Chinese PE regulation: Tug-of-war

Turf wars are not uncommon between Chinese regulators, where an official's sense of self is often only as big as his remit. Those watching the National Development and Reform Commission (NDRC), the country's economic planning agency, tussle with the China Securities Regulatory Commission (CSRC) over the right to govern private equity could be forgiven for feeling a sense of déjà vu.

Five years ago, these two heavyweights were competing for the then nascent corporate bonds market. The CSRC claimed that it, not the incumbent NDRC, should hold the regulatory mandate. After months of uncertainty, a grubby compromise emerged. The CSRC assumed responsibility for corporate bonds issued by listed companies while the NDRC remained in charge of enterprise bonds sold by unlisted entities.

Fast forward to the present and China's bond market is healthier, but dominated by short- and medium-term debt; corporate and enterprise bonds hold a relatively small share. This is blamed on the absence of unified standards.

Ever since China issued the draft Securities Investment Funds (SIF) Law at the end of last year - including private equity and therefore opening the door for the CSRC to play a regulatory role alongside the NDRC - the domestic PE industry has feared a similar outcome.

"There is a lot of uncertainty surrounding private equity regulation in China," says Frank Han, executive director of Bohai Industrial Investment Management. "Traditionally, the NDRC gave more guidance and fund managers followed one set of rules. That no longer seems to be the case."

The National Venture Capital Association (NVCA) and its local counterparts, which operate under the NDRC's guidance and have more than 600 members, reacted quickly to the draft regulations. A joint position paper was submitted voicing strong opposition to a role for the CSRC.

Their victory was pyrrhic. There was no specific reference to private equity but the language left sufficient room for interpretation that the CSRC could still wield significant influence over "non-publicly offered funds," also known as "sunshine funds." In February, the securities regulator issued its own draft guidelines for sunshine funds and went so far as to invite private equity firms to raise mutual funds, taking them outside the private placement space and potentially opening up new sources of retail capital within a regulated framework.

The NDRC promptly nixed the plan, reminding private equity managers that they are prohibited from running retail funds and investing in publicly traded securities. It also reiterated a call for managers to register with local governments.

Lack of coordination

The SIF Law comes into effect on June 1, and according to last amendments, the NDRC remains private equity's primary regulator. "It is now clear that the NDRC will regulate non-public investment funds, whereas the CSRC will rule public market activity. As sunshine funds' core business is investing in the secondary market, such as in listed securities, it is fair that the CSRC has control," says Sandra Lu, a partner at a Shanghai-based law firm Llinks Law.

This lack of regulatory coordination is seen as detrimental to the development of China's capital markets and financial sector as a whole. Yet there is a sense that the industry is witnessing numerous battles, none of which signal the conclusion of a war. In securing the sunshine funds mandate, the CSRC has the thin end of the wedge. The term non-publicly offered fund isn't clearly defined in the SIF Law and this potentially give license to make further inroads into what was once an NDRC hegemony.

"The CSRC may be tempted to take advantage of the power granted in Article 95 of the new SIF Law, pursuant to which it may designate other securities and related derivative products to be included under non-publicly offered funds," says Zhang Xuan, counsel at O'Melveny & Myers.

Other areas of uncertainty abound. Given the conflicting rulings issued by the NDRC and CSRC on private equity firms investing in public securities or operating public funds, would the NDRC pursue enforcement action against anyone that defies it and, if so, how? And if a private equity firm invests in a non-public company which goes on to complete an IPO within 3-5 years, does it report to the NDRC, CSRC or both?

The State Council is aware of the situation and wants to do something about it, according to a source close to the NDRC. "The NDRC doesn't want to give away any power on regulation. When people discuss the CSRC's proposal with the NDRC, they clearly don't feel comfortable," the source says. "The State Council is trying to coordinate the two parties. I am optimistic that soon more explanation will be issued concerning the two regulators respective duties and scope of responsibilities."

Interestingly, Liu Jianjun, a senior official at the NDRC whose remit included private equity, was recently been appointed to a leading role within the CSRC's fund department.

"It's too early to reach the conclusion that the CSRC will gain more power as a result of this move and become the ultimate regulator for the industry," adds Vincent Huang, a partner at fund-of-funds Pantheon and a founder of the Limited Partner Association of China. "However, it leaves door open for such possibility."

According to industry participants, the CSRC sees itself as the most appropriate regulator on the grounds that a single agency for private equity and IPOs is more efficient. It also has ambitions to promote a "pan-asset management" concept, encompassing mutual funds, fund-of-funds and private equity funds, as a means to further open up the capital markets. However, there are concerns about potential side-effects.

"In China, many PE fund managers come from the mutual funds sector. If more fund managers are able to launch investment products with similar features at the same time, it will create fierce competition," says Bohai's Han. "If private equity firms are going to launch mutual funds, they must set up independent teams and information protection protocols so as to eliminate conflicts of interest."

The NDRC's view follows a similar logic. China's capital markets aren't fully developed and releasing a host of private equity funds into the mutual fund space could cause considerable damage. Moreover, there is a fundamental difference in the PE and mutual fund managers' approaches to investment: the former make direct investments with a view to exiting after a period of several years, while the latter focus on secondary market deals and operate on a quarter-to-quarter basis, governed by redemption requirements.

