China's recent capital market reform
In April 2020, the Chinese government removed the limits on foreign ownership of fund management, securities, futures, life insurance, and currency brokerage firms. They implemented the decision one year earlier than it was initially scheduled. Previously, foreign financial firms could only obtain a minority stake in a Chinese joint venture. The joint venture prevents foreign firms from being overly involved in the Chinese financial system while allowing its partner firm to learn advanced financial know-hows. The State Administration of Foreign Exchange also removed Qualified Foreign Institutional Investors (QFII) and CNY Qualified Foreign Institutional Investors' (RQFII) investment quota. Since then, Chinese capital market's further opening has attracted many agile foreign investors.
China's swift move did not surprise the investment and asset management world. BlackRock and Neuberger Berman were the first two firms to apply for mutual fund management qualification in April 2020. On June 11, 2021, the Shanghai based BlackRock Fund Management Co Ltd got permission to operate as a fund management company, paving the way for BlackRock to launch its first domestic mutual fund in China.
On the securities business side, Goldman Sachs and Morgan Stanley were the first to acquire 51% equity in their Chinese joint ventures up from 49%. In July 2021, one year after the financial reform, Morgan Stanley increased its stake in the joint venture to 90% and changed the firm's name to Morgan Stanley Securities (China) Co Ltd, dropping off its Chinese partner's name from the joint venture.
Despite the recent US-China trade tensions and the impact of the Covid-19 pandemic, China was resolute in keeping its promise in opening its financial sector. China is in dire need to develop a mature capital market amid the goals of Chinese Yuan's internationalisation, rebalancing the misallocated domestic asset classes, and expanding the gradually depleting national pension fund pool.
Even though China's economy size is big, Morgan Stanley Capital International, an index provider company, only increased the ratio of China's A shares from 5% to 20% in its MSCI Emerging Markets Index in 2019. While the Chinese economy is still underrepresented in the index, it reflects the fact that the Chinese capital market is relatively immature. In terms of asset classes, most of China's investors put majority of their portfolio into the housing market. At the same time, China's fast growing ageing population is facing an exhausting pension fund system that is likely to run out by 2035. These problems, the policy makers found, can be alleviated by further opening the financial sector to international investors.
Specific reforms in the private equity sector in China
In the private equity fund world, China had announced more favourable policies before the broader financial opening that took place in 2020. These policies did not come from an integrated agency but were result of a series of economic dialogues with the United States and the United Kingdom. During the 7th and 8th US-China Strategic Economic Dialogue in 2015 and 2016, and the UK-China Economic Financial Dialogue in 2015, China announced the following policies:
- Allowing the Wholly Foreign Owned Enterprise (WFOE) and Joint Venture private equity funds to participate in private equity fund management, including secondary security market (US, 2015)
- Allowing foreign firms to set 51% owned securities firms in Shanghai Free Trade Zone (UK, 2015)
- The Asset Management Association of China to register foreign owned private equity funds (US, 2016)
The above-mentioned Asset Management Association of China (AMAC) is an NGO co-founded by Chinese asset management firms under the Security Investment Law in 2012. AMAC is set to carry out these policies. Its responsibility includes "making and implementing self-disciplinary rules; monitor, and inspect members' professional conducts", "creating industry standards", and "registering private equity managers". It is the officially sanctioned authority handling China's asset management firms' day to day regulatory affairs.
The basic qualifications to set up a private equity fund are simple: first, one must register a company in China; second, the foreign shareholders are institutions legally operating in a foreign territory and that foreign territory has signed a MoU with the China Securities Regulatory Commission; third, one and one's foreign shareholders did not receive any severe penalty in the recent three years.
There are, however, two minor limitations aside from the broader opening: China would monitor the fund's investment flow as well as profits & losses; trading decision should be made independently from the China based firm, no foreign based (including the use of foreign trading system) trading decision in securities and futures transactions is allowed.
In addition, since 2016, foreign fund management companies can participate in private equity investments in China with domestically sourced CNY fundings.
Structure of the foreign PE firms and funds
An investor or firm can set up a WFOE Private Fund Management (WFOE PFM) in a Free Trade Zone to join in the Chinese private equity landscape and fund management. For example, Bridgewater Associates LP, the world's largest hedge fund manager based in the United States, founded Bridgewater (China) Investment Management Co Ltd in March 2016 in Shanghai Free Trade Zone and registered with the AMAC in June 2018.
Bridgewater (China) has 310 million CNY registered capital and around 210 million CNY paid-in capital. With approximately 2,000 to 5,000 million CNY assets under management, Bridgewater was permitted to invest in securities and fund of funds. In 2018, Bridgewater opened its first private equity and securities funds in China with the names "Bridgewater All Weather Enhanced China Private Securities Investment Fund I (&II)". In 2019, Bridgewater got the qualification to conduct investment advisory business in China.
