China’s new rules to strengthen governance and transparency in the private equity industry will help to align it with environmental, social and corporate governance (ESG) ideals, but the country's controlled currency exchange system will continue to keep foreign private equity investors at bay.

The China Securities Regulatory Commission (CSRC) rolled out a set of rules on January 11, marking the first time the country’s regulator directly unveiled specific measures for the PE market.

Under the new rules, private equity managers must provide more transparent information regarding fundraising activities and corporate matters, face more restrictions on private funds’ investment activities, particularly in lending, and navigate more stringent regulations on private equity managers’ potential conflicts of interest.

Experts believe that the provisions will create a healthier investment climate for both fund managers and investors and reduce risks in the sector. 

Melody Yang,
Simmons & Simmons

China’s private fund investment sector has seen rapid development in recent years. However, this progress is also “accompanied by chaos, such as disguised public fundraising, circumventing the requirements of qualified investors, failing to fulfil the obligations of registration and filing as well as complex group and capital pool operations,” observed Melody Yang, a partner at Simmons & Simmons.  “All of these are bringing risks into the industry,” she added.

BARRIERS REMAIN

 

“The new provisions will serve as enhanced enforcement tools to reinforce China’s supervision of private funds, crack down violations emerging in the past couple of years as well as to protect the legal rights and interests of investors,” Yang said.

However, the rules are unlikely to spur a significant increase in private equity investment because the yuan isn’t fully convertible as yet.

For foreign investors who are hungry for China’s private equity assets, barriers such as foreign exchange limitations are keeping investors passive, according to Yang.

Still, she noted that the country’s foreign exchange policies have been more relaxed in recent years, particularly towards cross border equity investment through various pilot programmes, including the Qualified Foreign Limited Partnership (QFLPs). The government has in recent years expanded the scheme to include more cities. Such pathway allows foreign limited partner to tap into a Chinese private equity and venture capital (VC) funds.

Richard Tan, portfolio specialist for Asia at Mercer, echoed Yang’s point. "The new measures will enable qualified investors made up of institutional investors to penetrate deeper into the market,” he said, adding that “more deal flow is expected to occur if regulators address currency restrictions.”

Nils Rode, Schroder Adveq

PRIVATE EQUITY REBOUND

The new rules come at a time when private equity activities are rebounding in China.

After a drop in the first quarter last year, fundraising in the third quarter was 41% higher year-on-year and doubled the second-quarter amount. Investment activities had also seen a year-on-year increase of 40% in the third quarter of 2020, according to a January 12 Mercer report.

The country recorded a 2.3% GDP growth in 2020, and its PE industry has seen steady growth.

As of the end of the third quarter last year, there were 91,798 registered PE funds with total assets of Rmb15.8 trillion ($2.44 trillion) in the country, according to Asset Management Association of China data. A respective 15% and 16% increase year-on-year.

In Asian private equity markets, despite the effects of the pandemic as well as the ongoing political tension between the US and China, China may still offer attractive investment opportunities, Tan projected.

ESG RISES

Richard Tan, Mercer

PE is also particularly well suited for investors with a strong ESG focus, according to Nils Rode, the chief investment officer of Schroder Adveq.

Due to the controlled nature of the investments and the often lengthy due diligence process, private equity is well-positioned to achieve increasingly important ESG and impact-related objectives in addition to financial goals, Rode noted in a January 14 report, Outlook 2021: Private Assets.

It will become more important for investors keen on China’s market to capture the “complexity premium”, he added, referring to the need for more creative and specific strategies to capture premiums.

This can be found in more specialised and harder-to-access private equity market segments such as small buyouts and direct/co-investments, he wrote.

Such segments in China will require an enhanced level of due diligence, said Tan from Mercer.

“Co-investments require quick decision making with a sufficient due diligence procedure under a competitive investment climate. Institutional investors have been looping internal and external teams to strengthen the ability to capture investment opportunities in certain cases,” he said.