. As a result, it is easier to
recognize hedge funds than it is to define them.3
Due to strong economic growth while major developed countries
suffered from the global recession, China recently surpassed Japan to
become the world’s second-largest economy.4 The value of the Chinese
stock market has boomed. From a marketplace with only twelve stocks
trading when its first two stock exchanges opened in 1990 in Shanghai
and Shenzhen,5 the combined value of companies with stocks traded on
China’s equities markets is now comparable to that of Japan’s,
surpassing the latter periodically during the past two or three years.6
Furthermore, the long-anticipated margin trading 7 and stock index
4. David Barboza, China Passes Japan as Second-Largest Economy, N.Y. TIMES,
Aug. 15, 2010, at B1.
5. Bai Haiyan, Ziben shichang fazhan dui gongsi zhili de zuoyong [The Impact of
the Development of Capital Markets over Corporate Governance], 22 ZHONGGUO
JINGMAO [CHINESE BUS. UPDATE] 83, 83 (2008).
6. The combined value of companies trading on China’s equities markets reached
US$3.09 trillion as of August 16, 2010, compared with US$3.51 trillion for Japan,
according to data compiled by Bloomberg News. See China to Surpass Japan as No. 2
Stock Market, BLOOMBERG NEWS, Aug. 17, 2010, available at http://business.financial
China briefly surpassed Japan by capitalization in January 2008, shortly after
PetroChina Co. debuted in Shanghai, and again in July 2009 as a consequence of the
government’s 4 trillion-yuan (US$587 billion) economic stimulus program directed at
infrastructure projects and shares.
7. Margin trading was officially legalized in June 2006 by Zhengquan gongsi
rongzi rongquan yewu shidian guanli banfa [Measures for the Administration of Pilot
Securities Lending and Borrowing Business of Securities Companies] (promulgated by
China Securities Regulatory Commission [hereinafter CSRC], June 30, 2006),
LAWINFOCHINA, available at http://www.lawinfochina.com, but only materialized on
Mar. 19, 2010 when the CSRC designated six securities brokerage firms as the first
batch of “trial firms” to begin the business of margin trading and securities lending.
Mainland China Securities Survey 2010 (KPMG China, Hong Kong), Sep. 2010, at 6,
available at http://www.kpmg.com/cn/en/IssuesAndInsights/ArticlesPublications/Page
s/China-securities-survey-201010.aspx. The day before the official launch of the trial
program, CITIC Securities signed an agreement with Jiangsu Winfast Investment and
Development Co. Ltd., offering the latter credit limits of RMB 28 million for margin
trading and RMB 10 million for short selling. This is considered to be the very first of
such transactions in China. See Hu Yang, China Begins Margin Trading Trial, CHINA
DAILY, Mar. 31, 2010, available at
http://www.chinadaily.com.cn/business/201003/31/content_9668589.htm. Jiangsu Winfast is a securities asset management
company, and has several sunshine funds (one type of Chinese hedge funds) under its
management. See Jiangsu Winfast Investment Holding Grp., Company Profile,
http://www.jiangsuruihua.com/en/article.asp?c_id=42 (last visited Nov. 8, 2011);
Jiangsu Winfast Investment Holding Grp., Securities Trust Schemes Issued by Winfast,
http://www.jiangsuruihua.com/en/article.asp?c_id=56 (last visited Nov. 8, 2011).
futures8 finally materialized in the spring of 2010, so it is now possible
to get credit quotas for margin trading and short-selling from approved
securities brokerage firms, and to trade Shanghai-Shenzhen 300 stock
index futures contracts. These technical developments, combined with
considerable market capitalization and strong economic growth,
demonstrate China’s great potential to become an important hedge fund
Nonetheless, a “hedge fund” is still a very novel concept in China.
Given that Chinese people’s familiarity with hedge funds is somewhat
limited to anecdotal knowledge,9 the apparent existence of the Chinese
hedge fund industry is ambiguous. Among other things, this ambiguity
partially results from the general aversion in China towards the phrase
“hedge funds,” due to the negative impression they left on South-eastern
Asian countries in the 1997 Asian financial crisis,10 and more recently,
8. Financial derivatives (specifically, futures) were officially legalized in March
2007 by Qihuo jiaoyi guanli tiaoli [Regulation on the Administration of Futures
Trading] (promulgated by the State Council, Mar. 16, 2007), LAWINFOCHINA, available
at http://www.lawinfochina.com, but only materialized in April 2010 when the
Shanghai-Shenzhen 300 stock index futures contracts, the very first of such in China,
were listed on the China Financial Futures Exchange. See Mainland China Securities
Survey 2010, supra note 7, at 8.
9. For a collection of anecdotal articles on hedge funds in China, see generally
Richard Wilson, China – Hedge Funds: Guide to Hedge Funds in China,
http://richard-wilson.blogspot.com/2008/05/china-hedgefunds-hedge-funds-in-china.html (last visited Nov. 2, 2011).
10. Hedge funds have been charged with playing a pivotal role in the 1997-98
Asian financial crisis due to their involvement in large transactions they have done in
various Asian currency markets, such as Thailand, Malaysia, the Philippines, and then
Hong Kong, South Korea, etc. In particular, the then Prime Minister of Malaysia
blamed hedge fund manager George Soros for “attacks in the marketplace on the
Malaysian ringgit and other currencies in order to generate profits for themselves
without regard to the livelihood of the Malaysian or other local people.” See DICK K.
NANTO, CONG. RESEARCH SERV., THE 1997-98 ASIAN FINANCIAL CRISIS (1998),
available at http://www.fas.org/man/crs/crs-asia2.htm; see also Barry Eichengreen &
Donald Mathieson, Hedge Funds, What Do We Really Know?, ECON ISSUES No. 19,
International Monetary Fund (1999), available at http://www.imf.org/external/pubs
/ft/issues/issues19/index.htm#5. However, it is also submitted that despite these
allegations, there is no empirical evidence that George Soros, or any other hedge fund
managers, were responsible for the crisis. See Stephen J. Brown et al., Hedge Funds
and the Asian Currency Crisis, 26 J. PORTFOLIO MGMT. 95 (2000).
accusations against them in the 2008 global financial crisis.11 As such, it
would be unwise and difficult for private investment managers to raise a
fund in China under a name that the public generally associates with a
negative image. Rather, the hedge-fund-like investment vehicles are
referred to as “sunshine privately offered funds,” 12 which can sound
quite odd to outsiders. For the sake of simplicity, I refer to these funds
as “sunshine funds” in this article.
Another important factor contributing to the dearth of information
on Chinese hedge funds is their unique organizational structure. In the
United States, which has the world’s most developed hedge fund
industry, 13 the limited partnership (“LP”) prevails as the prevalent
business form for a hedge fund.14 On the one hand, fund managers act as
general partners, actively managing the fund and bearing unlimited
liability.15 On the other hand, investors are passive limited partners who
11. The financial crisis of 2008 has led to renewed debate about the impact of
hedge funds on the functioning of financial markets. Although it is largely recognized
that hedge funds should not be blamed for causing the crisis, there seems to be a
consensus among regulators in the world that they should be more regulated, which is
arguably stems more from a political fear for being criticized if no scapegoat can be
spotted rather than from a real need. See Anne C. Rivière, The Future of Hedge Fund
Regulation: A Comparative Approach: United States, United Kingdom, France, Italy,
and Germany, 10 RICH. J. GLOBAL L. & BUS. 263, 291 (2011).
