Venture Capital Funds in Hong Kong: Legal Structure, Regulation, and Fund Terms

Introduction

Venture capital has emerged as a critical component of Hong Kong's financial ecosystem, supporting the development of the city's technology and innovation sector and providing a bridge between Hong Kong's deep capital markets and the vibrant startup ecosystems of Greater China and Southeast Asia. While Hong Kong has traditionally been more associated with private equity, listed equities, and fixed income, the government and regulators have taken deliberate steps in recent years to position Hong Kong as a competitive location for venture capital funds, including through the introduction of the Limited Partnership Fund (LPF) Ordinance in 2020 and targeted tax concessions for qualifying funds.

For general partners (GPs) considering establishing a venture capital fund in Hong Kong and for limited partners (LPs) considering investing in Hong Kong-domiciled venture funds, understanding the legal structure, regulatory requirements, and key fund terms applicable to Hong Kong venture capital funds is essential. This article provides a comprehensive overview of these topics, with particular focus on the choice of fund structure, SFC licensing requirements, and the key terms that investors and managers negotiate in a typical venture capital fund.

The Hong Kong Venture Capital Market

Hong Kong's venture capital market has grown significantly over the past decade, driven by the city's proximity to mainland China's technology sector, its status as Asia's premier capital markets hub, and the government's active promotion of innovation and technology. The Investment and Innovation Hub initiative and the dedicated InnoHub programme have attracted a range of international and regional venture capital managers to establish operations in Hong Kong.

The LP base for Hong Kong venture funds is diverse, drawing on sovereign wealth funds from the Middle East and Southeast Asia, family offices based in Hong Kong and Singapore, institutional investors (including insurance companies and pension funds), fund of funds, and, increasingly, government-backed co-investment vehicles such as the Innovation and Technology Venture Fund (ITVF).

Choosing the Right Fund Structure

The first decision for a VC fund manager is where and how to domicile the fund. The principal options are:

Hong Kong Limited Partnership Fund (LPF)

The LPF, introduced under the Limited Partnership Fund Ordinance (Cap. 637) in 2020, is a purpose-built fund vehicle available in Hong Kong. An LPF is a limited partnership registered with the Companies Registry in Hong Kong, with at least one general partner (who manages the fund and has unlimited liability) and one or more limited partners (who contribute capital and have limited liability). The LPF can be established quickly and at relatively low cost, and it benefits from Hong Kong's well-developed legal system and its network of double tax treaties.

A key advantage of the LPF for venture capital is the availability of the Unified Fund Exemption from Hong Kong profits tax for qualifying funds, including LPFs that meet the applicable conditions. The LPF has gained increasing traction with local and regional fund managers since its introduction and is now a viable alternative to offshore domiciles for many funds targeting Asian investment opportunities.

Cayman Islands Exempted Limited Partnership

The Cayman Islands exempted limited partnership (ELP) remains the dominant fund vehicle for international private equity and venture capital funds targeting Asian investments. Most major international VC funds that invest in Hong Kong and mainland China are domiciled in the Cayman Islands, primarily because of Cayman's long-established track record as an offshore fund jurisdiction, the familiarity of institutional LPs with the Cayman structure, and the extensive body of Cayman fund precedent. The Cayman ELP is managed from Hong Kong under the SFC's licensing framework.

Open-Ended Fund Company (OFC)

The OFC is a corporate fund vehicle introduced in Hong Kong in 2018. While the OFC is more commonly used for open-ended investment funds (such as mutual funds and ETFs), it can in principle be used for closed-ended private equity and venture capital funds. However, the OFC is less commonly used for VC funds than the LPF or Cayman ELP, primarily because the limited partnership structure is more natural for the closed-ended, carried interest-based economics of a VC fund.

