China WFOE rules constraining private funds business

Foreign asset managers may decide against setting up or upgrading to an investment management wholly foreign-owned enterprise (IM WFOE) in China because of constraints on fundraising and on use of offshore electronic trading systems.

Alternative investment firms licensed under Shanghai’s qualified domestic limited partnership (QDLP) scheme must set up a new WFOE to run private funds onshore, as Beijing wants to see ring fencing between domestic and cross-border operations, noted Ge Yin, a counsel at UK law firm Clifford Chance.

“The [WFOE] policy change is a piece of great news, but foreign asset managers should not overlook the limitations,” she told AsianInvestor.

Offshore managers can, as of June 30, register with the Asset Management Association of China (Amac), a regulatory body under the China Securities Regulatory Commission (CSRC), after setting up an investment management WFOE or converting a consulting WFOE into an IM WFOE. This is the first time overseas asset managers have been able to access the mainland market directly.

But there are two major limitations under the new rules. First, such private fund firms must conduct all investment decision-making and execution onshore in China. As a result, hedge fund strategies that rely heavily on use of electronic trading – such as commodity trading adviser or quantitative managers – will find it difficult because they will not be able to use overseas systems. 

“This is consistent with the CSRC’s concerns about program trading in the domestic market via offshore-based system,” said Ge. 

The mainland securities watchdog has put more scrutiny on systematic and automated trading as a result of the equity market rout that began in June last year. The CSRC suspended and investigated at least 34 trading accounts in August due to suspected short-selling during the market correction, including one at the joint-venture brokerage arm of US hedge fund Citadel, as reported.

Moreover, there are strict restrictions on cross-border capital flows under the WFOE rules – not only must investment be done onshore, but so must fundraising. This may deter some foreign managers’ from using this access channel, as their main goal may be to raise money from mainland clients to invest in their offshore products, said Ge.

In light of these limitations, foreign managers under the QDLP scheme, which allows foreign firms to raise renminbi to invest in their overseas funds, may not wish to put resources into a WFOE.

Fifteen foreign managers have received QDLP licences and quota in Shanghai, and 11 have registered with Amac. To obtain such a licence, they must have a WFOE with scope to do overseas investment fund business, but such entities cannot make onshore investments. These so-called QDLP WFOEs cannot simply be upgraded to an IM WFOE that can run private funds onshore.

A Shanghai-based source said Shanghai’s Financial Services Office had made it clear that a QDLP WFOE could not make such a move at this stage.

A foreign asset manager may therefore have to establish two WFOEs – one for QDLP business and one to run domestic private funds, said Ge. “The regulators want ring fencing between pure domestic and cross-border fund management business, at least for the time being.”

Ge said many of her overseas clients were considering how to react to the new policy; not all of them are planning to set up a WFOE or register with Amac immediately.

“The new policy has asked them to re-consider their China business plans,” she noted. Some foreign firms with stakes in mainland joint-venture fund houses or securities companies are considering whether to consolidate such businesses under an IM WFOE.

It’s possible that a mainland WFOE could be used to conduct mutual fund management in the future, Ge added. Chinese private fund managers become eligible to apply for a mutual fund company licence when they have three years’ operating track record.

In an email to AsianInvestor, Amac did not comment on whether a QDLP WFOE was eligible to register as a domestic private fund firm, but said all WFOEs needed to present a certificate of approval for establishment, stating their permitted business scope.

Among the 15 QDLP managers, US-based firm BlackRock stands out as having established three WFOEs in China: one in Beijing for real estate investment and two in Shanghai, one for QDLP business and one for consulting business.

China's private funds industry growth has outpaced the growth of mutual funds in the past two years, admittedly from a relatively lower base. Private funds AUM swelled 24% to Rmb2.2 trillion in the first five months of this year, while mutual funds AUM fell 4% to Rmb8.1 trillion in the same period. That said, mutual fund assets had leapt 267% to Rmb1.8 trillion during 2015 from Rmb488 billion as of end-2014.