12. The term “sunshine privately offered funds” is a literal translation of the
corresponding Chinese. For a brief introduction of sunshine funds, see
http://www.asimu.com/knowledge/infocontent/1238/41297.html. Because this type of
fund uses a trust to raise capital from investors and then manages the raised capital for
them, they are legal and thus “under the sunshine.” In contrast, those funds that do not
use the trust form may face various challenges such as ambiguous legal status, thus they
operate “in the shadow.” Therefore, this name is actually a vivid depiction of those
privately offered funds, using the trust as their business form, and primarily focusing on
investing in publicly listed securities. Sunshine funds, particularly the unstructured ones
(further discussion in Part II.B), are considered comparable to hedge funds, in that that
they both aim to pursue absolute returns and have similar fee structures. See
13. As of the end of 2009, the US was the largest management center for hedge
funds and also the leading location for management of hedge fund assets with over
twothirds of the total. See International Financial Services London, IFSL Research Hedge
Funds 2010, THECITYUK.com, (Apr. 2010), available at http://www.thecityuk.com
14. DOUGLAS L. HAMMER ET AL., U.S. REGULATION OF HEDGE FUNDS 88 (2008).
15. Jacob Preiserowicz, The New Regulatory Regime for Hedge Funds: Has the
SEC Gone Down the Wrong Path?, 11 FORDHAM J. CORP. & FIN. L. 807, 812 (2005). In
practice, however, the “actual” general partner of a fund is often not the fund manager
are shielded with limited liability protection but have to leave
investment decisions to general partners. 16 One important feature
common to virtually all LP-type hedge funds is their fee structure,
typically consisting of a management fee of 2% and a performance fee
of 20%.17 This structure heavily incentivizes managers to generate good
performance for investors. In contrast, no Chinese hedge fund was
formed as a LP until March 2010, when the first LP-type private
securities investment fund was created in Beijing.18 Although limited
partnerships have been legally authorized in China since 2007,19 only 31
private securities investment funds were identified as LPs as of the end
of 2011.20 Arguably, the low usage of LPs among Chinese hedge funds
may be a result of the fact that there are virtually no precedents available
to regulators, practitioners, and taxation authorities on how to deal with
this new business form.21
itself, but a management company set up by it. By doing this, fund managers are
shielded by the limited liability protection of the management company, thus leaving
the unlimited liability at the entity level. See infra notes 15, 28 and accompanying text.
16. Alon Brav et al., Hedge Fund Activism, Corporate Governance, and Firm
Performance, 63 J. FIN. 1729, 1735 (2008).
18. Zhao Juan & Hu Zhongbin, Shouge hehuozhi zhengquan simu jijin tanmi
[Exploring the First Privately Offered Partnership Securities Fund], JINGJI GUANCHA
BAO [THE ECONOMIC OBSERVER], Mar. 1
, available at http://www.eeo.com.
cn/finance/securities/2010/03/13/165159.shtml. This first partnership fund is named
Yinhe Purun, and is registered in Beijing.
19. Limited partnership was first legally permitted in 2006, when China amended
its Partnership Enterprise Law. See Zhonghua renmin gongheguo hehuo qiye fa
[Partnership Enterprise Law (P.R.C.)] (promulgated by the Nat’l People’s Cong., Feb.
23, 1997) (amended Aug. 27, 2006) (took effect June
available at http://www.lawinfochina.com.
20. According to the database provided by Simuwang.com, a total of 11 funds were
set up as limited partnerships for the entire year of 2010, and 20 funds for the entire
year of 2011. See http://data.simuwang.com/product.php
(follow “product type”; then
select limited partnership; next choose 2010 and 2011 from under “year established”)
21. It is submitted that in order to enhance the popularity of limited partnership
among privately offered securities investment funds, four difficult questions need to be
tackled first. Among other things, it remains to be seen (1) whether these LP-organized
funds will be equally attractive to investors when there is no trust company involved;
(2) how LP-organized funds are going to properly entertain frequent subscription and
redemption needs, given the statutory requirement for unanimous approval from all
partners and changing official registration with the regulatory authorities when an
Instead of the LP form, the vast majority of Chinese hedge funds
are created as securities investment trust plans based on a “four party
cooperation platform” provided by various trust companies.22 This might
explain the impression that China seems to lack a hedge fund industry –
after all, these trust-like funds look quite different from the much better
known LP-type funds. The very first trust-organized sunshine fund in
China was created in 2004,23 yet the industry has been developing at a
remarkable pace ever since. According to the Go-Goal Database for
High-End Investors, there are altogether 703 trust sunshine funds in
operation as of August 9, 2010, and the number increases to 838 when
including those that had been terminated.24 Although it is undisputed
that China’s hedge fund industry still has a long way to go, it seems
equally unwarranted to simply deny its existence when a large number
of funds are already in the business. Given the limited understanding of
these trust sunshine funds, timely research into them is both worthwhile
Just as LP agreements provide insight into the creation and
governance of American hedge funds, the best way to understand how
Chinese sunshine funds are established and operated is to look at their
“trust agreements for collective securities investment funds.”
Fortunately, while hedge funds in developed markets are generally
existing partner exits or a new partner is brought into the partnership; (3) how they are
going to safely keep and use the money from investors when the Partnership Enterprise
Law does not make mandatory a custodian bank to be designated for that purpose; and
(4) which governmental authority should be supervising LP-organized sunshine funds.
Moreover, many questions also remain unanswered as to the taxation of limited
partnerships and their investors and managers. See Xiao Yongjie, Yangguang simu
youxian hehuo zhi sida nanti [Four Difficulties for Sunshine Funds Organized as
Limited Partnerships], ZHENGQUAN SHIBAO [SECURITIES TIMES], Mar. 15, 2010,
available at http://simu.howbuy.com/xinwen/178846.html.
22. See infra Part II.B.
23. This fund was called SZITIC PureHeart, created on Feb. 20, 2004 in Shenzhen
and terminated on Jan. 15, 2008. The fund is reported to have realized an accumulated
return of 370.86% as of its liquidation. See Zhang Bin, Zhao Danyang: Shangwu huigui
A gu shichang de jihua [Zhao Danyang: Currently No Plan to Return to a Stock
Market], CAIJING, Feb. 18, 2009, available at
24. See GO-GOAL DATABASE FOR HIGH-END INVESTORS,
http://www.gogoal.com/inv_trust/basic/default.aspx. See infra Part III for further discussion of
empirical data. Sunshine funds were filtered out manually by the author on the website
considered quite secretive due to the much lighter regulation and
disclosure requirements imposed on them, the trust-like sunshine funds
are somewhat more transparent because trust companies in China are
subject to certain disclosure requirements as supervised and regulated
financial institutions.25 In addition, some fund managers also voluntarily
publish information on their websites about the funds they manage. As a
result, it is possible to obtain the trust contracts of some Chinese hedge
funds. Using a sample of 139 trust agreements and explanations of trust
plans,26 this article investigates the contractual arrangements of Chinese
sunshine funds and aims to demonstrate how the salient terms of these
trust plans govern the operation of sunshine funds. Particular attention
will be given to those terms that control the roles of investment advisers
and trust companies, who cooperate and interact with each other in a
manner analogous to fund managers in American hedge funds contracts.
Part I of this article provides a brief summary of the contractual and
governance structure of American LP-type hedge funds, together with
an overview of previous research papers written on the contractual
arrangements of alternative private investment vehicles. Part II describes
the current regulatory environment surrounding hedge funds in China.
Finally, Part III discusses and analyzes empirical data regarding the
structure, covenants, and compensation mechanisms of sunshine funds.