SFC Licensing Requirements

The management of a venture capital fund in Hong Kong typically requires SFC licensing if the fund manager provides services to third-party LPs. Specifically:

• Type 9 (Asset Management): A VC fund manager that manages a portfolio of investments on behalf of the fund (whether in securities or other assets) will typically require a Type 9 licence. This is the most common licence required for VC fund managers in Hong Kong.
• Type 4 (Advising on Securities): Where the fund manager provides investment advice on securities to the fund or to investors, a Type 4 licence may also be required.
• Type 1 (Dealing in Securities): Where the fund manager executes trades on behalf of the fund, a Type 1 licence may be required, although in practice most VC managers execute trades through licensed brokers.

The SFC's licensing requirements include fit and proper standards for the management company and its responsible officers, capital adequacy requirements, compliance and risk management obligations, and ongoing regulatory reporting and disclosure duties. New applicants should allow several months for the licensing process and engage experienced regulatory counsel to assist with the application.

Venture Capital Manager Exemption

Importantly, the Securities and Futures Ordinance provides an exemption from licensing for managers of certain qualifying venture capital funds. The exemption applies to managers of funds that invest solely in "qualifying investments" (broadly, equity and equity-linked securities in private companies) provided certain conditions are met. VC fund managers who qualify for this exemption are not required to hold an SFC licence to manage the qualifying fund, but they must register with the SFC and comply with certain conduct and reporting obligations. The exemption has been used by a number of smaller VC managers to operate in Hong Kong without the full burden of SFC licensing.

Key Fund Terms

The terms of a venture capital fund are set out in the fund's limited partnership agreement (LPA) or constitutional documents and, for many funds, a side letter programme that grants specific terms to particular LPs. Key fund terms include:

Fund Size and Investment Period

VC funds typically have a defined investment period (usually three to five years) during which new investments are made, and a fund life of around ten years (with possible extensions of one to two years). Fund sizes vary widely, from small seed funds of a few tens of millions of dollars to growth-stage funds of several hundred million dollars or more.

Management Fees

Management fees are typically charged at 1.5% to 2% of committed capital during the investment period and at 1% to 1.5% of net asset value or invested capital during the harvest period. Management fees fund the ongoing operational expenses of the fund manager. Institutional LPs increasingly push for management fee discounts and operational expense transparency.

Carried Interest

Carried interest is the GP's share of fund profits, typically set at 20% of profits above a specified hurdle rate (usually 8% per annum). Carried interest is calculated either on a deal-by-deal basis (which favours the GP) or on a whole-fund basis (which favours the LP). The whole-fund carry model is more prevalent in institutional VC funds. The carried interest waterfall — the order in which profits are distributed to LPs and the GP — is one of the most heavily negotiated aspects of VC fund documentation.

Clawback

A clawback provision requires the GP to return carried interest received in respect of early profitable investments if, at the end of the fund's life, the LP has not received the return of its capital plus its preferred return. Clawbacks protect LPs from overpayment of carried interest and are a standard feature of institutional VC fund terms.

Key Person Provisions

Key person provisions protect LPs from management disruption by requiring that specified key executives of the fund manager remain actively involved in the fund. If a key person departs (or ceases to devote the requisite time to the fund), the investment period may be suspended and, in some cases, LPs may be entitled to remove the GP or wind down the fund.

LP Advisory Committee

The LP advisory committee (LPAC) is a governance body comprising representatives of the fund's major LPs. The LPAC approves conflicts of interest, provides consent for material amendments to the LPA, and in some cases provides approval for specific investment decisions. The LPAC is an important investor protection mechanism in VC funds.

Conclusion

Hong Kong has positioned itself as a competitive location for venture capital funds, with purpose-built fund vehicles (the LPF), a favourable tax environment, and an experienced regulatory regime. For VC managers considering Hong Kong as a domicile or management location, the combination of legal infrastructure, regulatory expertise, and proximity to the Asian technology ecosystem makes it an attractive proposition.

For LPs investing in Hong Kong venture funds, the key considerations are fund structure, management quality, fund terms, and regulatory compliance. Engaging experienced fund formation and regulatory counsel is essential to navigating the legal and regulatory landscape effectively and to ensuring that a VC fund is structured in a manner that meets the expectations of institutional investors and complies with all applicable regulatory requirements.