Given the increasing importance of gaining exposure to investments in mainland China the purpose of this client briefing is to consider the type of Irish funds that are best suited to be established as China A Shares funds and the rules that apply to funds investing in China A Shares funds.
The China A Shares market
In the past many Irish funds wishing to gain exposure to Chinese issuers did so typically by investing in the securities of Chinese issuers listed in Hong Kong or by investing in the B shares of issuers listed on mainland China's two stock exchanges in Shanghai and Shenzhen. The B share market is only open to foreign investors and B shares are not denominated in Renminbi but in foreign currency, US dollars in Shanghai and Hong Kong dollars in Shenzhen. In 2003 the Chinese authorities introduced a scheme to encourage long term investment by overseas investors in its domestic securities market. The regime allows select foreign institutions, called Qualified Foreign Institutional Investors ("QFIIs"), to buy A shares which are the securities of Chinese issuers denominated in Renminbi and traded on the Shanghai and Shenzhen stock exchanges.
The QFII rules allow foreign investors (such as fund management companies, banks and insurance companies) to apply for approval to invest a certain specified amount or quota in the Chinese domestic securities market. An applicant needs to satisfy certain criteria, including, among other things, evidence of experience and a threshold level of assets under management or capitalisation. Although the QFII regime opened up China's stock market to foreign investors there are rules in place that restrict both inflows and outflows of foreign capital from the country. Any investment by a QFII investor is subject to detailed rules on remittance and repatriation which if not adhered to may lead to the revocation of the quota allotted to the QFII investor. The rules pose difficulties for fund managers operating open-ended funds which need to be taken into account when structuring funds.
Investment managers have shown considerable interest in seeking exposure to investments in the emerging markets recently and in particular mainland China. This is illustrated by the fact that the China Securities Regulatory Commission has now approved the QFII status for over 70 institutions with quotas placed under the programme amounting to US$30 billion. Not all types of Irish funds are suitable to invest a significant proportion of their assets in the China A Shares market using the QFII process and this memorandum examines some of the issues that need to be considered when establishing a fund that is to invest in China A Shares or when investing in such a fund.
Establishing a fund which invests in China A Shares UCITS
A UCITS fund is perhaps not the most suitable vehicle to invest principally in China A Shares. The constraints the QFII rules impose on remittance and repatriation are difficult to reconcile with the need for a UCITS to meet its liquidity requirements. The QFII rules, for example, only allow a QFII investor to repatriate cash from the realisation of the investment after an initial lock-up period of three months and thereafter the maximum amount that can be redeemed on a monthly basis must not exceed US$49 million. In order for a UCITS fund to deal at least once a fortnight (or more frequently) its investments must be liquid in that they must be capable of being realised at limited cost within a short settlement period. Given that a UCITS fund needs to provide at least fortnightly dealing the QFII restrictions are likely to prevent an Irish UCITS from investing any significant amount in China A Shares directly.
Also, although the general presumption is that if shares are listed on a regulated market they are deemed to meet the Financial Regulator's liquidity requirements, this presumption is rebutted where information is available that would lead the UCITS to determine that investment in a transferable security could compromise the ability of the fund to meet redemption requests. Consequently, in assessing a UCITS fund's liquidity risk it would be difficult to argue, taking into account the need for a UCITS to deal at least once a fortnight, that a fund investing principally in China A Shares meets the eligibility requirements.
PIF and QIF
Both the professional investor fund ("PIF") and the qualifying investor fund ("QIF") are the more suitable vehicles in which to launch a fund that invests principally in China A Shares. The choice as to the most appropriate vehicle - a PIF or a QIF - is for the promoter to decide depending on which form it prefers as the fund can be established in either form easily. Consideration should be given to the QFII investment restrictions, minimum investment period and repatriation of monies. Both a PIF and a QIF can have a lock-in period such as the three month lock-in required for all QFII investors. Redemptions in a PIF or a QIF can be monthly and each type of fund can have an extended settlement cycle of up to 90 or 95 days respectively. The lengthy settlement cycle may be particularly relevant given the Peoples Republic of China's ("PRC") prohibition on redemptions exceeding US$49 million in any one month. If the US$49 million redemption threshold is less than the usual 10% redemption gate threshold for a monthly dealing fund (which triggers the imposition of the redemption gate and the fund's ability to defer payments) the ability to pay out proceeds over a 90 or 95 day period could prove particularly useful.
Investors in a QIF must meet the qualifying investor criteria (by meeting certain thresholds relating to net worth in the case of an individual or the level of assets under management in the case of a legal entity) and also subscribe a minimum amount of €250,000. The advantage of a PIF compared with a QIF is that there are no certification requirements for investors relating to their status. However, investors in a PIF must also invest a minimum amount but it is only €125,000. In the case of a PIF the investment restrictions that apply to a retail fund are doubled. For example, in a PIF the maximum amount that can be invested with any one issuer is 20% of the fund's net asset value. In a QIF no such diversification limits apply and so the percentage invested in any one issuer could be as high as 40% of a fund's net asset value as the investment restrictions are set by the promoter on a case by case basis. Whilst the investment flexibility of a PIF is, however, somewhat limited compared to a QIF this does not appear to be relevant in this case as the PRC's diversification requirements are like those of a retail fund (such as the 10% diversification requirement per issuer) and sit easily within the PIF requirements.
Establishing a QIF is of course now subject to a much more streamlined approval process than any other type of Irish fund as it involves no prior review of the documentation by the Financial Regulator. Essentially a fund can be authorised on the day following the submission of the complete set of documentation to the Financial Regulator. The PIF approval process however typically involves the review of two or three drafts of the prospectus and the various key fund documents by the Financial Regulator over a six week period.