25. Generally, trust companies must disclose to their clients and the relevant
interested parties the key information about their business. For a collective capital trust
plan, they must, at least for every quarter of a year, create a “trust capital management
report” to disclose the major issues in managing the trust. They must also disclose
weekly on their websites the unit net asset value of each of their securities investment
trusts (such as sunshine funds). See art. 34-38 of Xintuo gongsi jihe zijin xintuo jihua
guanli banfa [Administrative Measures for Collective Capital Trusts Established by
Trust Companies] (promulgated by the CBRC, Jan. 23, 2007), LAWINFOCHINA,
available at http://www.lawinfochina.com; see also art. 15-17 of Xintuo gongsi
zhengquan touzi xintuo yewu caozuo zhiyin [Guidelines on Running the Business of
Securities Investment Trusts by Trust Companies],
(promulgated by the CBRC on Jan.
, LAWINFOCHINA, available at http://www.lawinfochina.com.
26. See infra Part III.A.
CONTRACTUAL AND GOVERNANCE STRUCTURE OF HEDGE
A. LIMITED PARTNERSHIP AS THE PREVALENT BUSINESS FORM IN
PRIVATE INVESTMENT FUND INDUSTRY
LPs are widely used to contain the business of both hedge funds
and private equity funds. The popularity of the LP in the private
investment fund industry can be attributed to two primary incentives:
flexible contractual structure and favorable tax benefits. Limited
partners are those persons contributing substantially all of the
partnership’s capital, such as institutional investors, wealthy
individuals,27 and sometimes other hedge funds (giving rise to the fund
of funds).28 The general partner is a management company set up by
professional investment managers, who are effectively shielded from the
risk of unlimited personal liability arising as a result of actively
managing the partnership and making investment decisions on the
pooled capital.29 Unlike a corporation, LPs are not separately taxed as
an entity, so that the fund’s profits and losses are passed through to its
partners without any entity level tax.30 Compared to limited partners, the
general partner only contributes a nominal portion of the total
assets/committed capital of the partnership, normally 1%,31 but has the
right of compensation much greater than its original contribution if the
fund runs well. Such compensation is often referred to as the “2-20”
mechanism, consisting of a fixed management fee, usually 2% of the
total assets/committed capital of the fund, and a performance-based right
to share 20% of the fund’s net profits. 32 Such an arrangement serves to
incentivize the general partner to work hard and manage investments
diligently, providing an effective solution to the principal-agent problem.
The governance structures of a typical private equity fund and hedge
fund are shown in Figure 1 and Figure 2 below.
Particularly, the compensation scheme in hedge fund partnership
agreements is usually identified by one important feature: high-water
marks. By definition, a high-water mark is the highest peak in value that
an investment fund has reached.33 As already mentioned above, such
performance-based compensation normally amounts to 20% of the net
new profits if the previous high water mark is exceeded. The prevalence
of high-water marks among hedge funds might be partially explained by
the high level of reliance on fund manager expertise. Since investor
payoff is presumably based more upon the expectation of superior
managerial skill and less upon the expected returns to an
undifferentiated or passively managed portfolio of assets, a mechanism
is needed to incentivize fund managers to demonstrate their skills in
order to justify their fees.34
33. William N. Goetzmann et al., High-Water Marks and Hedge Fund
Management Contracts, 58 J. FIN. 1685, 1685 (2003).
34. Id. at 1686.
Governance Structures of Private Equity Funds and Hedge Funds Figure 1 Private Equity Fund
JOSEPH A. MCCAHERY & ERIK P. M. VERMEULEN, CORPORATE GOVERNANCE
Despite a certain level of similarity between the two diagrams
above, hedge funds differ from private equity funds in that hedge funds
generally invest in public liquid assets via a brokerage account, whereas
private equity funds typically purchase stock directly in non-listed
portfolio companies. As such, hedge funds need an array of service
providers working around them in order to maintain their operations.
Figure 3, below, lists the typical parties involved in the operation of
hedge funds. Specifically, an administrator is appointed to maintain
records, as well as to independently verify the asset value of the fund. A
registrar/transfer agent is responsible for processing subscriptions and
redemptions and maintaining the registry of shareholders. A prime
broker provides access to stock and loan financing and serves as a host
36. Id. at 186.
of value-added services.37 A custodian ensures the safe-keeping of assets.
At the top level, the board of directors or trustee of the fund bears a
fiduciary duty to the investors to ensure that all parties involved in the
fund properly carry out their respective tasks. 38 It is submitted that
outsourcing a hedge fund’s functions can help to minimize the risk of
collusion among hedge fund participants to perpetuate fraud, and may
also mitigate liability in the event that hedge fund participants are
accused of improperly performing their management duties.39
Source: Cumming & Dai (2010)40
B. COVENANTS IN HEDGE FUND PARTNERSHIP AGREEMENTS – HOW
CAN THE CORRESPONDING LITERATURE ON PRIVATE EQUITY
FUNDS BE HELPFUL?
Although both private equity and hedge funds employ the same
legal structure and “2-20” compensation mechanism from the outset,
there are also pronounced differences between them in terms of their
operations. Such differences result from the contractual flexibility of
limited partnerships, which allows investors and fund managers to enter
into covenants and schemes to suit their respective investment
mandates.41 A straightforward example in this regard is differing fund
terms. Since investments by private equity funds are generally highly
illiquid42—private equity funds focus on buying shares in unlisted firms
and only hope to harvest from there after three to seven years.43 There is
a need to agree on a limited fund term at the expiration of which the
general partner is obliged to return to limited partners the capital
together with distributed profits. Correspondingly, general partners
cannot access the full amount of the committed capital from the
beginning of the fund, but they have the right to call in capital
contributions once they have located proper investment projects.44 Once
the capital is invested, limited partners then need to remain patient and
are prohibited from redeeming their partnership units until the end of the
fund. In contrast, because hedge funds primarily invest in publicly listed
securities, their assets are comparatively more liquid and investors can
get back their contributed capital through periodically-opened
redemptions. This explains why many hedge funds are perpetual in life
rather than having a fixed fund term, and why limited partners have to
make contributions up front.
While an in-depth comparison of the difference between the two
types of funds is beyond the scope of this article, it is nevertheless
necessary and inspiring to bring up the topic here. As mentioned in the
Introduction, a good way to understand how hedge funds are set up and
operated is to look at their contracts, either LP agreements for typical
American-style hedge funds or trust agreements for Chinese sunshine
funds. Given the many similarities between private equity and hedge
funds in terms of organizational structure and compensation
mechanisms, a look into the contractual arrangements (covenants in
particular) of private equity LP agreements will provide helpful
guidance in understanding the contractual arrangements of hedge funds,
which, however, have received scant attention in literature. The lack of
literature on hedge fund contractual arrangements might result from the
difficulty of obtaining access to the organizational documents of hedge
funds; but it is more likely explained by the fact that hedge funds tend to
rely much less on self-regulatory means like covenants due to shorter
lock-up periods and the fund’s liquidity. Furthermore, those hedge fund
activities that fall within the public domain, particularly in the market
for corporate control, can also help to limit the principal-agent problems
that may otherwise emerge. 45 The following paragraphs summarize
important research on contractual covenants in the agreements of private
investment funds, including both private equity funds, as well as venture
capital funds, one of the most important subtypes of private equity.
Although this information might not be directly useful in terms of
drawing conclusions for this paper given the different topics and
jurisdictions covered in this area, exploring methods of classifying
covenants may be a good starting point for classifying the covenant
arrangements in Chinese hedge funds.
In their 1996 paper, Professors Gompers and Lerner studied
covenants in a sample of 140 U.S. VC partnership agreements.46 They
focused on 14 classes of covenants, which were divided into three broad
families: (a) covenants relating to overall fund management; (b)
covenants relating to activities of general partners; and (c) covenants
restricting the types of investment. 47 According to them, contractual
restrictiveness in VC funds, measured by the number and kind of
covenants in the partnership agreement, is determined by two important
factors, namely, the supply and demand conditions in the VC market, as
45. See MCCAHERY & VERMEULEN, supra note 35, at 190.
46. See Paul A. Gompers & Josh Lerner, The Use of Covenants: An Empirical
Analysis of Venture Partnership Agreements, 39 J.L. & ECON. 463 (1996).
