China PE regulation: Operation good guys

It took just 18 months of aggressive advertising for Ezubao to emerge as one of China's largest peer-to-peer (P2P) lending platform. The company, which claimed to follow the standard model of matching investors with potential borrowers, promised annual returns of up to 14%, well in excess of the interest rates offered by traditional banks. It facilitated RMB70 billion ($11 billion) worth of transactions between July 2014 and December 2015.

As it turned out, the sums didn't add up. Ezubao was a Ponzi scheme: instead of distributing returns from the revenues generated by real projects, it was paying existing investors using money deposited by new ones. About 95% of borrowers were fictional entities, Xinhua News Agency reported following the arrest of Ezubao's founder last month. More than 900,000 investors lost an estimated RMB50 billion ($7.8 billion), potentially the biggest case of financial fraud in China's history.

Despite its scale, Ezubao represented only a small portion of the frauds perpetrated in the booming but unruly online finance industry. The malfeasance extends into private equity, with a large number of local fund managers recently exposed for engaging in illegal fundraising activity online.

Once they are de-registered, fund managers can re-register with AMAC again provided they comply with the rules – Ning Zhang

Deceit is hardly a new phenomenon in this field, but the extent to which managers used the internet to run a host of small-scale scams across the nation is unprecedented. The Asset Management Association of China (AMAC) - an industry body set up by the Chinese securities regulator - responded with predictable force: registration requirements for private fund managers have been tightened up and tougher fundraising rules are set to follow.

"The regulators studied US and European regulatory models before coming out with these new rules," says James Wang, a partner in the investment funds group at Han Kun Law Office. "They are trying to distinguish the good guys from the bad guys, and drive the bad guys out of the industry. Many of those guys are raising capital from unqualified investors in the name of private equity, and give people a false impression that whatever you invest in, you can make a lot of money with no risk."

Trigger point

Over the course of 2014 and 2015, online lending proliferated in China. As of the end of last year, about 2,600 P2P lending platforms were in operations, up from 1,600 in 2014, according to Online Lending House, which tracks the industry. Total outstanding loans came to RMB439 billion in 2015, compared to RMB104 billion in 2014 and RMB26.8 billion in 2013.

Many of these platforms serve a positive purpose: they are a bridge between lenders and small and medium-sized enterprises, many of which are unable to get funding from traditional banks. Several others have been the cause of sizeable investment scandals. Notably, following the collapse of Fanya Metals Exchanges, an investment platform for trading in rare metals, hundreds of angry investors took to the streets in Beijing and Shanghai, saying they lost $6 billion from high-yield products.

"As China's economy slows, investors can no longer generate good returns from traditional investment channels. They become opportunistic and so they are drawn to online finance platforms that promise much higher returns. Some domestic fund managers have entered this space by packaging private equity funds as wealth management products and raising capital from public investors. They are taking advantage of regulatory loopholes," says Raymond Wang, managing partner at law firm Anli Partners.

The scale of illegal activity and resultant public outcry alerted regulators to the problem. Last year, the State Council set up a special committee and called upon local governments to investigate illegal fundraising activities, particularly those involving online investment products. In Beijing, the authorities responded by suspending domestic PE investment registration. Any proposals that included wording such as project investment, equity investment, investment management and financial leasing were banned. Local authorities in Shenzhen, Shanghai and Tianjin followed suit.

Then in January, the China Security Regulatory Commission (CSRC) announced that at least 27 private fund managers would be fined or placed under administrative supervision due to suspected violations. They included high-profile names such as Shanghai Gopher Asset Management and China Science & Merchants Investment Management Group (CSC Group).

AMAC has since followed up by saying it will revoke the registrations of new private fund firms - including private equity, venture capital and hedge funds - if they fail to launch a product within six months of registration. Those that have been registered for more than one year must issue new products by May 1, while those with under one year's tenure have until August 1.

AMAC replaced the National Development and Regulatory Commission (NDRC) as the registration agency for domestic private equity managers in January 2014. It does not require managers to hold a license in order to set up a private fund, but registration is compulsory.

As of the end of January, there were 25,841 private fund firms registered with AMAC. However, more than two thirds had no real fund investment operations. Rather, they were operating on the wrong side of the law - in investment banking, P2P lending, crowdfunding, private lending and providing loan guarantees. AMAC certification is often used to inflate these firms' credibility and mislead investors. As such, the association will no longer issue registration certificates for new entrants. Its ultimate goal is to reduce the number of registered private fund managers.

"AMAC is very clear on what it wants to supervise. Firstly, it removed P2P and other online finance activities from its scope of supervision, because they are irrelevant to private equity. It wants to get rid of those ‘shell company' registrations. Once they are de-registered, fund managers can re-register with AMAC again provided they comply with the rules," says Ning Zhang, a Beijing-based partner at Orrick.

Zhang adds that the purpose of new regulations is to improve the quality of industry practices, rather than add pressure to business operations. Indeed, AMAC now requires senior executives employed by investment fund firms - including legal representatives, general managers and risk control managers - to take a written exam to qualify for registration.

The crackdown will make life harder for first-time renminbi-denominated fund managers that have already registered with AMAC, because they must launch their vehicles before the May or August deadline, but industry participants are generally supportive.

"There is an urgent need to regulate the industry because it's in a state of chaos. Everyone nowadays could claim to be a private equity fund manager in order to raise capital. They launch massive marketing campaigns and pay pop stars to mislead ordinary people - who believe in the registration certificate and so invest. The new rules will reduce unnecessary competition and benefit established managers," says Lin-Lin Zhou, CEO at Principle Capital.

The longer view

The next step involves issuing new fundraising rules - currently in the consultation phrase - that address information disclosures and fundraising reporting on an ongoing basis. In addition, managers will only be able to use qualified distributors to raise private equity funds, which lead to higher to higher fundraising costs.

"At present the threshold for setting up a wealth management firm to distribute private equity products is very low. The regulators want to change that. Under the proposed rules, almost 70% of distributors will not quality because they aren't licensed by the CSRC," says Sandra Lu, a partner Llinkslaw. "Some industry participants have strong opinions on the proposed change, because it raises the bar for private fundraising to a standard applicable to retail fund distribution, which is not often seen globally."

Nevertheless, overall renminbi fundraising is not expected to slowdown. Domestic investment opportunities are growing much faster than those offshore, in part driven by increased anticipation for A-share listings. At the same time, there is a deepening pool of institutional investors, such as pension funds and insurance companies, looking to deploy capital in the asset class. These LPs are essential to the long-term sustainability of the asset class and regulators want to keep unsophisticated retail investors out of the mix.

Han Kun's Wang compares the situation in China now with the tighter regulation introduced in the US and Europe after the global financial crisis. However, the comparison works only up to a point.

"The investing public remains very unsophisticated and can easily fall victim to unscrupulous managers. There are only a small number of sophisticated institutional investors, which is very different from the US where individual investors invest in private equity through funds of funds or other institutional investors rather than in their own capacity."

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• Topics
• Greater China
• Fundraising
• Regulation
• GPs
• Renminbi fund
• Renminbi
• Principle Capital
• CSRC