China’s incoming rules to regulate private fund investing could leave a loophole that allows privately-raised fund vehicles to continue investing into credit assets, such as corporate lending. That would run counter to the government's long-running attempts to crack down on the country's shadow lending market.

The State Council released draft rules on ‘Interim Measures for the Supervision and Administration of Privately-raised Investment Funds’ on August 30. It is inviting the public to express their opinions about the draft rules during the one-month consultation period, which ends on September 30.

The council's document defines privately-raised investment funds as being either a private equity fund or a private fund that invests in securities in the secondary market.

However, the document didn't explicitly include oversight of private funds that invest in non-standard assets. Non-standard assets are defined as ones not traded on the inter-bank bond market or stock exchanges. This includes trust loans, bills of exchange, accounts receivable and other credit products. 

“There is a loophole in this regulation," Shi Jingyuan, partner at international law firm Simmons & Simmons, told AsianInvestor

Liao Qiang, senior director at S&P Global Ratings, told AsianInvestor the key issue at stake is that the new rules could effectively allow private funds to lend money to corporates.

"The key concern is whether they would operate like a bank," he said.

Such behaviour would potentially place funds that act as lenders in opposition to Beijing's increased attempts to reduce or better monitor the country's thriving shadow banking industry, or lending conducted outside the banking sector. 

"If funds are set up purely to circumvent banking rules then I would expect at some time that the government will take an interest in what they are doing," Keith Pogson, senior partner for Asia-Pacific financial services at consultancy EY, told AsianInvestor.

Morever, if the underlying credit assets do not consistently make better returns than bank deposits or index tracking style returns—in other words demonstrate positive alpha—then investors will become less likely to invest in such funds, Pogson said.

Monitor, not ban 

Simmons & Simmons' Shi was confident the government would act quickly to plug this loophole.

"If, in the final draft, private funds investing in non-standard assets are still not caught then I would expect that there will be other rules [regulating them],” she said.

Liao argued that new rules were not necesarily needed, with the term 'private equity' being broad enough to cover funds that invest into both private companies and also non-standard assets. He added that regulators should monitor funds conducting such activities instead of banning them.

“It’s up to effective supervision and regulatory enforcement … I do not think it’s a good idea to simply ban something just because of concerns of inadequate supervision,” he said.

The key issue, Liao said, was that fund managers and investors agree on what types of assets are permissible and ensure there is proper transparency and risk valuation. Non-standard asset investing such as corporate lending could be potentially less risky than investing into equities, where investors risk losing their entire principal, he added.

Pogson noted that Chinese regulators have become more vigilant when monitoring unregulated lending activities after the failure of many P2P lenders. However, he said this did not necessarily mean the government would close down private funds investing in non-standard credit assets. 

"To the extent that private funds are specialists in credit or distressed assets then it makes complete sense for them to do so," he said.

Penalties defined

The China Securities Regulatory Commission drafted former interim measures on private funds in 2013 and passed these rules in 2014. It was said to have mulled suspending private funds’ ability to invest into non-standard assets when drafting the current set of rules, according to a news report by the 21 Century Business Herald.

This time around, the State Council released the draft. It is the country’s chief administrative body, which highlights the importance of the new measures, said Shi of Simmons & Simmons.

The legislation is largely expected and welcomed by the investment community, she said. Most of the rules are by themselves not new, but penalties for rule breakers are defined in the new version.

“There is no definite timeline on legislation of the rules ... I personally think for this one, it should be relatively quick,” said Shi, pointing to the serious concerns in China about the private funds industry, in light of legislative efforts in this area. 

To provide the latest insights on investment in China, AsianInvestor is hosting its 4th China Global Investment Forum at the Westin Beijing Financial Street on September 21. For further details, visit the website or contact Terry Rayner via email or on +852 3175 1963.