How Amac is cutting China's private funds down to size
Singer Hu Haiquan, one half of Chinese soft-rock duo Yu Quan, proudly updated his Weibo followers on April 27 with the results of his fund industry examination. Having passed China’s first mandatory new exam for private-sector investment managers and senior executives, Hu is now a fully registered private equity fund operator.
Whether that means private equity managers are the new rock stars or vice versa is an open question, but it does underline the extent to which Chinese regulators are now working to ensure that an industry once left to its own devices adheres to a minimum set of standards.
As a result of the exam, Chinese private fund managers and executives are now officially required to demonstrate their product knowledge and understanding of best practice. Unless they pass they cannot be private fund portfolio managers or senior executives within these companies.
Overall, 65,000 participants from private securities firms and 14,000 participants from private equity or venture capital firms took the first round of exams. It was no rubber-stamping exercise either. Only 29% of the 313,000 people who took the first exam passed the second paper, which tests their financial knowledge.
Hu was part of the presumably smarter and better informed private equity and venture capital subset, but even their pass rate only stood at 54.7%.
“The results reflected the importance of this exam because many industry participants do not have basic [financial] knowledge,” said Davis Wang, China head at law firm Simmons & Simmons in Beijing.
Private fund firms, which encompass hedge funds, private equity and venture capital companies, were once virtually unregulated in China, unlike their rules-bound mutual fund house counterparts. This changed in February 2014 when the China Securities Regulatory Commission (CSRC) began to loosely oversee their operations.
Hedge funds, private equity and venture capital firms must now register with the Asset Management Association of China (Amac), a self-regulatory body supervised under the CSRC, if they wish to launch their own products. In the past such funds could only launch products by partnering with a financial institution such as a trust company, which would not mention the fund when selling the products. It’s a simple process though and, once they register, the fund firms largely regulate themselves, only volunteering information to Amac on the products they launch and how much they raise.
Such a low barrier to entry means almost anybody in the country could set up a private fund firm, launch products, and raise funds from investors. And that causes problems.
According to Amac, 25,841 private fund firms were registered with it at the end of January compared with 6,974 firms a year ago. Assets under management over the same period have grown to Rmb5.3 trillion ($817 billion) from Rmb2.6 trillion. Many of these firms aren’t investment vehicles at all, or have jumped into areas they shouldn’t, such as peer-to-peer (P2P) lending.
Hence the exam being introduced as one means to test the credibility of these aspiring private fund operators. It’s not the only measure either, with demanding due diligence standards also being introduced. The new requirements could well end up in a culling of the thousands of firms currently calling themselves private funds.
It won’t be pretty. But it is necessary, if the industry is to regain its integrity.
Industry chaos
China’s private funds industry growth is explosive, in almost all senses of the word. Loose regulation and untrammeled expansion has inevitably given rise to many allegations of fraud and mis-selling. These issues have led state media to describe the trend as “savage growth”.
“Compare to the business growth, regulations over the private fund industry are lagging behind. Illegal fundraising has become the core of [industry] chaos,” said Hong Lei, Amac’s chairman, at a conference last December.
Instead, they used the ‘registration certificate’ they receive upon registering with Amac to mislead investors about the credibility of their operations. That has helped many raise large sums via P2P lending, crowd-funding, private lending and providing product return guarantees – activities that a private fund shouldn’t be involved in anyway. How bad is it? Very. Amac found that more than 17,000 or 69% of registered private managers were shell companies with no real fund investment operations or evident plans to start a funds business.
The agency also scolded private fund firms for their weak legal compliance after many of them filed false information, and criticised their lack of sufficient risk controls.
Some of these issues surfaced during the Chinese stock market’s slump in the second half of last year. One high-profile example is the arrest in November of Xu Xiang, the head of Shanghai-based Zexi Investment. Dubbed by local media as “China’s Carl Icahn”, Xu was the first mainland hedge fund manager to be charged with insider trading and stock price manipulation, even though many mutual fund managers have been caught in the past.
The new policies come in the wake of the Chinese government’s crackdown on illegal fundraising after Ezubao, an Rmb50 billion online P2P pyramid-lending scheme, was shut down last December. The Shanghai municipal government followed Beijing’s municipal administration in April by halting applications by new firms containing keywords like “investment”, “finance”, “wealth management”, “capital” and “fund”.
Raising standards
Amac’s aim now is to raise entry barriers in private fund industry.
One step is the exam. Like other registered private fund managers, Hu was required by Amac to obtain the new Fund Industry Professional Practitioners Examination qualification within three months of the new rules taking effect in February. Those who failed the exam have two more chances left – in June and July this year – to pass.
However, there are signs the body will grandfather some participants. Amac offered to give exceptions to private equity executives with 12 years of industry experience, after receiving complaints.
Fortunately, other steps are also being introduced. Existing private firms and new entrants will need to hire a law firm to provide a formal legal opinion that its disclosed information is correct, following a due diligence process. Amac will deregister existing firms that fail to launch funds or gain such a legal opinion within 12 months of their registration.
One Shanghai-based consultant who focuses on private funds told AsianInvestor the regulator’s goal is to cut the number of private fund firms to 2,000, suggesting less than 10% of registered firm can survive eventually.
That culling process already appears to be underway. Nearly 2,000 firms were expelled between February to April and Beijing-based private fund distributor Gesafe Wealth Advisory estimates that a further 6,856 firms risk being deregistered in the next three months.
Some industry insiders say the change in regime is being imposed too quickly on private fund firms, which are catching flak due to problems elsewhere in the Chinese financial sector.
“The policy shifting is too fast from a loose stance to many rigorous controls,” said a senior executive at a Beijing-based private fund firm contacted by AsianInvestor, who preferred to remain anonymous. “The problem is the illegal fundraising activities associated with P2P and [the] internet financing industry, where the regulators should be blamed due to their insufficient regulations.”
For others, though, it made sense for the securities regulator to work with some urgency. “It is far better that the CSRC take actions now, as it is likely to take quite some time before they have achieved their objectives,” Stewart Aldcroft, a Hong Kong-based senior funds industry adviser at CitiTrust, said.
Aldcroft estimates that thousands of private fund firms are operating illegally or below the radar screen in China. He sees a rise in failures as inevitable, either through fraud or poor management.
He ascribed the CSRC’s tougher new approach to the regulatory body’s new head, Liu Shiyu, who replaced Xiao Gang in February. “I believe Liu is forward-thinking, from what we can tell, and is aiming to provide a regulatory environment that gets much closer to international standards,” he said.
Wang of Simmons & Simmons added: “It is like the [tightening of rules surrounding the] hedge fund industry in the US; it is a right approach to get closer to global practice with better information disclosure.”
“Existing managers with larger [AUM] will benefit,” said the Beijing-based executive. “If 2,000 private firms survive, it will be almost like receiving a licence from the regulator.”
In part 2, AsianInvestor describes how China's better-run local private funds are looking to foreign fund managers, even as international funds seek entrance to the mainland.