47. Id. at 480.
well as the variations of the cost of contracting.48 When the supply of
capital is large and the demand for the services of experienced,
professional VC managers is great, fewer covenants are observed, and
general partners’ compensation under the partnership agreement is
higher.49 Such supply and demand theory is generally supported by all
types of covenants.50 In terms of variations in the cost of contracting, the
rationale is that because negotiating and monitoring specific covenants
can be costly, and the ease of monitoring and the potential of engaging
in opportunistic behavior may vary across funds, more restrictive
contracts will be employed when monitoring is easier and the potential
for opportunistic behavior is greater. 51 Such theory is supported
particularly by those covenants restricting the fund management and
In Europe, Daniel Schmidt and Mark Wahrenburg explored factors
that influence the design of financing contracts in terms of covenant
restrictions and compensation schemes between VC investors and
European VC funds. 53 Their analyses focused on the impact of VC
funds’ reputations and changes in the overall demand for VC services.54
While conventional wisdom would assume established market
participants care more about their reputation and have less incentive to
behave opportunistically, thus requiring fewer covenant restrictions,
their findings show that established funds are actually more severely
restricted by contractual covenants.55 Moreover, empirical results also
show that established fund managers with stronger reputations are more
often obligated to make a capital contribution than first-time fund
managers.56 Such results indicate that when established funds care less
RMB 10 million paid up capital; 161 as for a trust company, the law
requires for at least RMB 300 million registered capital, which must be
already fully paid up.162
By the same token, investors in China may find it hard to accept
when a fund manager is going to use their money at his discretion and
share one-fifth of what they are going to earn, while the manager only
contributes a nominal amount relative to what investors have invested.
In some sense, this could also sound like a sham. Comparatively, a 10%
capital contribution will better bind the adviser, and the business will
look more serious in the eyes of investors. Given that the idea of hedge
funds is still so novel, and that the whole scheme is based on contracts,
the requirement that investment adviser contributes at least 10% of the
fund’s total assets serves as a quasi-legal mechanism to provide the
needed sense of security to investors. This argument echoes the thesis of
a paper by Professors Lerner and Schoar in 2005.163 They found that, in
a private equity investment context, transactions in low enforcement and
civil law nations tend to use common stock and debt, and rely on more
rigid yet straightforward mechanisms such as equity and board control
to monitor portfolio companies, instead of convertible preferred stock,
which is more flexible yet more contractual in nature, as seen in
common law countries. 164 Similarly, the higher investment adviser
contribution requirement used in the Chinese hedge fund contract
context serves as a more rigid and straightforward mechanism to make
up for the general unfamiliarity and uncertainty of Chinese investors
towards the new business, reflecting of the civil law culture in China.
b. Liability Concerns of Trust Companies
If an investment adviser underperforms and the sunshine fund
under its management loses money, the reputation of the trust company
will also be negatively affected because the fund is created and operated
under its name. From a formal point of view, a trust company is the one
signing the trust contract directly with the investors, while the
investment adviser is standing one step back being the third-party
service provider retained by the trust company through an advisory
service agreement. As such, a trust company would have the incentive to
preserve its reputation as a reliable market player. It need to have some
reliable mechanisms to ensure that if the investment adviser fails to
bring in good returns for a sunshine fund, disgruntled investors of that
fund will not make its life too difficult. With a high investment adviser
capital contribution at the outset, the investors may feel that their losses
are at least partially shared by the person who caused the losses.
Otherwise, annoyed investors will first blame the trust company for not
installing a mechanism to hold the investment adviser accountable, and
liability on the part of trust company may even be triggered. In this
sense, it is understandable that most trust companies have included this
requirement in their contracts, despite the incentive-dampening effect it
is likely to have on investment advisers.
c. Legal Restrictions
A recent regulation, namely, Guidelines on Running the Business
of Securities Investment Trusts by Trust Companies, which took effect
in February 2009,165 permitted trust companies to charge management
fees and performance-based compensation by virtue of running
securities investment trusts business. However, performance-based
compensation can only be paid as of the termination of a trust, provided
that the trust has been profitable.166 Furthermore, the fees incurred as a
result of retaining third-party investment advisers should only be paid
out of the management fees and performance-based compensation
charged by the trust company from investors.167 This means that the
investment adviser will have problems getting its incentive fees on a
regular basis, as the trust company cannot get its performance-based
compensation until the fund’s termination in the first place. However, if
the investment adviser contributes a higher level of capital into a fund
and thus gets more trust units in return, such regulatory restriction can
be circumvented by paying dividends or “special trust interests” from
165. Guidelines on Running the Business of Securities Investment Trusts by Trust
Companies, supra note 25.
166. Id. art. 18.
167. Id. art. 21.
time to time to the investment adviser based on its holding of trust units.
In this respect, a higher level of capital contribution by the adviser as
seen in many sunshine funds contracts is even necessary under the
current Chinese regulatory framework. This issue will be discussed in
more detail in Part III.E.
3. Covenants on Types of Investment
This category of covenants serves to limit investment advisers
specifically with respect to certain risky securities. Within the sunshine
funds context, I identify two important types of covenants under this
category, namely, restriction on types of investment and the decision
power on expanding investment scope of a fund. Findings on the two
types of covenants are summarized and presented in the two Tables,
Not allowed to actively buy in derivatives on secondary markets
Allowed but with certain percentage restrictions
Allowed plus certain percentage restrictions if approved by the investors of the
Restrictions on engaging in short selling/margin trading
Not allowed at all
Allowed, if approved by the investors of the trust
Allowed, if agreed by the trust company
Restrictions on investing in ChiNext168 stocks
Allowed but with certain percentage restrictions
168. ChiNext is specially tailored to list those enterprises engaged in independent
innovation and other growing venture enterprises. It was only officially launched on
Oct. 23, 2009. See Samuel Shen & Fion Li, China launches second board for start-ups,
REUTERS, Oct. 23, 2009, available at http://www.reuters.comarticle/2009/10/23/chine
Restrictions on investing in the securities of related parties169
Not allowed to invest in securities of the trust company as well as the related
Not allowed to invest in securities of the companies that are related parties of the
Not allowed to engage in non-arms length transactions among other funds as
managed by the same trust company and/or the investment adviser
Not allowed to invest in those securities that may involve personal interests of
the trust company and the investment adviser, and the managers thereof
Restrictions on investing in an exchange-traded fund (“ETF”)
Only trade ETF within an exchange
Obligation to invest certain percent of trust assets in securities with at least “neutral”
or “hold” rating
169. Note that the law does not generally prohibit related party transactions by trust
companies, provided that they are carried out with fair market price and reported to the
CBRC in advance on a transaction-by-transaction basis. See Measures for
Administration of Trust Companies, supra note 142, art. 35.
How can a decision of investment scope expansion be made?
