The last year has seen tremendous changes in the investment fund industry of China.
In regards to the onshore fund market:
- the implementation of the Guiding Opinion on Regulating the Asset Management Business of Financial Institutions (Guiding Opinion) adversely influences the fund raising process and shrinks the fund scale in the investment fund market; and
- a series of newly released regulations and policies symbolises the latest regulatory emphasis on non-standardised debt assets investment.
In regards to offshore fund investment:
- an offshore fund manager of equity investment funds invested by a domestic insurance institution is obliged to complete information reports in the Equity Investment Information Reporting System;
- it is interpreted that prior approval from the National Development and Reform Commission (NDRC) for offshore fund investment of insurance institutions is a necessity under current outbound investment regulation; and
- the Shanghai Qualified Domestic Limited Partners Pilot Scheme (Shanghai QDLP Pilot Scheme) and the Shenzhen Qualified Domestic Investment Enterprise Pilot Scheme (Shenzhen QDIE Pilot Scheme) were granted with new quotas for outbound fund investment.
Overview of the Onshore Fund Market
Impact of guiding opinion
In China, various financial regulators, including the People’s Bank of China (PBOC), the China Banking and Insurance Regulatory Commission (CBIRC), the China Securities Regulatory Commission (CSRC) and the State Administration of Foreign Exchange (SAFE) respectively regulate different sectors of financial institutions and their asset management products by applying different regulatory requirements, which resulted in regulatory chaos or gaps leading to inevitable regulatory arbitrage. With ever-growing prosperity in the asset management business of financial institutions and a noteworthy surge in the scale of assets under management, the PBOC, CBIRC and CSRC have aligned with SAFE issued Guiding Opinion in April 2018 in order to unify the regulatory standards regarding the asset management business. Based on the oral response of the Asset Management Association of China (AMAC), a self-disciplinary organisation functioning in a way similar to the regulator of private investment funds (accessible to wholesale investors only) in China, the Guiding Opinion at this stage is not applicable to private investment funds and the AMAC is working on the detailed implementing rules.
However, the Guiding Opinion is perceived as the major reason for substantial decline of fund-raising in 2018. According to the updated statistics of Zero2IPO Research, as of November 2018, the amount of funds raised in the private equity fund market was barely close to RMB910.8 billion, which declined almost by 50% as compared with 2017. The Guiding Opinion impacts the fund-raising of investment funds in the following aspects.
- Funds pool – before the Guiding Opinion, a major funding source of investment funds was the asset management products managed by commercial banks (Bank Products), which may be further categorised into public Bank Products (accessible to retail investors and wholesale investors), and private Bank Products (accessible to wholesale investors only). Instead of linking a specific Bank Product with specific underlying assets, usually the funds of various Bank Products were pooled together for making different types of investments, including investments in investment funds, and the liquidity of the pool is supported by new funds from new Bank Products, which may be used as the return of previous Bank Products. In this way, short-term Bank Products may provide funding for long-term fund investments etc. This is not a safe model for asset management. According to the Guiding Opinion, these funds pools are not allowed and commercial banks shall take action to decrease the size of existing funds pools so that, by the year 2020, the overall Bank Products are in line with the regulatory requirements of the Guiding Opinion and each specific Bank Product shall be linked to specific underlying assets, which means no funds pool is allowed after 2020.
- Multiple Layers of Asset Management Products – in retrospect, Bank Products used to be invested in investment funds through other asset management products, such as investment trusts, etc, where three layers of asset management products are involved, ie, the Bank Product, the investment trust and the investment fund. Pursuant to the Guiding Opinion, up to two layers of asset management products are allowed, which also makes it more difficult to seek funding from Bank Products.
- Investment Restriction on Public Bank Products – the Guiding Opinion also prohibits public Bank Products from investing into private equity, which is read as including private equity funds, while public Bank Products account for the majority of all Bank Products.
- Prohibition of Guaranteed Return for Investors – some of the asset management products of financial institutions, including Bank Products, and the private investment funds may have certain explicit or implied arrangements of guaranteed minimum returns for their investors, which sometimes is the key consideration of investors. The Guiding Opinion prohibits these guarantees of return, which applies to the asset management products of financial institutions, and the AMAC sets similar standards for private investment funds.
