Fund managers with a China joint venture that operates a segregated account subsidiary have been urged to review the latter’s liability firewalling, risk control and capitalisation levels with their mainland partner.

The warning was issued by Shanghai-based consultancy Z-Ben Advisors. It comes after subsidiaries of Value Partners Goldstate, Wanjia and Huachen Asset Mirae all disclosed potential product defaults or repayment problems from borrowers of a size that dwarfs those subsidiaries’ capitalisation.

AsianInvestor reported yesterday on the case of Value Partners Goldstate. It is the SA subsidiary of Value Partners Goldstate Fund Management – a joint venture between Hong Kong’s Value Partners and Goldstate Securities.

Z-Ben pointed to a substantial mismatch between many foreign owners’ evaluation of the financial, brand and political risk being taken by JV subsidiaries and the potential for liability.

“With evidence mounting that regulators may involve themselves to resolve payouts to investors in the event of product defaults, every foreign JV partner should now form their own independent view of the quantitative and qualitative risks their subsidiaries run,” noted Z-Ben.

The consultancy said the subsidiary of any fund management firm should be viewed as presenting a meaningful risk, potentially even putting the parent fund management firm’s capital in danger.

It suggested that the development of what has become known locally as “channel business”, which at its roots referrs to pools of loans from banks packaged for resale, had created risks that many JV partners were entirely unaware of.

“A significant portion of FMC subsidiary channel business is now much more akin to loan origination, where products are created to meet the needs of a single borrower, in an unknown percentage of cases without any meaningful due diligence undertaken on that borrower’s ability to repay or quality of collateral,” stated Z-Ben.

It argued that insufficient due diligence was being conducted by FMC subsidiaries over credit quality in a product universe that it estimates to have reached Rmb2 trillion ($325 billion), from a standing start in late 2012.

As Z-Ben stressed, FMC subsidiaries’ own registered capital – as low as Rmb20 billion and typically about Rmb55 billion – appears wholly inadequate to meet even a small proportion of potential claims.

How these firms and the regulator will resolve such issues is unclear. Moreover, liability in the event of defaults or investor losses for FMC subsidiary products has not been tested.

The consultancy said there appeared to be little understanding how far this channel business had drifted from its original form. By way of comparison, Z-Ben noted that the trust industry – whose channel AUM has grown in step with that of FMC subsidiaries – had undergone largescale recapitalisation over the past two years.

The average recapitalising trust had increased its registered capital by 300-400% in response to growth in potential liabilities as product AUM soared, stated Z-Ben.

“Whatever assurances you believe you have for protection against losses at subsidiary level, they will almost certainly need to be re-evaluated as a result of changed business practices and the possibility of impending regulatory involvement,” it urged fund managers with China JV partners.