China grants private equity an A-share investment platform

Investor appetite for Chinese stocks reached a new low in July: The benchmark Shanghai Composite Index closed at 2,103 points, down 5.5% from June and its lowest level since March 2009. The Shenzhen Composite Index fell even more sharply, losing 8.5% of its value over the course of the month.

With the government wary of the impact this malaise is having on investors, regulators' long-term plans to bring stability and wider participation to the capital markets has been given a short-term boost. In July, the China Securities Regulatory Commission (CSRC) loosened restrictions on the Qualified Foreign Institutional Investor (QFII) program through which overseas investors gain exposure to public debt and equities. This included opening the door to private equity firms.

It is a step in the right direction, but PE investors have yet to find out the conditions under which they will be allowed to operate, while longstanding QFII concerns about quota size and tax treatment remain unresolved.

"Given that the valuation of many public companies in China is even lower than private companies these days, QFII might be appealing to offshore private equity funds," Maurice Hoo, global leader of the firm's M&A and Private Equity Practice Group, tells AVCJ. "However, it remains to be seen how much quota will be apportioned and how many foreign private equity funds may - under their own constitutional documents - invest in the A-share market."

Rapid reforms

China has introduced a raft of reforms designed to expand the QFII program in recent months. In April, the CSRC raised the overall QFII quota by $50 billion to $80 billion. One month later, the foreign exchange regulator promised fast-track approvals for quotas going to medium- and long-term overseas funds. Between January 1 and July 20, China distributed a total of $7 billion in quotas to 52 QFIIs. This is equates to more than 20% of the quota granted to 149 investors throughout the program's 10-year history.

The inclusion of private equity is good news for the asset class as it means the costs of buying into domestically listed companies are significantly reduced. Previously, private equity firms could only hire quotas from established QFIIs, usually international banks, if they wanted to participate. The rental price is understood to be prohibitively expensive due to limited supply and strong demand driven by an increasing number of exchange-traded funds (ETFs) that track the performances of A-shares.

The latest reforms also see qualification thresholds for existing categories of foreign investors substantially lowered. Insurers, pension funds and asset management institutions - the latter category now includes PE funds - are required to have at least $500 million under management to qualify for a QFII license, down from $5 billion. This will create a window for smaller funds to enter into the A-share market.

"I expect a lot of mid-sized fund managers, which has asset under management of $500 million to under $5 billion, will be potential QFII applicants after the relaxation of QFII program," says James Wang, a partner at Han Kun Law Offices. "Many of these players - who have been interested to participate into A-shares - were not qualified but are now thinking about applying for quotas on their own."

While the CSRC has created a favorable platform for foreign PE players to bet on local stocks, the maximum stake a QFII can own in a Chinese listed company is currently 30%. This is an improvement on the previous cap of 20%, but it is still not large enough to accommodate the demands of many PE investors, who prefer to take a significant minority stake in portfolio companies, if not overall control.

In addition, given the current average quota size is just $100-150 million, it is questionable whether QFII offers private equity players sufficient scope to acquire significant minority stakes in multiple public companies.

"The most likely private equity QFII applicants will be funds that have the flexibility or capacity to get minority stakes in public deals, and are looking to access to public companies that have attractive valuations and track records," John Gu, senior M&A tax partner at KPMG, tells AVCJ. "To those funds which want to gain control or a board seat through public deals, this scheme may not be suitable."

Taxing uncertainty

Gu adds that PE funds which aren't put off by these restrictions should still be aware of the taxation problems tied to the QFII program. The State Administration of Taxation has released only two documents pertaining to QFII: Circular No. 155 in 2005, which guarantees a business tax exemption on gains arising from investments; and Circular No.47 in 2009, which imposes a 10% withholding tax on dividends and interest income. It is unclear whether a QFII would also be subject to a 10% levy on capital gains.

Any charges on the profits generated by QFIIs are likely to be passed on to fund managers and their investors. Legal and tax advisers argue that private equity players - who are new to the QFII club - should address the potential tax issue with advanced and detailed planning. Until Chinese regulators offer further clarification, the best approach for GPs right now is to work through various potential taxation scenarios and seek agreements with their LPs to compromise on calculation methodologies.

"When GPs draft their limited partnership agreements, they should be aware of the potential taxation risks concerning their investments in Chinese listed companies," says Han Kun's Wang. "For example, they may preserve the right to ask for the return of distributions in case the authorities ask for previously unclaimed QFII taxes, even though in practice the risk of back-claim is relatively low."

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Regulation
• Greater China
• PIPEs
• China
• CSRC
• PIPE
• regulation