Jury still out on Shanghai RMB QFLP program
The reported approval by China's State Administration of Foreign Exchange (SAFE) of a $3 billion quota for the Shanghai municipal government to allow foreign currencies to be converted into RMB for investing into local private equity funds has been hailed by some as another significant milestone in the development of the Mainland’s private equity ecosystem.
But this not unexpected preparation for the full rollout of the Qualified Foreign Limited Partner (QFLP) scheme, designed to allow foreign LPs to invest directly into domestic Chinese private equity funds, still lacks some key components before it is likely to attract foreign capital.
QFLPs and domestic GPs
The original Reuters report indicated that SAFE has approved the quota to allow established global LPs to invest in Shanghai-incorporated RMB-denominated private equity funds, with the Shanghai government likely to grant $300 million entitlements to three foreign institutions.
However, as fundraising professionals pointed out to AVCJ, the latest developments carry no further details on the taxation structure surrounding such investments, nor on the status of funds under the scheme when seeking to invest in companies in China’s FDI-restricted sectors.
The much-publicized RMB funds launched by foreign GPs such as TPG Capital and the Blackstone Group are a different stage of development to the QFLP platform. These are already able to attract RMB-denominated investment from any institution. The conversion approval threshold is part of the effort to deliver the other end of the equation: opening RMB funds launched by domestic GPs to foreign institutional investors. However, with the modest size of current RMB vehicles, this first quota will hardly allow much foreign LP interest to be absorbed.
According to Dennis Montecillo, the CEO and Senior MD of independent placement agent Diamond Dragon Advisors, “the absolute amount is less significant than what it may signal in terms of direction. The government has always been supportive of private equity to the extent that it benefits the development of important sectors of the economy.”
The taxation issue, still unresolved to the point that China has no tax laws specifically for private equity, leaves the new measures well short of realizing that goal. Funds set up under the new rules will have few attractions for foreign LPs unless they carry a 5-10% withholding tax structure with safeharbor provisions, rather than China’s 25% enterprise income tax level.
For domestic LPs investing in the foreign GPs, this is not an issue as they pay the 25% tax anyway. But for foreign LPs, present offshore fund structures look set to continue to offer a far more favorable tax profile.
Japan as a precedent
Japan recently introduced reforms to tackle a similar issue, which was starving local GPs of foreign LP support (see AVCJ Apr 20). Prior to 2009, international LPs faced double taxation, but in April last year, the country introduced new regulations backed by the Ministry of Economy, Trade and Industry (METI) and Financial Services Agency (FSA) granting tax exemptions for foreign LPs investing in domestic Japanese GPs. While a step in the right direction, the new regulations were seen as difficult for foreign LPs to understand, leading to some local PE professionals to press for an even simpler system.
There certainly was no immediate ramp-up of commitments to Japanese PE firms, with most international institutions still seeking their exposure to Japan through pan-regional funds. However, because the new regulations coincided with the downturn in the economy, it is difficult to weigh the effects of each separately.
Absence of policy consensus
Some useful clarification at least appears to have come out of this round of development and disclosure. The reported rules on what foreign LPs are eligible for the scheme appear to be fairly lax, requiring just $1 billion of assets or $500 million of capital, and only two years’ appropriate investment experience. As such, there is no guarantee of providing the value-added input of seasoned institutions that PRC authorities might hope for.
Montecillo points out that the RMB sector “has already attracted worldwide attention, although by most accounts it is very young. This move could eventually focus investors on what really matters in private equity – the quality of the GP and the understanding of the risks and rewards by the LPs – instead of external (albeit important) issues like currency and regulatory arbitrage.”
As yet though, there is no sign of movement toward a safe harbor tax provision for foreign LPs in China. Even though authorities in Shanghai and elsewhere are clearly aware of the problem, they add, there does not seem to be enough consensus, or shared interests, between the requisite parts of the PRC power structure to keep the necessary policies in step.
Nonetheless, Montecillo sees China’s private equity industry continuing on a fast growth curve, moving up and to the right. “The ‘slope’ of this ‘curve’ is what the government is trying to manage.”
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