Investment scope not changeable
All of the principals’ consent must be sought
Half of the principals need to approve
Sole decision by trust company but consent of investment adviser should be sought
Sole decision by trust company provided that advance notice is made on its website
Joint consultation and decision by the trust company and investment adviser
Sole decision by investment adviser, once the trust company permits it to do so
Sole decision by investment adviser
In particular, Cumming and Johan’s 2006 paper finds that private
equity funds in civil law countries are more likely to have covenants
pertaining to the types of investment than private equity funds in
common law countries.170 Since no research was presented regarding
covenants in hedge fund partnership contracts, I cannot say whether
their conclusion is also true within the hedge fund context by comparing
the covenants from the two systems. However, one may have the
impression from looking at the covenants summarized in the above two
Tables that investment advisers have limited freedom in terms of the
types of investments they can make. Hedge funds in developed countries
usually advertise themselves as being able to make use of a wide range
of sophisticated financial instruments and transactions for the purposes
of delivering absolute returns. Apparently, Chinese hedge funds are far
more limited in that regard. In essence, they are still at the stage of being
“stock trading funds” rather than real “hedge funds.” This being said,
the current cautious approach of allowing only limited types of
investment is however understandable and even worthwhile, given that
the Chinese capital market is a huge laboratory itself where many new
things are still to be tested.
It is important to note one particular point about the data presented
above. Despite some variations, it is apparent that the trust company
Cumming & Johan, supra note 60, at 571.
plays quite a role in terms of deciding what kind of investments are to be
made or not, as well as whether to allow the investment scope expansion.
As already mentioned above, a trust company is more like a service
provider than a de facto fund manager for the sunshine funds created
under its name.171 Decisions regarding which securities to invest in, at
what price to buy in or sell out, and the number to be bought in or sold
out, are all made by the investment adviser and contained in a document
called the “investment plan.” A trust company normally is there only to
conduct a formality check upon the investment plan before executing it.
It is a “formality check” in that the trust company will only refuse to
carry out the investment plan if the recommendations contained in the
investment plan involve investments violating the relevant legal
requirements or contractual stipulations in the trust contract, or when
exogenous reasons make it impossible to trade a stock as of the time of
the investment plan, e.g., when that stock is suspended from trading
during preparations for periodic reporting. Thus, the trust company is
not there to judge whether the specific investment decisions made by the
adviser in the investment plan, i.e., those regarding how, when and at
what price to dispose of certain securities, are good or bad. 172 That said,
a trust company does retain an important right allowing it to have a say
over issues on a more general level, such as what kind of securities can a
fund invest in and what kind of transactions can a fund engage in. As
can be seen from the two Tables above, if an investment adviser wants
to invest in risky assets, such as special treatment stocks or warrants, or
deploy risky trading strategies, such as short selling, or want to have a
more liberal investment scope, it is most likely that the adviser has to
ask for the trust company’s permission. Therefore, compared with a
manager in a classic hedge fund partnership, an investment adviser to a
Chinese sunshine fund enjoys most but not full discretion in making
investment decisions, and there are times that the trust company may
interfere, mostly on formal and general issues. Again, the reason here
relates to the liability concern of trust companies. Since their reputation
and interests are on the line if the investments in risky assets lead to
investors’ losses, they have the incentive to retain the power of deciding
whether to allow their advisers to do so in the first place.
See supra note 107 and the accompanying text.
Summarized based on contracts in my sample. See also id.
Covenants on Fund Operation
This category of covenants covers those issues regarding the
general management and operation of a sunshine fund. Some covenants
shown in the Table below can also fall under the previous sub-category
of investment types. Table 9, below, provides a summary of the usage of
this kind of covenants in 60 sunshine funds contracts that explicitly
provide information on restrictive covenants (usually in a separate
section named “Investment Restrictions”). To avoid misunderstanding, I
excluded covenants that deal with those restrictions already expressly
stipulated in the relevant statutes.173
173. For example, there are eight funds in my sample prohibiting using the trust
assets to extend loans or attach any encumbrance thereon. Such a covenant, however, is
not included in Table 9 because there is an explicit statutory provision saying that trust
companies shall refrain from using the trust assets for purposes other than ones
stipulated in the trust contract, nor should they use trust assets to provide collateral for
others. See Measures for Administration of Trust Companies, supra note 142, art. 34.
174. Such time limits are: Western Trust Cheng Nuo No.1: 14 trading days; Western
Trust Mingyuan Bakelai; 14 trading days; BJITIC Tong Wei Value Increase: 15 trading
days; and FOTIC Ying Rong Da No. 1: 5 trading days.
5. Limitation of Investment Adviser’s Power
The last category of covenants is also unique to Chinese hedge
funds. Essentially, these covenants deal with a situation where an
investment adviser will lose all of its power and the trust company will
take over. This could happen both in the case of a particular security in a
fund’s portfolio, and in the case of the fund as a whole. The happening
of the latter will directly lead to the termination of the sunshine fund.
The right of a trust company to dispose securities in a fund without
consulting the investment adviser is called the “special transaction right.”
To be sure, this section does not lend itself to talking about the general
circumstances in which a trust company has the right to terminate a
sunshine fund. After all, technically it is the trust company and not the
investment adviser who creates a sunshine fund; it follows that the trust
company will also have a termination right. There can be a set of such
circumstances where the termination will simply be a natural and logical
outcome thereof. For example, the trust company can terminate a fund
when all the beneficiaries (i.e., investors) decide so; when the core
managers of the investment adviser leave and there is no one else to
replace them; when the investment adviser cooperates with other trust
companies to launch similar trust funds without obtaining prior consent
of the current trust company; or when the fund is so under-subscribed
that its NAV is lower than a defined minimum amount for a certain
period of time.
Triggers of the Special Transaction Right
The situations listed Table 10, above, however, are of a different
nature. In these cases, the decision of the trust company to sell a security
or even to terminate a fund by selling all of the securities therein is a
substantive one. The first category of triggers allows a trust company to
sell certain securities if it has reason to believe that they should not be
held. It encompasses, for example, the right of a trust company to sell a
175. Note that although a trust company should impose certain appropriate “alert
thresholds” depending on the nature of a trust fund and the market trends, and also
diligently keep track of the market on a daily basis, it is not a mandatory statutory
requirement to also have a “loss-stopping threshold.” A “loss-stopping threshold”
entitles the trust company to sell trust assets and stop losses for a trust fund. Whether to
include a “loss-stopping threshold” clause is left to the discretion of the business parties,
and if they do agree on the clause in the trust contract, the trust company should take
action accordingly. See Guidelines on Running the Business of Securities Investment
Trusts by Trust Companies, supra note 25, art. 14. That said, Chinese law makes it
mandatory that trust companies impose “loss-stopping thresholds” for structured trust
funds, so as to limit losses for preferred class investors. See Notice of China Banking
Regulatory Commission on Strengthening the Supervision of the Structured Trust
Business of Trust Companies, supra note 109, art. 9.
176. This includes eight structured funds.
security when the investment adviser (or together with its related parties)
holds more than 5% of that stock. However, this is not the real point of
the special transaction right embodied in this trigger, as selling the stock
to make its holding fall back under 5% is merely for legal compliance
purposes, otherwise a disclosure will have to be made.177 Rather, it deals
more with the situation when, for example, the market falls 3% in one
day or 8% accumulatively for two consecutive days, or the value of the
any stock falls under 90% of its initial cost, or trading volume of any
stock doubles for two consecutive days.178 Upon the occurrence of any
of these listed scenarios, the trust company will be alerted and ready
take further actions, if necessary. It is no longer bound by the decisions
of the investment adviser any more, even if it chooses to consult with
the investment adviser first about the possible solutions. It can directly
decide to sell the concerned security to stop further losses, even if the
adviser wants to keep it for a longer period.
