New era for private funds in China

China’s new regulation related to private funds paves the way for healthy growth and innovation

China is set to overhaul its 21 trillion RMB (US$2.9 trillion) private funds sector with new rules that will come into effect on September 1. 

The “Regulation on the Supervision and Administration of Private Investment Funds” comprising seven chapters and 62 articles was approved by the State Council and signed off by Vice Premier Li Qiang in July. It is the country’s first administrative regulation governing private funds, bringing them under the nation’s official legal regime.

Private funds are a relatively new development in China and were not covered by the 2003 Securities Investment Fund Law or its amendment in 2012. 

The new regulation is administrative and therefore has a lower legal status than the 2003 law, according to Chinese legal firm Links. But it ranks above departmental rules related to private funds, such as those issued by the China Securities Regulatory Commission (CSRC), or self-regulatory measures. It overrides all other supervisory rules and measures and will be used by Chinese courts for judgements on civil and administrative lawsuits related to private funds. 

The regulation applies to all types of private funds, whether they are in the form of contractual, corporate or partnership structures. It defines fund manager and custodian obligations, fundraising and investment operations compliance, investor suitability assessment, personnel and products registration procedures, exit rules, legal liabilities, and various other supervisory and administrative issues. 

“The regulation aims to encourage a regulated and healthy development of the private fund sector, better protect the legitimate rights and interests of investors, and encourage the sector to play a greater role in serving the real economy and promoting scientific and technological innovation,” the State Council Information Office says in a statement.

Private funds in China are strictly only for investment by high-net-worth individuals and institutional investors. They cover a broad range of investment strategies, from private equity and venture capital to securities investment funds, commodities funds, and hedge funds such as long-short, quant, macro, and arbitrage.

Although these funds have been in existence for decades, they only came under official purview in 2014 when the CSRC issued interim measures requiring them to register with the Asset Management Association of China (AMAC) and operate under its guidance.

Since then, assets under management of private funds have surged from 385.5 billion RMB to nearly 21 trillion RMB as of April 2023. This represents around 30% of the 67.28 trillion RMB of assets in China’s multi-sector asset management industry. The private fund sector is the second largest after public mutual funds, with more than 22,000 firms managing over 153,000 products and employing over 176,000 people.

Irregularities

Private funds are increasingly accepted by accredited investors who are willing to take higher risk for higher returns, reflecting the maturing of the Chinese investment market.

However, as former CSRC Vice Chairman Yan Qingmin noted at a forum in 2019, many private funds are “small, scattered, and weak” and their funding sources and investment behaviour are oriented towards the short term.

This is underscored by AMAC data, which shows that as of December 2022, only 1.7% of private fund management firms managed more than ten billion RMB of assets. Around 27% managed less than ten million RMB, while almost 9% were zombie firms without assets.

There have been various headline-grabbing incidents involving private fund irregularities over the last few years, such as insider trading by hedge funds and illegal fund embezzlement using fake private funds. AMAC de-registered more than a dozen private funds for bad conduct and fined several firms and individuals, including some big names.

To revamp the industry, the CSRC released a consultation paper in September 2022 and published several rectification provisions early in 2023 based on feedback from the industry.

Meanwhile, AMAC moved to weed out weaker and bad players in May this year by raising the paid-in capital requirement of private fund management firms from two million RMB to at least ten million RMB. It also tightened requirements for registration and the filing of products, including initial product offerings. 

These measures have started to clean up the industry. According to data from AMAC, almost 2,000 private funds have been de-registered this year as of July.

As such, the new regulation did not come as a surprise. It provides the long-awaited legal framework to enhance investor protection and strengthen governance, paving the way for the sector’s healthy development. 

Startups in focus

What’s noteworthy is its spotlight on private funds investing in early-stage businesses, with one chapter dedicated to such investments. Private funds that put money into startups will be given preferential treatment, such as simplified registration procedures, less frequent on-site checks and easier investment exits.

Among the different categories of private funds, private equity and venture capital funds had 11.16 trillion RMB and 3.04 trillion RMB of assets, respectively, for a total 14.2 trillion RMB. By contrast, private funds covering various securities investment strategies had 8.7 trillion RMB of combined assets.

According to a question and answer blog about the regulation published on the CSRC website, as of March 2023, PE/VC funds have invested 11.6 trillion RMB into 200,000 domestic unlisted companies as well as companies and refinancing projects listed on the National Equities Exchange and Quotations, referred to as the New Third Board. 

Almost 90% of companies on the Science and Technology Innovation Board, 60% of those on the Growth Enterprise Market, and over 90% of companies on the Beijing Stock Exchange received support from these funds before going public.

In addition, these funds invested five trillion RMB in startups in the fields of technological innovation earmarked as strategic national priorities, such as computing, semiconductor, and biopharmaceutical. 

“Private equity and venture capital funds play an important and positive role in supporting entrepreneurship and innovation, raising the level of direct financing, while supporting people's wealth management,” the CSRC says.

Underdevelopment

The private market’s increasingly significant role in China is in line with the global trend. According to McKinsey’s Global Private Markets Review 2023, private markets’ assets under management reached $11.7 trillion as of June 2022, growing at an annual rate of nearly 20% since 2017. 

Asia’s private markets are collectively worth $2.5 trillion, the second largest region in the world after North America and surpassing Europe’s $2.3 trillion. Chinese PE/VC fund assets of roughly $2 trillion represent almost 80% of Asia’s total.

Foreign participants have been active in China’s private market development since the beginning of PE/VC funds in the country, not just in providing capital but also international expertise and market reach. 

At the same time, various Chinese government entities at provincial, municipal, county and district levels provided substantial funding. According to ratings agency Fitch, 22% of capital raised by RMB-denominated PE/VC funds in 2021 came from Chinese government funding vehicles.

But foreign participation is no longer reliable. Global private markets were hit last year amid concerns about interest rate hikes, rising commodity prices and an economic slowdown, with fundraising down 11% from 2021 to $1.2 trillion.

Investment appetite in China is also blunted by intensifying geopolitical tensions with the US, which is increasing trade restrictions on Chinese hi-tech and strategic industries and heightening government scrutiny of Chinese mergers and acquisition deals by US firms. 

PE/VC investments in China by US investors have dropped dramatically. According to S&P Global Market Intelligence data, aggregate deal value in 2022 fell 25% to $7.1 billion from 2021 and the number of deals plunged 60%. This trend continued into the first quarter of this year with total deal value plummeting 86% to $400 million from $3.03 billion a year ago. The number of deals shrank to 28 from 61. 

Meanwhile, China’s post-Covid economic recovery has been uneven and slow. And government coffers are being squeezed.

China’s private market is underdeveloped, representing only 1% of the country’s total financial assets. Launches of RMB-denominated PE/VC funds to tap domestic liquidity are on the rise amid growing difficulties in foreign fundraising. These funds raised the equivalent of $455 billion in 2022, just 4% lower than in 2021, according to Chinese private equity data provider Zero2IPO. 

Promoting a vibrant domestic private market is a key way for China to reset the world’s second largest economy and achieve its goal of self-reliance in science, technology and industrial innovation.

*This article was published in Asia Asset Management’s august 2023 magazine titled “Far-reaching overhaul”.