Restriction on non-standardised debt assets investment
The Guiding Opinion characterises standardised debt assets as:
- in equal units and tradable;
- sufficient information disclosure;
- collectively registered and with independent custody;
- with a fair price and sound liquidity; and
- traded in exchanges approved by the State Council, such as the inter-bank exchange and securities exchange.
Debt assets falling outside of the scope of standardised debt assets shall be non-standardised debt assets. This means a majority of the investments made by private credit funds shall be deemed as non-standardised debt assets.
The interest rate of bank loans is highly regulated and relatively low, which may not be enough to match the risks of lending to borrowers without sufficient creditworthiness or collaterals. Non-standardised debt assets with more flexible and usually higher interest rates play an important role in financing those borrowers. However, non-standardised assets have been under increasing scrutiny and regulation due to a lack of transparency, high leverage and regulatory arbitrage.
- Prohibition of new Private Credit Fund – private fund managers are classified by AMAC as a (i) “private securities fund manager”, (ii) “private equity fund manager”, (iii) “private VC fund manager” and (iv) “private alternative fund manager.” Previously, private alternative fund managers may raise and manage private credit funds. However, AMAC suspended the registration of new “private alternative fund managers” and the filing of private credit funds raised by existing private alternative fund managers, which effectively prohibits the formation of new private credit funds. Having said that, private equity funds are still allowed to invest in a convertible bond/loan, which may be converted into equity.
- Restriction on Entrustment Loan Business – private credit funds usually provide loans to the borrower through a bank, which is a unique arrangement in China, named as an entrustment loan. An entrustment loan arrangement may enhance the enforceability of the loan and enable the registration of a real estate mortgage for the loan. Nonetheless, CBIRC issued Measures for the Administration of Entrustment Loans of Commercial Banks on 5 January 2018, pursuant to which banks are prohibited from participating in entrustment loan for private credit funds.
- Trend of relaxation on regulation – according to the Guiding Opinion, public Bank Products shall mainly invest into standardised debt assets and listed shares, without mentioning non-standardised debt assets. However, in the Notice of Further Clarifying Relevant Matters regarding Guiding Opinion on Regulating the Asset Management Business of Financial Institutions issued by PBOC later on 20 July 2018, public Bank Products are expressly allowed to invest into non-standardised debt assets. On 13 December 2018, Yi Gang, chairman of the PBOC, appeared at the Changan Forum and recognised the contribution of shadow banking by describing shadow banking as an essential supplement to China’s financial markets, indicating a possible switch of attitude towards regulating shadow banking as well as non-standardised debt assets, given that non-standardised debt assets are a key element of shadow banking.
Development in Offshore Fund Investment
Information disclosure obligation of offshore fund manager
The burden of information disclosure obligations on an offshore fund manager managing equity investment funds invested by Chinese insurance institutions has been relatively aggravated since the application of the Equity Investment Information Reporting System (the System), a brand new information reporting system developed by Insurance Asset Management Association of China (IAMAC). Pursuant to the Notice on Further Strengthening Supervision on Post-report of Equity Investment of Insurance Assets and Supervision on Information Reporting regarding Equity Investment by Insurance Assets issued by the Insurance Assets Operation Supervision Department of CBIRC, information to be reported by an offshore fund manager includes:
- an investment report;
- an operation and management report;
- a report regarding major events and changes; and
- a liquidation report.
These reports shall be fulfilled in the System within a required time limit in sequence and delivered to domestic insurance institutions (ie, the investor of the offshore fund), which is obliged to urge fund managers on reports delivery, for review before submitting to IAMAC. Failure to fulfil the information reporting obligation as required may be questioned, publicly criticised or even added into a blacklist by the CBIRC. Fund managers in a blacklist shall not manage insurance assets or provide services for equity investment of insurance assets for three years.
