Accessing Chinese Investors: A Quick Regulatory Update
Fundraising from Chinese investors is generally restricted by China’s foreign exchange control regulations and other regulations concerning outbound investments. As a result, for offshore fund managers seeking capital from China, there is an additional layer of complexities. Generally, Chinese investors need to get approval to make offshore investments. However, over the past decade, China has gradually opened its door so that new sources of capital are becoming available to offshore fund managers. This note briefly discusses the regulatory landscape, in particular, new channels for raising RMB from PRC investors.
Historical Restrictions on Overseas Investments by Domestic Investors
Until the initiation of the Qualified Domestic Institutional Investor (QDII) regime in 2006, outbound investments by Chinese institutions were normally subject to multiple regulatory approvals. Typically, an outbound transaction had to be approved by the National Development and Reform Commission (NDRC), the Ministry of Commerce (MOFCOM) and the State Administration of Foreign Exchange (SAFE).
As to offshore investments by Chinese individuals, a big hurdle lies in the conversion of foreign exchange. Due to China’s foreign exchange control, Chinese resident individuals generally do not have the ability to convert sufficient RMB into US dollars for offshore investments.
For a long time, Chinese investors accessible by offshore fund managers have been limited to Chinese institutions capable of investing with US dollars or already having offshore investment vehicles, and PRC nationals having permanent residence outside of China and/or owning offshore bank accounts and/or foreign assets denominated in foreign currency.
Opening Up: QDII, Relaxation of the Approval Regime for Outbound Investments, and QDLP/QDIE
The opening up started in 2006 with the introduction of the QDII regime. Under the QDII program, qualified Chinese financial institutions are permitted to pool capital from domestic individuals and institutions for investing in offshore secondary market. Applicants may apply to become a QDII with the China Securities Regulatory Commission (CSRC) and a corresponding quota from SAFE will be issued for converting RMB into foreign currency for offshore investments. An offshore fund manager may serve as an investment advisor to a QDII fund but does not have the ability to raise capital directly in China. Only Chinese financial institutions, including commercial banks, trust companies, fund management companies, securities companies or insurance companies, can participate. The regulatory framework for QDIIs of different types of financial institutions varies in terms of eligibility requirements and investment scope but generally the permissible investment scope is limited to overseas secondary market. The QDII regime has been criticized for being too restrictive.
The liberalization continued in October 2012, when Chinese insurance companies were permitted to invest in offshore money market products, fixed income products, equity type products, real estate, securities investment funds and private equity funds. Although only small steps had been taken by Chinese insurers since the restriction was lifted, that was a groundbreaking development and potentially opened a tremendous amount of capital to offshore funds. Even though insurance companies are unlikely to commit to many offshore funds in the immediate future, it might be worthwhile starting to build relationships.
Relaxation of the Approval Regime for Outbound Investments
The opening up gathered pace with the liberalization of the outbound investment approval regime first in the Shanghai Free Trade Zone (FTZ) in 2013 and then nationwide in 2014. The NDRC and MOFCOM approvals for outbound investments have generally been lifted except that the NDRC approval is still required for outbound investment (i) in sensitive countries or regions; (ii) in sensitive industries; or (iii) with an investment amount over US$1 billion and the MOFCOM approval is still required for non-financial outbound investments where “sensitive countries or regions” or “sensitive industries” are involved. All other investments are only subject to a pre-investment filing with the NDRC and MOFCOM or a local branch thereof if applicable. As to entities established in the Shanghai FTZ, they only need to file with the FTZ management committee. This is a remarkable regulatory development as it has significantly shortened the time required to complete an offshore investment. For offshore fund managers, this potentially creates an opportunity to raise RMB directly from China’s institutional investors for an offshore project fund or a co-investment fund without having to establish an onshore entity.
In addition to the regulatory reform at the national level, several local pilot programs – Qualified Domestic Limited Partner (QDLP) in Shanghai, Tianjin and Qingdao and Qualified Domestic Investment Enterprise (QDIE) in Shenzhen – had been launched since 2012. These pilot programs provide alternative channels for onshore investors to invest in offshore asset classes that are not otherwise permissible under the QDII regime, such as offshore hedge funds, real estate, and private equity funds, among others. Under such a regime, an offshore fund manager can effectively raise RMB directly from qualified domestic Chinese investors and invest in their offshore funds. Some of the programs also permit onshore fund managers to raise RMB for investing offshore. A number of funds have been raised under such programs, proving the attractiveness of the programs and the onshore market demand for increased access to offshore funds.
The programs offered by different cities share many common features, but as shown in the chart above, the newly established programs are relatively more flexible in terms of eligible participants, investible assets, minimum fund size and minimum subscription amount by each qualified investor. This trend has led market participants to expect further liberalization as these programs further develop.