The other way to get involved in private equity is through the newly created Qualified Foreign Limited Partnership (QFLP) pilot scheme structure. According to AMAC's registration database, there are about 30 QFLP structured private equity firms at the end of 2020. The domestic based limited partner firms are usually subsidiary of a parent investment management firm, making the investment vehicle more flexible both in terms of its investment strategy and profit-sharing scheme.
The QFLP structure offers certain tax advantages at the partnership level and enjoys more flexibility in forex settlement. If the limited partner is an individual investor, their income would be taxed as individual income, if it was a legal entity, then corporate income tax would apply. The QFLP's structure allows foreign LPs to control the China based firm with a General Partner management entity to invest with a CNY based fund in China, investing in public securities and private placements. The GP management entity could either be China based investors, foreign investors, or a mixture of both, though this condition varies in different QFLP pilot areas.
First introduced in Shanghai in 2010, the QFLP pilot scheme had expanded to cities such as Qingdao, Shenzhen, Zhuhai, Guangdong Province, Guizhou Province, and other provincial or municipal regions.
Because there is no centralised coordination in setting up a national QFLP standard, the specific rules regarding setting up a QFLP entity in different administrative regions are fragmented.
For example, Shanghai has a negative list providing the specific items where a QFLP fund cannot invest, but some other places do not have such clear indication. In another case, the Zhuhai authority's requirement for the amount of asset under management is a minimum of 12 million USD, which is smaller than other administrative regions' requirements.
As a side note, QFLP should not be confused with Qualified Domestic Limited Partnership (QDLP). Simply put, QDLP is an investment vehicle that puts domestic Chinese investor's CNY fund to overseas direct investment through China based foreign intermediates. For example, BlackRock Fund Management Co Ltd operates two QDII funds in China that can accept QDLP's money. The first one is the BlackRock World Technology Fund, the other is the BlackRock Global Asset Allocation Fund.
The QDLP scheme, combined with QDII qualified institutions, provides Chinese investors an alternative in allocating their CNY assets globally. As of now, there are 28 qualified institutions in China to take QDLP's investment in their funds. QFLP is the other way around, allowing foreign investors to participate in the Chinese market with a CNY based fund.
Opportunities and challenges
As discussed in the previous sections, China is making it easier for foreign financiers to operate in China. There are ample opportunities as well as challenges for this rapidly expanding industry in China. There are also pending reforms that foreign investors should pay attention to with prudence.
The Shanghai Free Trade Zone so far has the biggest financial freedom in China and has been enjoying most of the policy benefits ahead of other regions. As we can see that almost all of the QFII institutions are registered in Shanghai. These institutions are already the best in their home country. For example, the Man Group is the oldest asset management firm in the United Kingdom with more than 230 years of history. Japan's Nomura Group has $604 billion USD asset under management globally.
Shanghai also has 4,600 registered private equity funds managing 4,280 billion CNY assets. Shenzhen has 4,400 private equity funds registered but only manages half worth of Shanghai's assets. As mentioned before, the QFLP policies in China is very fragmented and varies region by region, thus making Shanghai even more attractive because of its transparency and clear policy guidance. Shanghai possesses absolute advantages against other regions in attracting foreign financiers.
The pace of China's financial reform and foreign financier's adaptation is a symbiosis relationship. In April 2020, the financial authority in Shanghai announced to support the opening of preferred stock, convertible bond, subordinate debt to QFLPs. The central government permitted QFLPs' participation in fund of funds in order to support the Greater Bay Area's development.
During the process, foreign managers also facilitated the use of both onshore and offshore CNY, indirectly promoting CNY's internationalisation. By investing in the secondary market as institutional investors, they can also test the water of China's famous policy and momentum driven stock market, which might bring substantial headache to foreign financiers who expect lower volatility.
As China's economic growth matures, its need of sophisticated financial instruments and platform rises. China's opening up of its financial sector not only brings needed resources and expertise, but also stirs competition among its domestic peers. Private equity, or alternative asset management in general, is a relatively new concept both in the West and in China.
Entering the Chinese private equity landscape is a desirable goal for ambitious foreign managers. The Chinese QFLP pilot scheme and the existing WFOE PFM structure provides convenience for them to do so. An easy entrance to China's PE is one thing, however, taking root in China is another thing. Foreign fund managers should constantly learn and adapt to China's unique financial circumstances and pay attention to the latest policy development.
If you want to know more about the (ever changing) regulatory framework for registered foreign entities in China, please do not hesitate to contact us. We will assist you with the navigation through the registration process and ensure a compliant set up in China. Feel free to reach out and set up a meeting.