As to the second category of triggers, selling thresholds (i.e.,
lossstopping thresholds) higher than 80% of the original NAV are mostly
found within structured, as opposed to unstructured, fund contracts. The
selling threshold for structured fund contracts is generally higher
because investment advisers need to meet the fixed target return for their
preferred class of investors, thus leading to a more acute need to limit
loss than for unstructured fund contracts. Moreover, there is normally
also a “capital add-in threshold” to serve as the first-step buffer before
the selling threshold is reached. Therefore, a structured fund will only be
terminated if the subordinated investors are not willing to contribute
new capital into the fund to make up for the loss, and the fund’s NAV
keeps falling toward the selling threshold. In any case, cashing out all
securities and terminating a fund is a substantive right of the trust
company leading to a serious outcome, as it deprives the investment
adviser of the chance to reverse the losses by changing its strategy and
177. If an investor’s holdings reach 5% of the issued shares of a listed company, a
disclosure must be made within three days. See art. 13, Shangshi gongsi shougou guanli
banfa [Regulations on the Takeover of Listed Companies] (promulgated by the CSRC,
) (amended Aug. 27, 2008), LAWINFOCHINA, available at
178. These circumstances are expressly stipulated in SZITIC trust contracts, and the
trust company may, upon the occurrence of such circumstances, exercise its special
transaction right to sell a stock without consulting the investment adviser. Trust
contracts from other trust companies have similar stipulations of such circumstances.
It is not hard to understand why so many trust companies choose to
retain the special transaction rights. As the party signing the trust
contract with investors directly, a trust company bears more risk than the
investment adviser of becoming the target of a lawsuit if the fund’s
losses make investors unhappy. In this sense, the existence of a special
transaction rights can serve as a liability exemption or reduction
disclaimer against the accusation that “the trust company has failed to
fulfill its duty to monitor the investment adviser and stop losses.”179
Such disclaimer, although effectively limiting the potential liabilities
that may be charged upon trust companies, comes at the cost of
sacrificing investment advisers’ decision power in very important
circumstances. In this sense, trust companies are not merely playing the
role of transaction executors, but also the role of substantive decision
makers in Chinese hedge funds. As long as trust companies are
providing investment advisers with the trust platform on which to base
sunshine funds, it is not likely for them to give up their special
transaction rights. Industry practitioners thus would be curiously
anticipating the prospective development of
limited-partnershiporganized hedge funds, especially in terms of their potential to
overcome the inherent shortcomings (such as special transaction rights)
of trust-organized ones.
Since sunshine funds are based on trusts, the compensation
mechanisms in their contracts also have some unique aspects that reflect
this fact. In simple words, the fixed and flexible fees paid by investors
of a fund are shared between the investment adviser and the trust
company, with the former taking a larger portion. The following two
Tables summarize some important features of compensation
179. Such an accusation was raised by investors in a lawsuit against SZITIC, as a
result of the huge losses (more than 60%) of Xinpeng No. 1, a sunshine fund created
under its name. See Dan Youwei, Huarun xintuo yu kehu duibu gongtang: cheng
Xinpeng 1 qi bucunzai qizha [SZITIC Responded on the Lawsuit Brought by Its Clients:
We Did Not Defraud on Xinpeng Trust Contract], SHANGHAI ZHENGQUAN BAO
[SHANGHAI SECURITIES NEWS], Dec. 2
, available at http://news.hexun.com/20
mechanisms of 82 sunshine funds in
information on fees and compensation.
my sample that provided
* The numbers in the Table might not add up to 82 because in some cases, the specific proportion of
split is not given.
** This proportion is only applicable during the first year of the fund. Afterwards, the proportion is
changed into 17%/3%. See the contract of SZITIC Hengda Tonghui No.1.
*** The two columns of fixed fees should be read separately from each other. They are sorted from low
to high under each column, but the numbers in the same row are not related to each other, e.g., the 0%
and 0.5% in the first row does not mean a 0%/5% split of fixed fees between adviser and trust company.
Investment Adviser /
Combination = 20%
12% / 8%
15% / 5%
16% / 4%
17% / 3%
17.5% / 1.5%
18% / 2%
18.5% / 1.5%
20% / 0%
Combination > 20%
19% / 3%**
20% / 2%
30% / 0%
35% / 0%
Usage of High Water Mark (N=78)
Usage of High Water Mark
Typical high water mark, with hurdle rate
Typical high water mark, no hurdle rate
Hurdle rate, no high water mark
Revised or no high water mark, no hurdle rate
Difference between the NAV of the compensation payment day and the purchase
price of trust units
Flexible fees paid yearly, based on the difference of the NAV of year end between
the NAV of year beginning
Difference between the NAV of the current compensation payment day and the
NAV of the last payment day
Highest historical NAV during the past 12 months
Similar to the typical hedge fund industry practice, the
performance-based flexible fees in Chinese sunshine funds also largely
cluster at 20%. However, what is different is that the 20% needs to be
split between the investment adviser and the trust company, and the
most frequently seen proportion of such a split is 17% to the investment
adviser and 3% to the trust company. Fixed management fees are also
split; however, if adding the investment adviser’s portion with the trust
company’s portion, the sum does not cluster at 2%. As shown in Table
11, above, the level of fixed management fees charged by trust
companies is generally at a higher level than that charged by investment
advisers. The usage of a high water mark is also identified as a prevalent
practice among sunshine funds. A high water mark is defined in most
contracts as the highest historical NAV; it has been used in a few
contracts with twists to this meaning to make the conditions of
compensation payouts less stringent, as shown in Table 12, above.
As already mentioned in Part III.D.2, a regulation that took effect in
February 2009 introduced into the industry some very strange legal
requirements. According to that regulation, performance-based
compensation can only be paid as of the termination of a trust provided
that the trust remains profitable.180 Furthermore, the fees incurred as a
result of retaining third-party investment advisers should only be paid
See supra note 166 and the accompanying text.
out of the management fees and performance-based compensation
charged by the trust company from investors. 181 Such requirements
might be well-meant. For example, it may be that the regulatory
authorities do not want investors to bear the obligation of paying
sunshine funds managers (trust company and investment adviser) on a
periodic basis, when the NAV of these funds can be so volatile182 that, in
the end, investors will only earn nominal returns compared to the
accumulated amount of fees they have paid out. They may also have
gotten the inspiration from the compensation mechanism of private
equity funds, which normally require general partners to return part or
all of the capital committed or invested by limited partners before they
can share the 20% carried interests.183
Moreover, it is interesting to note that certain changes have been
evolving among hedge funds as a result of the shock to the industry
brought about by the 2008 financial crisis. According to Job Search
Digest’s 2010 Hedge Fund Compensation Report, many funds are
contemplating a new form of partnership with their LPs in exchange for
money being locked in for a longer period of time.184 For this purpose,
they will, among other things, charge the incentive fee in two or
threeyear rolling cycles as opposed to the current norm of annual or
semiannual payment. In this respect, the hedge fund industry’s compensation
structure is also partially converging toward that of the private equity
Although making perfect sense within a private equity context
where long-horizon investments and lack of liquidity are the norm, the
arrangement that carried interest is only payable upon the investors’
recoupment of their contributed capital might not be an ideal solution to
incentivizing hedge funds managers. Hedge fund incentive fees are often
viewed as having option-like characteristics.186 Incentive fees are earned
181. See supra note 167 and the accompanying text.
182. Indeed, it has been submitted that Chinese hedge funds in general still lack the
ability to maintain a relatively stable level of high returns. Rather, their NAV curves are
quite volatile, which is also a result of the high volatility of the Chinese stock market.
See Zhang, Reward for Reputation, supra note 150.
183. TOLL, supra note 151, at 51.
184. Job Search Digest, The 2010 Hedge Fund Compensation Report 11 (2010) (on
file with author).
186. See, e.g., Carl Ackermann et al., The Performance of Hedge Funds: Risk,
Return and Incentives, 54 J. OF FIN. 833, 840 (1999); see also William N. Goetzmann et
when the fund’s performance exceeds a high-water mark, which is
analogous to a call option with the high-water mark as the strike price.
