WFOEs weigh up China’s private fund rules
China is continuing its push to establish the renminbi as an investment currency by opening up its private fund industry to wholly foreign-owned firms. While this is likely to spark plenty of interest, market participants said foreign asset managers need to be ready to launch even before registering for a licence.
The China Securities Regulatory Commission (CSRC) and Asset Management of Association of China (AMAC) jointly unveiled the new initiative on June 30, publishing a set of criteria for wholly foreign owned enterprises (WFOEs) and joint venture firms to apply for a private securities fund management licence in the country.
According to the rules, an applicant must be a China-incorporated firm. If the applicant has foreign ownership, the foreign shareholders must be an approved financial institution from a jurisdiction whose securities regulator is either recognised by the CSRC, or by another overseas authority that has a working memorandum with the Chinese regulator.
This is a breakthrough for foreign asset managers given that WFOEs were previously not allowed to conduct any securities business in the country.
WFOEs are one of four ways a foreign company can set up shop in China. The other three methods being a joint venture, a representative office and foreign invested partnership enterprises (FIPE). Before the new rules, foreign asset managers were mostly operating in China via joint ventures in the public funds sector.
But there is one sticking point as Chinese legislation caps foreign ownership in businesses engaging in securities activities at 49%, which effectively gives control of the JV to the local partner the foreign asset manager has to team up with.
This has long been an issue as it limits the ability of a foreign asset manager to run the business especially given the huge differences with local partners when it comes to compliance, daily operations, internal decision making and investment decisions.
WFOE, as its name suggests, does not have this problem as it is entirely foreign owned.
“I think this is beneficial to foreign asset managers because if you look at their JVs for public funds – a lot of them have operational issues, didn’t perform well and many foreign asset managers have since sold their stakes,” said Elva Yu, a Beijing based partner at Links Law Offices. “WFOE suits their taste much better because they have full control.”
This development has been a long time coming as it was part of the seventh (2015) and eighth (2016) joint meetings of the US-China Strategic and Economic Dialogue, as well as the seventh (2015) UK-China Economic and Financial Dialogue.
In all of those dialogues, China said WFOEs would soon be able to operate under the same rules as local private funds although it is only now that Beijing has laid down the ground rules.
Still, that has not stop foreign asset managers from setting up WFOEs in preparation even if the entities were not cleared to conduct securities advisory activities or secondary market trading. Asset managers that have WFOEs include Aberdeen, Blackrock, Fidelity and Schroders among others.
But the lack of guidelines means that many existing WFOEs either have little or no operations. Those that do have operations mostly engage in research activities, but even then they are only allowed to distribute their research to offshore clients.
“Post-2013, a lot of foreign asset managers have been setting up joint ventures and WFOEs in China,” Yu said. “But a lot of the WFOEs, for example, don’t actually engage in fundraising or have any products because they were mostly setup in preparation of this rule change, which had been lobbied for years.”
That is because plenty of work still needs to be done in order to comply with the requirements laid out by AMAC even if managers already have a WFOE.
One of the rules, for example, requires the shareholder of a WFOE to be a registered financial institution in their respective jurisdiction. This can be an issue given that most of the direct shareholders in existing WFOEs are simply shell companies incorporated in the likes of British Virgin Islands or Cayman Islands.
“We’ll have to rejig our shareholding structure,” the CIO of an international hedge fund who has a WFOE told GlobalRMB. “Still, it’s not a terribly complicated process since it’s more or less a clean transfer.”
However, complying with the shareholding agreement is just one of the steps needed.
AMAC also subjects managers to a six-month timeframe to launch their first product once a licence has been granted. The asset manager risks getting their registration revoked if they fail to do so within the stipulated time.
As a result, foreign asset managers need to have a clear idea of what products they are going to launch even before registering for a licence.
“It basically means all the infrastructure needs to be there before registering,” he said. “Hiring a full team with the proper know-how of the domestic market is going to take a lot of time, not to mention the internal processes we have to go through before we even get to that stage.”
Apart from getting a product ready, creating the proper distribution channel is another major challenge.
Unlike their domestic peers, which already have an established client base, the CIO said it is inevitable that they will have to link up with a local intermediary such as a private bank in order to sell their products.
“We do know some HNWIs [high net worth individuals] in China although our own connections won’t be enough if we want to achieve scale,” he explained. “But some of the local banks are charging really high distribution fees, which makes you think if it is worth it to run money in China.”
In addition, Chen Zhen, a partner at Fangda Partners, also points out that even after gaining a licence to launch private securities investment funds, foreign asset managers will still need to be mindful of other types of restrictions.
For instance, there are foreign ownership rules pertaining to sensitive industries such as technology, media and telecom (TMT).
And for those that do not already have a WFOE in place, the hurdles are even higher.
Chen said the private fund industry has been under a lot of scrutiny ever since several cases of fraud and illegal fundraising surfaced last year.
Because of that, many local Administration for Industry and Commerce (AIC), which are in-charge of company registration, have been extremely reluctant to approve applications with the words funds, investment, investment management or asset management in them.
“At the end of the day, this is all about the internationalisation of the RMB and how China is keen to create more investment products for the currency,” one Shanghai based analyst who works for a corporate advisory firm said. “This is all part of the shift of the RMB from simply being a major trading currency to an investment currency.”
In his eyes, the latest initiative compliments some of the other recent schemes launched by Beijing such as qualified domestic limited partnership (QDLP) licence.
Unlike a domestic private securities fund licence, which can only source onshore funds for domestic investments, QDLP WFOEs can also source onshore funds but only for offshore investments. China introduced QDLP in 2013.
Other efforts to open up the fund industry include the China-Hong Kong mutual fund recognition scheme (China-HK MRF) launched last year.
And Hubert Tse, a Shanghai based partner at Boss & Young thinks more is about to come. He believes that all the recent developments are pointing towards the eventual possibility for overseas mutual funds to start operating in the onshore Chinese market.
“In the next three to five years, I think we could even see foreign mutual funds being able to do more in China,” he said. “At the moment, global mutual fund companies can only set up minority JVs with Chinese partners and they can also access Chinese investors via China-HK MRF.”
“But the signs are pointing towards the gradual opening up of the industry given we have recently seen the set-up of the first ever foreign controlled JV securities company under CEPA [Hong Kong Closer Economic Partnership Agreement].”
Tse was referring to Hang Seng Qianhai Fund Management Company, which obtained approval from the CSRC last month.
Based in Qianhai, it is the first foreign controlled JV securities firm in China with Hong Kong’s Hang Seng Bank holding a 70% stake. The remaining stake belongs to Shenzhen Qianhai Financial Holdings, which is wholly owned by the authority of Qianhai Shenzhen-Hong Kong Modern Service Cooperation Zone.