VIDEO: Shearman & Sterling's Lorna Chen

"The most important thing for these funds is national treatment, which means they can get around the onerous local approval process for investments," says Chen. "Now that this has been denied by the central government... plus the slow currency conversion process with the State Administration of Foreign Exchange and the lack of tax clarity... it will be very difficult for foreign-backed renminbi funds to fundraise in China."

The National Development and Reform Commission (NDRC) clarified its position on local funds raised by foreign PE firms in response to a request from The Blackstone Group. Blackstone, The Carlyle Group and TPG Capital won the right to launch renminbi funds in 2009, hoping it would present a means of circuiting the obstacles to foreign currency vehicles: regulatory bureaucracy that slows down transaction approvals and restrictions on target investment areas.

These obstacles remain, which is irritating but hardly unforeseen. "From a practical perspective, we have always been telling clients that there are limitations in these local rules in that once you are out of the territory there is great doubt as to how you will enforce these pilot programs," says Chen.

Regulatory issues are just as pertinent for China-focused managers raising US dollar-denominated funds. The Securities and Exchange Commission's (SEC) requirement that GPs sourcing capital from US investors must go through local registration procedures is now in force, but not all managers are taking it seriously. Smaller GPs are said to be particularly at fault, effectively gambling that they won't show up on the regulator's radar.

"From a business perspective, once a manager is sanctioned by the SEC for non-compliance, it casts great doubt in the market," says Chen. "A lot of reputable LPs wouldn't want to do business with these managers."

In most cases, documents signed by the GP and LP include representations from the former that it is in compliance with applicable law. Although an investor can't sue a GP for failing to register under the provisions of the US Advisors Act, it could make a claim for breach of contract.

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