Anthony Zhao, senior partner at law firm Zhong Lun, disappointed an audience of private-equity professionals yesterday in Hong Kong by quashing rumours that a new pilot programme in China would show US dollar-based investors a route to being treated on par with domestic investors.

Under ‘QFLP’, a scheme for qualified foreign limited partners to convert investments into renminbi that’s just been launched in Shanghai, any fund with any foreign investor, no matter how small a portion of the underlying capital, is still considered ‘foreign’.

This means such funds will face the same restrictions on downstream investments, meaning they can’t invest in sectors where the government prohibits foreign capital, or in secondary stock market or bond market trading. Nor can they invest in real estate unless it’s for the fund’s own use, or use non-owned funds to make investments.

Zhao made his comments at a conference in Hong Kong organised by the Hong Kong Venture Capital and Private Equity Association, where the proliferation of onshore RMB-denominated PE funds has stirred worries among the established investment community, which by definition has operated in US dollars.

Purely domestic RMB-denominated funds enjoy preferential treatment. More dollar-fund managers are launching RMB-denominated strategies as well, in a bid to keep up with the new reality, but this unsettles their investors and, anyway, has not delivered the same benefits as pure domestic GPs enjoy.

The QFLP scheme will not solve their problem but it will at least make it easy for offshore funds, managed by firms that lack a local presence or ability to raise a fund in renminbi, to convert their dollars into renminbi upfront. And it could become a badge of acceptance towards winning access to state-owned money.

In the meantime, the international PE community has a problem on its hands.

Conrad Tsang, managing director at Baring Private Equity Asia, says in 2010, Chinese private equity raised 82 funds totalling $27.6 billion, of which 85% came in the form of RMB funds. The US dollar market remains bigger but the growth is clearly in the RMB segment.

Alvin Li, managing director for direct investments at CCB International Asset Management (which for now only has US dollar PE funds), says there are now more than 2,000 RMB-denominated PE funds on the mainland, most of which are small, under Rmb100 million.

Such funds operate less on the basis of strict due diligence and bringing operational value to a company, and more on fast-paced deals based on relationships with local cadres or entrepreneurs – although the biggest ones such as Legend Capital or Hony Capital, or the investment arms of the big commercial banks, operate along traditional PE lines.

The result of these funds has been to push up valuations and put a lid on investment returns.

“As an international investor, this means we need to set ourselves apart,” says Adam Roseman, managing director of ARC China. This means emphasising operating expertise, an international network for companies, and other resources beyond mere capital provision.

Until the raucous market of RMB funds rationalises, the best investment stories may not be in China, warns Vincent Chu, founder and chairman of First Eastern Investment, which has been investing in Chinese PE since the 1980s.

Chu notes the sector has seen waves of excited money before, along with inflated multiples on asset valuations, and a long-term investor needs to ignore the noise and bide his time.

For now, the explosion of RMB funds hurts his business and undermines market discipline, so Chu prefers to invest in Europe, where valuations are cheaper and the currency is weak, and then bring those investee companies to China to set up partnerships and joint-ventures, and co-invest with them.

For funds or LPs focused on China or Asia, RMB funds are simply a fact of life, but not a reason to question the overall investment thesis.

“Yes there’s overinvestment in certain areas and an overreliance on exports, but we’re a pension fund with a 20-30 year outlook,” says Eric Rogan Mason, senior vice-president in Hong Kong at the $9 billion US-based The Church Pension Fund.

And for LPs, the name of the game is still about sifting through many GPs to find the right fit.

Alice Chow, managing director at Squadron Capital, a fund of funds, sums it up: “Do we understand what we’re getting into with a GP when we give someone our money for the next 10 years?”

She says Squadron has now more than a thousand candidate GPs to analyse. The trick is to remain methodical and bottom-up, and not feel pressured to commit capital for its own sake.

The private-equity game for investors is still about picking experienced managers with a competitive edge to take advantage of China’s secular growth story. The RMB funds phenomenon is not going to go away but it will one day mature, and quality execution should still deliver LPs the high returns they expect.