Managers are incentivized to work hard and keep the fund value above
the high-water mark in order to assure that their incentive options will
finish in the money.187 However, if they can only exercise their options
at the end of the game, but not periodically throughout the life of the
fund, their incentives are dampened. Opportunistic fund managers may
fail to manage their funds diligently until they approach the end of their
terms. For example, if they lose money during a certain period, they
may feel a less urgent need to adjust their trading strategy to stop the
losses and recoup some of their losses as soon as possible, as they will
not be rewarded even if they indeed manage to make money for the next
period and there is enough time to try out before the end of fund term
anyway. Alternatively, they could choose to comfortably maintain a
conservative trading strategy so that they can secure a modest
compensation at the termination. Either way, it is unlikely that fund
managers will constantly exert their best efforts to maximize the net
asset value when running the fund. This is apparently not in the best
interest of the investors. Different from private equity, the primary focus
of hedge funds on active short term trading of public securities requires
fund managers to actively monitor the market and work consistently to
trade in and out; otherwise many money-making or loss-stopping
opportunities may be missed in the blink of an eye. In this respect, the
one-time-at-termination compensation system may work poorly despite
its well-meant intention.
Regardless of the real motive for regulators to impose such
apparently strange requirements, the rules are already promulgated and
industry players should comply. It would thus be natural to predict that
funds created as of February 2009, the effectuation date of the
Guidelines on Running the Business of Securities Investment Trusts by
Trust Companies, should have complied by changing the language of
their compensation clauses to allow payment of flexible fees only upon
termination. This is because performance-based compensation can only
al., supra note 33, at 1687; James E. Hodder & Jens Carsten Jackwerth, Incentive
Contracts and Hedge Fund Management, 42 J. FIN. & QUANTITATIVE ANALYSIS 811,
187. Hodder & Jackwerth, supra note 186.
be paid at the termination of a profitable trust pursuant to the
regulation. 188 However, a look at the contracts in my sample—
recognizing the limited nature of the sample 189 —does not seem to
support such a prediction. Only one unstructured fund190 out of the 55
fund contracts that (a) were dated prior to or in February 2009 and (b)
contained information on trust company and/or investment adviser
compensation stipulated for compensation payment upon termination.
After this cut-off point, only two unstructured funds191 out of 27 fund
contracts that were (a) dated after February 2009 and (b) contained
information on trust company and/or investment adviser compensation
stipulated for compensation payment upon termination.192 Given such an
apparently low rate of compliance with the February 2009 regulations,
one may wonder what strategies trust companies and investment
advisers might have crafted to adapt to the unfavorable legal
requirements. As far as my sample shows, four strategies can be
1. Temporarily No Performance-Based Compensation; to be
Resumed if Allowed by Law in the Future
The point of this strategy is that once the ban is lifted by a new law
and the fund managers (trust company and investment adviser) are
188. See supra notes 165-67.
189. See supra Parts III.A, III.B for a discussion of the limitations of the sample.
The reader is reminded that the sample consists of unexecuted documents obtained
from online sources, and that the sample covers approximately one-sixth of the
sunshine funds listed in the Go-Goal database as of August 9, 2010.
190. I only refer to unstructured funds here because structured fund fees are
normally paid at termination with or without the 2009 regulation in place, given that
these funds normally only have less than five years of life by their design anyway, see
supra note 124. The name of this unstructured fund is Western Trust Cheng Nuo No. 1.
191. The two funds are: CRTrust Xin Lan Rui No. 2 and XMITIC Puer Qilin.
192. Among the 27 funds, there is one fund, namely, SZITIC Tong Wei No. 1, that
did not seem to adopt any particular strategy to mitigate against unfavorable regulations.
Arguably, I would not consider this a case of non-compliance, because the fund was
officially set up in March 2009. Normally, it would take some time before fund
managers could raise enough capital from investors and then officially set up a fund.
Therefore, the March establishment of SZITIC Tong Wei No. 1 very likely shows that
the trust documents were already executed by investors earlier than February 2009, thus
making the regulation not applicable to the fund.
allowed to charge fees periodically again, the new fees to be charged
then will be substantially raised to make up for the previous loss of fees.
This strategy has been adopted by one fund.193
2. Trust Companies’ Fixed Fees and Flexible Compensation
Combined Together and Called “Trust Management Fee”;
Investment Advisers’ Flexible Incentive Fees Received as “Special Trust Interests”
Although this strategy sounds like a “words game,” it has been
employed by seven funds.194 The rationale behind this strategy is quite
straightforward. Previously, trust companies’ compensation was usually
expressed as consisting of two portions, namely, a fixed fee (in most
cases 1%) and a performance-based compensation (in most cases 3%, as
shown in Table 11, above). Since the requirement in the 2009 regulation
only limits the payment of performance-based compensation and not the
fixed part,195 the limitations can be circumvented if the trust company is
only going to receive a fixed fee and not flexible one. As such, what
these seven funds did was to increase the level of the fixed management
fee, effectively covering the flexible fee. The investment adviser will
share with the trust company the fixed fee, without charging a
performance-based “fee” in exchange for its “investment advisory
services.” What it will receive is the so-called “special trust interest” as
a result of its identity as the “special beneficiary” of the sunshine fund.
There is usually one clause at the very beginning of fund contracts that
requires fund investors to agree to appoint the investment adviser as the
“special beneficiary.” This appointment, coupled with the fact that an
investment adviser is usually required to contribute and hold at least 10%
of the fund’s capital, will fortify its right to receive “special trust
interests.” These trust interests are special in that they are paid more
frequently, such as monthly or quarterly, are paid based on high water
mark, and are paid prior to the receipt by normal investors of their
“ordinary trust interests.” Essentially, this arrangement resembles the
193. This fund is called Ping An Fortune Tong Wei No. 1.
194. These seven funds are: SZITIC He Ying Fine Selection No.1, SZITIC Zhi
Cheng No. 2, No. 3, No.4 and No. 5, SZITIC Hengda Tonghui No. 1, and FOTIC
Steady Value Increase (Yongsheng Huiyuan).
195. See supra note 166 and accompanying text.
old incentive-based fees, but adapts to the regulatory change by using a
It is worth pointing out that, although the “special trust interests”
arrangement looks more sophisticated than the idea of an
“encompassing management fee,” it is actually not new to Chinese
hedge funds. As far as I can see in my sample, the earliest contract
adopting a “special trust interests” arrangement is PureHeart China
Growth I Fund, established in May 2006 by Ping An Trust. The earlier
two funds managed by the same investment adviser, including China’s
very first hedge fund, PureHeart Fund, established in February 2004 by
SZITIC, used the direct wording of “performance-based compensation.”
It is not clear at this point why the third fund managed by the same
adviser used different treatment on this issue than its previous two
counterparts. A reasonable deduction may be that the name “special
trust interest” sounds milder to investors and fits better into the “trust”
context. After all, the hedge fund business was and still is novel in
China, and Chinese investors might find it difficult to accept that
someone can share as much as almost 20% of their profits simply by
providing “investment advice” to their trustee. Regardless, such an
arrangement apparently worked to mitigate the impact of the 2009 new
regulation on China’s hedge fund industry; otherwise the consequences
might have been much more severe. A related interesting finding is how
this arrangement has been made more sophisticated alongside the
development of sunshine funds. A typical variation to the original
“special beneficiary” treatment would give an investment adviser the
status of a “principal” of the trust, where it is appointed as the
“representative of all principals” by all the other investors by entering
into the contract. As such, the trust company has the obligation to
consult and listen to the “principals’ representative” in managing the
fund, and the investment adviser thus receives its “special trust interest”
based on such status and work.