Nevertheless, StarRock Investment, a sunshine fund manager recently established an operationally independent unit to develop mutual fund products. Following the CSRC's process - and therefore ignoring the NDRC's ban - StarRock registered with the Asset Management Association of China (AMAC), a group set up by the securities regulator last year, which now has 370 members, up to 62 of which are private equity firms.

"We hope to be in the first batch of sunshine fund managers to enter into mutual fund space," says Xi Tao, media relations of StarRock. "We have to pay RMB 20,000 ($3,257) per year to register with AMAC as a special member. When the CSRC will give the green light for us to operate on the mutual funds market, we will become normal member in the category as part of mutual funds managers." According to the source close to the NDRC, retaliatory action against StarRock is unlikely.

Collateral damage

Given the SIF Law includes a range of requirements concerning capital levels, personnel and public markets investment experience, it is estimated less than 10 private equity managers will qualify to be mutual fund managers. But the dual regulatory system means GPs must spend more time and money on compliance.

"It would be hard to quantify the increase of the burden as it may not be just the actual capital requirements, but also the time needed to train staff, coordinate regarding compliance issues and monitor the further development of two sets of rules," says O'Melveny & Myers' Zhang.

Leading domestic GP CDH Investments, for example, has decided to separate its sunshine fund from the core private equity business, which covers both US dollar and renminbi-denominated vehicles.

"Our Qualified Foreign Institutional Investor (QFII) account is more than US$1 billion and our listed stock is huge, so whatever the CSRC says we have to follow," says Shanghzhi Wu, CDH's chairman and managing partner.

"At the same time we will follow the NDRC's rules. These state that a private equity firm shouldn't have a listed securities arm underneath it, so we will spin off the hedge fund affiliate, much like how we spun out of China International Capital Corporation."

However, Wu adds that the rules applied to those in the private placement as opposed to the publicly traded business aren't too difficult to comply with.

This echoes the views of many in the industry that soft-touch regulation is the preferred approach. Should the conflict between the NDRC and CRSC escalate it could result in a web of different rules that tie managers up in knots and hinder long-term development.

The China Venture Capital Association (CVCA), an independent association involved in the process of the SIF Law revision last year, has coordinated the issuance of the position paper against the inclusion of the private equity and venture capital in the scope of the SIF Law and sent this letter to the CSRC.

"PE in China is still in its infancy. It's understandable that all related stakeholders may take time for trial and error. There is definitely room for improvement in terms of regulation. The key here is clarity and consistency of laws and regulations, and execution," says Crystal Sui, president of the CVCA.

Among industry participants, the general opinion is that the NDRC has been too loose in its oversight, focusing on PE firm registration rather than behavior such as illegal fundraising. It was only last year that the agency issued the first nationwide rules for private equity in order to stop immature investors getting their fingers burnt. "I don't think that the NDRC will be the best authority to regulate the industry. It lacks the experience - the rules are more like guidelines and enforcement is not a priority," says one GP.

Whichever regulator emerges as the victor - or if there is another compromise situation along the lines of the corporate bonds situation - in an ideal world there should be a single set of rules for private equity and venture capital with clear regulations including registration and reporting procedures. On that, everyone is agreed.

"Guidelines in the form of government rules and circulars are fine to keep the regime flexible. If would also be helpful if the two regulators could coordinate with one another to issue those rules," says Lorna Chen, a partner with Shearman & Sterling.

 

SIDEBAR: PE oversight - NDRC and CSRC rules

The National Development and Reform Commission (NDRC) issues regulations for equity investment enterprises (EIEs), which apply to all PE firms that set up onshore:

• All EIEs with assets more than RMB 500 million ($80 million) are required to register with the NDRC. Those with a lower capital level must file with the relevant provincial government authority, which takes up to 20 working days. These local authorities should report registration information to the NDRC no later than the end of June 2013.

• Fundraising is restricted to private placements by qualified investors capable of risk tolerance. Solicitation to unspecific investors via public channels - such as through the media, seminars, text messages - and promising a fixed return is forbidden. The term "qualified investors" is not defined.

• EIEs can only invest in equity interests in companies that are not openly tradable. They may only deposit surplus funds with banks or use them for the purchase of fixed income investment products such as government bonds.

• Private equity firms are prohibited from operating mutual funds, derivatives or "sunshine funds" that trade public securities. Any offending private equity firms will be named on its website.

Under the revised Securities Investment Funds Law, which takes effect from June, the China Securities Regulatory Commission (CSRC) has jurisdiction over sunshine funds. They must:

• Registrater with the Asset Management Association of China (AMAC)

• Have at least RMB10 million in paid-up capital and be managed by two licensed individuals plus a risk control officer

• Have no record of illegal activity or adverse credit in the last three years

• Have investment exposure to publicly issued securities with a value of at least RMB 100 million

• Have at least RMB2 billion in average assets under management over the past three years

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• Topics
• Greater China
• Regulation
• regulation
• China
• CSRC
• NDRC