The basic structure under a QDLP or QDIE program requires the formation of an onshore fund in one of the pilot cities, which can be in the form of a company, a limited partnership, or a contractual fund. The fund will have an onshore fund manager and/or general partner in the form of a foreign-invested partnership enterprise or a wholly foreign-owned enterprise. The onshore fund will become an investor in one or more offshore funds affiliated with the offshore fund manager. In effect, the onshore fund will serve as a Chinese feeder fund into such offshore funds. Each program requires that the onshore fund engage a qualified domestic commercial bank as its custodian and a qualified fund administrator to provide back-office services. The service providers are subject to specific responsibilities as set out in the relevant QDLP or QDIE measures.
Overview and Practical Considerations
A joint committee or working group composed of various local regulators is involved in the approval process. Once approved, each onshore feeder will be granted a foreign currency quota and may apply for an additional quota as needed. For example, it is reported that, under the Shanghai QDLP program, an initial US$50 million was granted to each approved fund manager in the first batch and currently US$100 million would be granted to each approved manager, which could be later increased. The onshore feeder will generally accept subscription in RMB from Chinese investors, which can be converted into US dollars for investing into one or more offshore funds. Distributions received by the onshore feeder will be converted into RMB and then distributed by the onshore feeder to the Chinese investors. The onshore fund and the fund manager will be subject to the new regulatory regime over private funds in China, which includes the amended PRC Securities Investment Funds Law, the Measures for Registration of Private Investment Fund Managers and Filing of Private Investment Funds of the Asset Management Association of China (AMAC), the CSRC Interim Measures for Supervision and Administration of Private Investment Funds and the AMAC Guidelines Concerning Outsourcing of Fund-related Services. Accordingly the relevant rules concerning private placement, investor suitability requirements as well as ongoing filing and reporting requirements, among others, will apply to the onshore fund and the fund manager. In addition, the applicable QDLP/QDIE rules also contain disclosure requirements and ongoing reporting requirements applicable to the onshore fund, the fund manager and the service providers.
Obviously the opportunity to raise RMB directly onshore comes with additional costs in onshore operation and regulatory compliance. It also takes time to navigate the multi-layer regulatory framework and set up the entities. In addition, there is the issue of what sorts of local distribution platforms an offshore fund manager may have access to. Finally, as emerging Chinese investors are less sophisticated in respect of offshore fund investments, extra time and efforts will be required to explain the interaction between the onshore and offshore fund documentation.
For an offshore fund manager that is not positioned to raise RMB onshore itself, it may consider working with an onshore fund manager that is qualified to raise RMB for offshore investment under one of the pilot programs. This may prove to be practical especially for offshore fund managers that do not already have a presence in China.
It is anticipated that a new Qualified Domestic Individual Investor program (“QDII-2”) will be launched in six cities (i.e. Shanghai, Tianjin, Chongqing, Wuhan, Shenzhen and Wenzhou) to allow wealthy PRC individuals to directly invest offshore under a certain foreign exchange quota. On October 30, 2015, China’s central bank sent the signal to renew the financial reform push in the Shanghai FTZ by issuing a statement on its official website, where QDII-2 was specifically mentioned as one of the initiatives to further promote China’s capital account liberalization within the Shanghai FTZ and make it easier for qualified Chinese individuals to carry out foreign industrial investment, real estate investment and financial investment. Once QDII-2 is launched, both PRC domestic institutions and individuals will be allowed to convert RMB into foreign currency and invest directly in overseas market. This can potentially open up an additional source of capital for offshore fund managers.
Raise RMB directly for an Offshore Blind Pool without an Onshore Entity?
Removing the NDRC and MOFCOM approval requirements for PRC institutions’ outbound investments makes it possible for overseas fund managers to raise capital from such investors for a specific project without having to establish an onshore entity. It might become feasible for onshore institutions to invest in an offshore blind pool as the liberalization continues. In practice people have started to try this in the Shanghai FTZ but it remains to be seen whether and how this can be implemented.
The regulatory development clearly shows a trend of opening up of new sources of capital for offshore fund managers. The new pilot programs have been well received by onshore investors seeking access to offshore investment products and diversification of investment risks. Market participants believe that this trend of reform will continue as the new administration is determined to support Chinese investors in fulfilling their desire to invest offshore. For offshore fund managers, there is money increasingly available in China. Nonetheless, there are different rules to be navigated, and patience and preparation are required to build relationships with local regulators, services providers and potential investors.
About the author:
Xuan Zhang is Counsel at O’Melveny & Myers