Offshore fund investment of insurance institutions
- Offshore Fund Investment via QDII Scheme – QDII scheme stands for qualified domestic institutional investor scheme, under which domestic investors are allowed to make outbound investments into specified categories of assets within the related foreign exchange quota, ie, QDII quota. Interim Measures on the Administration of Overseas Investments of Insurance Assets (the Interim Measures) and its implementing rules constitute the basic regulatory framework of the QDII scheme for insurance institutions, under which domestic insurance companies are permitted to invest into three types of offshore funds, including a securities investment fund, an equity investment fund and a real estate investment trust. Based on the data publicised by SAFE in April 2018, the amount of QDII quota increased by USD8.34 billion to USD98.33 billion, which is reported to be the first increase in the last three years. Up to 29 December 2018, the total QDII quota amounted to USD103.23 billion, among which USD33.95 billion was granted to insurance institutions.
- Updated Regulatory Requirements on Outbound Fund Investment – on 1 March 2018, the Administrative Measures for Enterprise Outbound Investment (Order No 11) issued by NDRC came into force. Under Order No 11, projects involving sensitive countries and regions or sensitive industries (Sensitive Projects) are subject to the prior approval of NDRC while non-sensitive projects are simply required to be filed with or notified to NDRC, otherwise to be exempted. The Catalogue of Sensitive Industry for Outbound Investment issued by NDRC further supplements the list of sensitive industries to include offshore equity investment funds or investment platforms without specific underlying industrial projects. Before Order No 11, outbound fund investment may be conducted by an insurance institution within its QDII quota after completing the filing with CBIRC, but without the necessity of obtaining the approval of the NDRC. Order No 11 requires the approval of the NDRC for these fund investments, but with few precedents, there exists substantial uncertainty in obtaining the approval.
Grant of new QDLP and QDIE quota
Serving as part of China’s financial market opening-up, in April 2018, SAFE announced an increase of the quota to USD5 billion for two outbound investments pilot schemes (ie, the Shanghai QDLP Pilot Scheme and Shenzhen QDIE Pilot Scheme) respectively. Both schemes allow qualified domestic vehicles to raise funds directly from Chinese investors and invest into international markets.
- Introduction to Shanghai QDLP Pilot Scheme – last year, Shanghai updated the Shanghai QDLP Pilot Scheme in place of the one implemented since 2013, allowing qualified domestic private funds established in Shanghai (QDLP Fund) to invest into overseas markets, which may include offshore private equity funds and hedge funds. Under the Shanghai QDLP Pilot Scheme, an onshore investment management enterprise shall be set up in Shanghai to act as the investment fund manager (QDLP Onshore Fund Manager) of a QDLP Fund. Upon the approval of the Shanghai Financial Service Office, the Onshore Fund Manager can act as the general partner/fund manager to launch a QDLP Fund. The QDLP Fund could be established either in the form of a limited partnership or a contractual fund. Upon the establishment of the QDLP Fund, the Onshore Fund Manager shall apply for the quota for outbound investment. The QDLP Fund may, within the QDLP quota, convert RMB to foreign currency at its custodian bank and invest into the overseas market, including private equity funds and hedge funds.
- Introduction to Shenzhen QDIE Pilot Scheme – Shenzhen launched the so-called QDIE Pilot Scheme, ie, the Implementing Measures of the Overseas Investment by Qualified Domestic Investors Pilot Scheme (the Implementing Measures) dated back to 2014, which is similar to the Shanghai QDLP Pilot Scheme. There is no explicit provision regarding the investment target of the onshore RMB fund established in accordance with the Implementing Measures (QDIE Fund), and in theory, the QDIE Fund is allowed to invest in offshore private equity funds and hedge funds, but private equity funds may be difficult according to recent practice.
Trend of 2019
Considering the impact of the Guiding Opinion and other factors, the investment fund industry of China is expected to feature the following trends in 2019: state-owned companies and insurance companies may become the major sources of institutional investors for investment funds; top-tier fund managers may continue to succeed in raising successor funds and boutique fund managers with specific industrial expertise may still find their way of seeking commitments, while a substantial portion of other fund managers may face difficulty in fund-raising and some of them may disappear; and industrial players (such as medical companies, real estate companies, etc) may try to raise their own investment funds due to the shortness of liquidity in general.