3. Trust Company Designated Together with Investment Adviser as
Special Beneficiary to Share Special Trust Interests
The third alternative is based on a similar rationale as the second
one but the twist is elsewhere. Under this strategy, investors designate
both the investment adviser and the trust company as the special
beneficiaries of the sunshine trust fund. Since special trust interests can
be paid much more frequently as long as the fund’s new profits exceeds
its high water mark, this solves the problem posed by the 2009 new
regulation that a trust company is only able to receive its flexible
compensation as of fund termination. Two funds have adopted this
4. Flexible Fees Payable Upon Investors’ Redemption
This is a partial compliance strategy, but nonetheless based on
reasonable grounds. After all, the trust company and investment adviser
will not be able to get their fees if their investors have already left the
fund by redemption. This strategy has been adopted by two funds.197
With these strategies adopted by Chinese sunshine funds, as
discussed above, it is no longer a mystery why the compliance rate for
the “flexible compensation payment upon fund termination”
requirement, as stipulated in the regulation promulgated in 2009198 is so
low at first sight. Chinese hedge funds emerged by borrowing from
foreign experience, but they grew with their own characteristics from
the very first day. They have shown remarkable competence to
overcome unfavorable regulatory limitations and find new ways for
further development of the business. Of course, it remains to be seen
how the regulatory authorities will react to these apparent circumvention
strategies of sunshine funds, and, more generally, how Chinese
regulatory authorities are going to define their role in the regulation of
hedge funds. New and interesting findings may be generated by further
research when the industry is more mature structurally and when the
regulatory framework is more developed.
While the hedge funds industry is already a trillion dollar business
in the developed world, it is still in its infancy stage in China. Organized
as trusts, Chinese hedge funds take drastically different business forms
than LPs, making it more difficult for researchers to understand them.
This is a very interesting area that has not been researched thoroughly,
These two funds are: CITIC He Ju No. 1, and CITIC He Ying No. 1.
These two funds are CQITIC Chuan Shi No. 1, and ZRTrust Hun Dun No. 2.
See supra notes 165-67.
and this article is, to my knowledge, the first research exploring the
contractual arrangements of Chinese hedge fund agreements.
Using 139 contracts and explanations of trust plans of sunshine
funds collected by hand based on the list of securities investment trusts
provided by Go-Goal database, this article analyzed the structure,
covenants, and compensation mechanisms of sunshine funds. They have
been organized as trusts primarily because private fund managers cannot
legally pool capital from investors, and a trust was thus far the most
appropriate platform offered under the Chinese regulatory framework
for that purpose. As the article demonstrates, on the one hand, sunshine
funds do have similar contractual arrangements as typical LP-organized
hedge funds, such as charging, on top of a fixed management fee, a
performance-based compensation, which also largely cluster at 20%. On
the other hand, they are also undeniably different from LP-organized
hedge funds, due to jurisdiction-specific characteristics of China. The
most crucial difference is the involvement of the trust company in the
fund. Normally, it is merely a transaction executor responsible for
carrying out investment orders from the investment adviser. The trust
company also shares with the investment adviser a small portion of
performance-based compensation in exchange for such services to the
fund. However, because relying on trust companies has been the only
practical way for Chinese hedge fund managers to conduct the business,
and trust companies are the real contractual parties signing the trust
contracts with investors, investment advisers also need to accept certain
conditions that are much more stringent than mere profit sharing, such
as a higher level of fund manager capital contribution and narrowed
decision making power. Typically, an investment adviser (de facto
manager) to a sunshine fund in China is required to contribute or hold at
least 10% of the fund’s total assets. If a fund fails to perform well, the
trust company retains the power to sell all of the fund’s assets and
terminate the fund without consulting with the investment adviser.
Although harsh and even incentive dampening, these
Chinaspecific covenants and arrangements in sunshine funds contracts are
unlikely to be eliminated as long as trust companies remain involved.
This is because trust companies require some measures to protect their
pecuniary interests and reputational capital from being hurt as a result of
acting as a direct contractual party with investors. Moreover, given the
deep-rooted influence of civil law tradition and that hedge funds are still
mostly unheard of, Chinese investors may find it difficult to accept
certain highly contractual arrangements. Rather, they would prefer
1. Frank Partnoy & Randall S. Thomas, Gap Filling , Hedge Funds, and Financial Innovation, in BROOKINGS-NOMURA PAPERS ON FINANCIAL SERVICES , 23 ( Yasuki Fuchita & Robert E. Litan eds., 2007 ), available at http://ssrn.com/paper=931254.
2. Houman B. Shadab , Coming Together After the Crisis: Global Convergence of Private Equity and Hedge Funds , 29 NW. J. INT'L L . & BUS . 603 , 608 ( 2009 ).
3. Hedge Fund Standards Board , The Hedge Fund Sector: History and Present Context, HFSB .ORG, http://www.hfsb.org/sites/10109/files/what_is_ a_hedge_fund . pdf (last visited Nov. 4 , 2010 ).
27. JOSEPH G. NICHOLAS, INVESTING IN HEDGE FUNDS , REVISED AND UPDATED EDITION 16-17 ( 2005 ).
28. Id . at 39. See also Jacob Preiserowicz, supra note 15 , at 811.
29. Id . at 40.
30. NAVENDU P. VASAVADA , TAXATION OF U.S. INVESTMENT PARTNERSHIPS AND HEDGE FUNDS: ACCOUNTING POLICIES , TAX ALLOCATIONS , AND PERFORMANCE PRESENTATION 5 ( 2010 ).
31. Simon Friedman , Partnership Capital Accounts and Their Discontents , 2 N.Y.U. J.L. & BUS . 791 , 798 ( 2006 ).
32. See Victor Fleischer , Two and Twenty: Taxing Partnership Profits in Private Equity Funds , 83 N.Y.U. L. REV. 1 ( 2008 ) ; see also Friedman, supra note 31 . OF CORPORATE & FINANCIAL LAW 37 . Douglas J. Cumming & Na Dai , A Law and Finance Analysis of Hedge Funds, 39 FIN . MGMT. 997 , 1001 ( 2010 ).
38. Id . at 1001-1003.
39. See Cumming & Dai, supra note 37.
40. Id .
41. See MCCAHERY & VERMEULEN, supra note 35, at 172.
42. Josh Lerner & Antoinette Schoar , The Illiquidity Puzzle: Theory and Evidence from Private Equity, 72 J. FIN. ECON. 3 , 7 ( 2004 ).
43. Douglas Cumming & Uwe Walz , Private Equity Returns and Disclosure Around the World , 41 J. INT'L BUS. STUD . 727 , 728 ( 2010 ).
44. Ludovic Phalippou & Oliver Gottschalg , The Performance of Private Equity Funds, 22 REV. FINANC. STUD . 1747 , 1750 ( 2009 ).
48. See id. at 470.
49. See id. at 488.
50. Id . at 496.
51. Id . at 464.
52. Id . at 493.
53. See Daniel Schmidt & Mark Wahrenburg, Contractual Relations Between European VC Funds and Investors: The Impact of Bargaining Power and Reputation on Contractual Design (Risk Capital and the Financing of European Initiative Firms , Working Paper No. 8 , 2004 ), available at http://www2.lse.ac.uk/fmg/research/RICAFE /pdf/RICAFE-WP08-Schmidt.pdf.
54. Id .
55. Id . at 3-4.
56. Id . at 4.
161. See Guidelines on Running the Business of Securities Investment Trusts by Trust Companies, supra note 25, art . 22 .
162. See Measures for Administration of Trust Companies, supra note 142, art . 10 .
163. Josh Lerner & Antoinette Schoar , Does Legal Enforcement Affect Financial Transactions? The Contractual Channel in Private Equity , 120 Q.J. ECON. 223 ( 2005 ).
164. Id . at 223.