China insurance and PE: Get real

Chinese insurers have enjoyed a relatively free rein since winning approval in 2004 to set up independent asset management units, which in turn have become GPs in private equity funds. Able to invest in pure equity or debt deals, they ended up conflating the two – resulting in the launch of PE funds that provide debt to corporates and local governments. As the practice grew, so did the regulators’ concerns.

“Fake equity, real debt” has emerged as a common practice among Chinese financial institutions to evade rules intended to restrict lending to risky borrowers. Unlike traditional PE funds, “fake equity” vehicles offer regular payments plus reimbursement of the principal capital once an investment in a project expires. These are essentially debt-like arrangements, marketed in the name of private equity.

Earlier this month, the China Insurance Regulatory Commission (CIRC) banned insurance asset managers from issuing “fake equity, real debt” products, fearing their proliferation could inflate the country’s sizable debt burden. PE fundraising by insurance asset managers is expected to shrink as a result of this move, but industry watchers believe there will be long-term gains in the form of improved investment practices.

“There are PE funds, mostly renminbi-denominated funds, raising capital from banks, insurers and other financial institutions to provide financing for property developers and local infrastructure projects, that is equity appearance but debt in essence. As these investments are made under the form of equity investments, it’s hard for the government to capture the full extent of credit growth and debt leverage,” says Dali Qian, a partner at Llinks Law Office.

Channel risk

The CIRC not only wants to limit insurance asset managers’ debt financing channels, but also more closely supervise real equity-type investments. Under the new rules, managers cannot define an expected return when marketing funds or pay out fixed returns on a regular basis. Investments must involve risk capital, deployed based on assessments drawn from due diligence and returned in the event it is deployed successfully.

Perhaps most importantly, managers cannot raise debt financing through “channel business” - a mainstay of China’s RMB64.7 trillion ($9.7 trillion) shadow banking industry. It involves banks shifting assets from their balance sheets into wealth management products, and enlisting third-parties such as trust companies, brokers, mutual fund managers and insurance firms to help raise debt from individuals and institutions.

“In those circumstances, investors don’t care much who the ultimate manager is as long as they get guaranteed returns from their investments,” says Melody Yang, a partner Simmons & Simmons. “What the regulators are worried about is accumulated risk in the financial system, especially at the banking level. When some investments go wrong, all investors will rush to redeem their assets which may cause the banks to draw from their on-balance-sheet assets and entails systemic risks.”

Curbing financial risk was a prominent theme at last year’s Communist Party congress and it prompted several regulatory agencies to issue a consultation paper in November about imposing better risk controls on the asset management industry. A proposal that managers remove implicit guarantees of profit or the return of principal capital influenced the CIRC’s subsequent rule change.

“The CIRC has increased oversight of private funds launched by insurance asset managers over the last two years,” says one fund manager at a Chinese insurance firm. “They want us to disclose every deal, every investor in the funds. They also want to control all the information about the underlying assets we invest in – such as what they are and how much they are worth.”

At present, the majority of the capital managed by onshore insurance asset management units is transferred from their parent companies. Fixed income-type of investments account for 70-80% of the typical investment portfolio, with little capital deployed in pure private equity investments, the manager observes. Infrastructure projects, which are often closely tied to regional and local governments, have gained popularity among insurers as they need long-term assets to match their liabilities.

Indeed, of the 154 investment schemes – which amounted to RMB384.4 billion – launched by 23 insurance asset managers between January and October 2017, 61 were infrastructure debt investment plans worth RMB191.3 billion, according to the Insurance Asset Management Association of China. Eighty-two were property debt schemes, accounting for a further RMB144.3 billion. Only 11 private equity funds were launched during the period, with a combined worth of RMB48.9 billion.  

Risk factors

Given these preferences, the main challenge is a supply-demand imbalance. Some large insurance asset managers work directly with local governments to invest in infrastructure projects such as public-private partnerships (PPP), but not everyone has this kind of access. As a result, the only way they can get exposure to the asset class is through channel business.

In these debt-based fund schemes, local governments or state-owned enterprises (SOEs) often act as guarantors, agreeing to compensate asset managers if investment returns fail to reach a certain threshold or the project defaults. The risk to insurers is heightened by complex legal structures and insufficient disclosure.

By placing more restriction on channel business, the capital chain between investors and the underlying investment projects will be shortened and the risk lowered. The CIRC has not stopped insurance asset managers from launching PE funds or debt funds, as long as they fully disclose the strategies being pursued and stay away from “fake equity, real debt.” 

“The regulator is trying to provide insurance asset managers with more direct investment options – whether its debt funds or private equity funds – to support growth of the real economy. Meanwhile, installing a more comprehensive risk management system, including enhanced disclosure standards, helps them to manage the respective risks,” says Qian Zhu, a senior credit officer at Moody’s.  

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• Topics
• Greater China
• Financials
• Regulation
• China
• insurance
• Fundraising
• Renminbi