The Chinese authorities have banned private investment funds from investing in loans or loan-like assets in a move that experts said would give institutional investors more control over risk and improve the asset management industry.

The new rules had largely been anticipated following a comprehensive set of asset management rules in November, which installed tighter and more detailed regulation on asset management products. The latest regulations effectively prohibit private funds that invest into loan-like assets or acting as lenders.  

A notice released by the Asset Management Association of China (Amac) on Friday (January 12) defined private funds as being ones that carry risks which are borne by both fund managers and investors and reap returns through active risk management.

To ensure private funds stick to their original purpose—that is, investment—vehicles that are designed to lend will not be regarded as private funds and Amac will not process such applications from February 12 onwards, said Amac, a self-regulatory organisation under the China Securities Regulatory Commission (CSRC).
 
The move is also designed help to curb shadow banking activities in China amid Beijing's drive to deleverage the economy. 

Asset managers are not allowed to raise funds from non-qualified investors or provide any form of guarantees on principals or returns, according to the new rules. They must also abide by certain leverage ratios.

An analysis of the new rules indicates that private investment funds refer to vehicles that raise money private from qualified investors and invest in a variety of risk assets, including the stakes of non-listed companies (private equity) and derivatives.

Highlights of the new rules

1.Private funds cannot invest in private loans, micro loans, principal-guaranteed wealth management products or other assets that might fall in the category of lending.

2. Private funds cannot underpin lending activities conducted directly or indirectly through entrusted loans, trust loans, special-purpose vehicles or investment companies.

3. Private funds should be managed and audited independently. Irregularities such as cash pooling and duration mismatch are not allowed.

4. For private funds that are involved in related-party transactions, the managers are required to disclose the relationships in question, provide documents to prove the fair value of the underlying assets, and implement effective risk control.

Fundraising in China’s nascent asset management industry incorporates many implicit forms of guarantees, which effectively mean the industry is deviating from its original purpose—investment—to operate as a lending business, said Liao Qiang, a Beijing-based senior director at S&P Global Ratings.

Before these new rules, many asset managers and banks issued asset management products that had themselves invested into other investment products. These products effectively underpinned loans to companies in overcapacity industries, or with the capital being invested into equity stakes in the companies for a fixed time period, and offering a fixed return. These loan-like investments enjoyed an implicit guarantee because in many cases other shareholders promised to cover any shortfall in value.

Last week, the country’s insurance regulator introduced new rules to remove implicit guarantees from the equity investment plans of fund house affiliates. This week's move marks the latest step in this effort, with the elimination of private funds that rely on such guarantees.

Good news for the funds industry

Banning asset managers from using loans as underlying assets in private equity portfolios can help remove implicit guarantees and enable investors to better gauge the value of the underlying assets, Liao told AsianInvestor.

If a fund is invested in many non-liquid credit assets, it is very difficult for third parties to assess the value of those assets and work out the suitable returns of the investments. As a result implicit guarantees will come in one way or another, noted Liao.

Rachel Wang, director of Chinese fund manager research at Morningstar, told AsianInvestor that greater transparency of the underlying assets will mean lower risk for institutional investors.

Eliminating implicit guarantees, which prevent risk from being properly priced, will prevent the build-up of systemic risks in the financial system and make the fund management industry better off, she noted.

If such guarantees are not removed, asset management products issued by banks and fund houses will not compete on a level playing field. Investors will always prefer banks’ wealth management products that have implicit guarantees over mutual funds whose assets are priced according to fair market values, she said. 

“The industry will develop in a healthier way, [in that fund managers] will focus more on active asset management,” Wang said.

The new rules will help to reduce shadow banking activities, and encourage private fund managers to engage more in active management of funds, said an analyst at a Shanghai-based consultancy firm, who declined to be named. Some may shift towards funds managing public-private partnership projects and asset-backed securities.

*The People’s Bank of China, China Banking Regulatory Commission, China Securities Regulatory Commission, China Insurance Regulatory Commission and State Administration of Foreign Exchange jointly released a consultation paper on regulating asset management products on November 17, 2017.