General prospectus disclosure
The QFII investment restrictions relating to the lock-up and the monthly threshold need to be disclosed in the prospectus of a fund investing directly or indirectly in China A Shares. The prospectus will further highlight the risks of investing in emerging markets generally and the risks specific to the Chinese market because of the People's Republic of China investment restrictions, minimum investment period and repatriation of monies. The QFII rules are likely to be subject to further adjustment and modification and this would need to be disclosed in the prospectus in a prominent way. The range of share issues in the Peoples Republic of China is limited compared to other markets and obviously there is a lower level of liquidity in these shares compared to other markets which may not only lead to price volatility but also difficulties when the UCITS fund investing in the China A Shares fund suffers significant redemptions.
Investing in a fund which invests in China A Shares
A fund can gain exposure to China A Shares by investing in another fund that itself has a significant investment in China A Shares.
A UCITS fund may invest in another fund that invests in China A Shares subject to certain conditions. A UCITS fund can only invest in other funds that are UCITS or akin to UCITS. Any non-UCITS fund in which a UCITS invests must therefore have the characteristics of a UCITS fund. The Financial Regulator sets out a list of approved categories of non-UCITS funds in which a UCITS can invest (such as a non-UCITS retail Irish fund or a Jersey recognised scheme, for example). An Irish PIF or a QIF is not included in this list. This means that in order for a UCITS to invest in a PIF or a QIF established as a China A Shares fund (other than through the "10% unlisted bucket" referred to below) a submission needs to be made to the Financial Regulator for it to consider whether the fund is an eligible investment. A range of characteristics need to be taken into account in making this determination. For the most part these factors would be satisfied in the case of a PIF or a QIF (such as, for example, the existence of an independent custodian, restrictions on related party dealings and the spreading of risk if the underlying fund's investment restrictions reflect the PRC's diversification rules of 10% per issuer). However, one of the key factors to determine whether a non-UCITS fund has the same characteristics as a UCITS fund is the redemption frequency of the non-UCITS fund. It would be difficult to argue that a China A Shares established as a PIF or a QIF which redeems less frequently than once a fortnight, has an initial three month lock-in period and also has a cap on the absolute level of redemptions on a monthly basis has the equivalent redemption facilities to that of a UCITS.
A UCITS fund may however invest in a China A Shares fund within a different category of investment. A UCITS may invest up to 10% of its net assets in unlisted securities. Until relatively recently investments in this "10% unlisted bucket" (as it is commonly known) had been interpreted in a restrictive way. The Financial Regulator reconsidered its interpretation of this category of investment and has confirmed that a UCITS is permitted to invest up to 10% of its net assets in a broader range of investments, including unregulated funds, provided that the investments comply with the eligibility criteria for UCITS. Consequently, as long as an investment by a UCITS in a China A Shares PIF or QIF is less than 10% of its net asset value, a UCITS fund may be able to invest in the fund notwithstanding the fact that it does not meet the criteria set out in the Financial Regulator's guidance note on acceptable investments in funds.
However, if a UCITS fund wishes to invest in a China A Shares fund established as a PIF or a QIF using this "10% unlisted bucket", consideration does still need to be given to the liquidity of the investment. This means considering, for example:
a) the actual dealing frequency in the China A Shares fund;
b) the amount of the China A Shares fund the portfolio manager plans to buy;
c) the limitations on dealing in the China A Shares fund, such as the temporary suspension and the redemption gate provisions and the US$49 million monthly threshold.
The analysis must consider whether the restricted liquidity of the China A Shares fund is such as to restrict the ability of the UCITS fund to meet foreseeable redemption requests. Presumably however there will be sufficient other liquid securities in any UCITS fund which could be used to meet likely redemption requests and if only a small percentage of the net assets of the UCITS (and in any event up to 10%) is to be invested in the China A Shares fund the liquidity requirement should be satisfied. The ability to invest in such schemes using the "10% unlisted bucket" and the attendant risks in doing so should be disclosed in the UCITS prospectus.
PIF and QIF
No similar constraints apply to an investment by a PIF or a QIF in a China A Shares fund. A PIF can invest up to 40% in a single China A Shares fund and a QIF up to 50% in such a fund.
Concentration rules apply in respect of the underlying fund which vary depending on the type of fund that is to invest in the underlying fund.
If a UCITS fund is to invest in a China A Shares fund there are limits on the percentage holding it may have in the underlying fund. If a UCITS uses the "10% unlisted bucket" for the purposes of investing in a China A Shares fund established as a PIF or a QIF certain issuer concentration rules apply. The UCITS may not acquire any shares carrying voting rights which would enable it to exercise significant influence over the management of an issuing body. The Financial Regulator considers a significant influence as being 20% or more of the voting rights of a company. Obviously to the extent that the China A Shares fund is widely held by a number of investors from its initial launch this restriction should not be a problem for a UCITS fund investing in the underlying China A Shares fund.
However, a UCITS fund could not be used to seed a China A Shares fund as the fund's only initial investor because the investment would contravene this rule. The UCITS fund would need to invest in the China A Shares fund along with a number of other investors (and a minimum of four other UCITS funds) in order to avoid contravening this rule.
It is also worth noting that if the investment in the underlying China A Shares fund is in non-voting shares a concentration limit of 10% of the underlying fund is imposed on the investment.
PIF or QIF
The same restriction on not acquiring shares carrying voting rights which enable the fund to exercise significant influence would also apply to a PIF or a QIF investing in an underlying China A Shares fund.
There are a number of technical issues that need to be considered when establishing a fund which is to invest in China A Shares and if an Irish fund is to invest in another fund investing in China A Shares.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.