On 27 April 2018, the People’s Bank of China, the China Banking and Insurance Regulatory Commission, the China Securities Regulatory Commission (CSRC) and the State Administration of Foreign Exchange jointly issued the Guiding Opinions on Regulating the Asset Management Business of Financial Institutions (the new regulations). Under the previous divided regulatory model, issues such as regulatory arbitrage, product multi-level nesting, rigid payment, circumvention of financial regulation, etc. had arisen in the asset management business. To address the issues, the four authorities are cracking down in unison, in order to change the existing financial regulatory model by fully reflecting the trend towards cross-sectoral operation and regulation. With respect to private funds, the following changes should be made.
There is a need to revise the criteria for qualified investors of private funds. The new regulations set relatively low initial investment amounts of RMB300,000 (US$47,000) and RMB400,000 for fixed return products and mixed products. However, in light of the new regulations and the Asset Management Association of China’s (AMAC) explanation of the categories of private funds, we contend that what corresponds to private equity investment funds in the new regulations are equity products, whose minimum investment amount remains at RMB1 million, which is consistent with the Interim Measures for the Regulation of Private Investment Funds.
AMAC currently emphasizes that the managers of different types of private funds carry out professional operations, and accordingly, the setting of various minimum investment amounts for different asset management products has a relatively minor impact on private equity investment funds. In contrast, private securities investment funds issued under the new regulations will raise new issues and bring fresh approaches to compliance management of structural design and offerings of fixed return and mixed private securities investment funds.
Pursuant to a new provision of the new regulations that individual investors should have at least two years of investment experience, it is necessary to take note of the conduct of an investigation and the provision of a risk warning with respect to investment experience in the offering documents, and that investors are required to provide documentation evidencing their investment experience and an undertaking.
Penetrative review of multi-level nesting structures. The new regulations expressly specify that an asset management product may invest in another (second) asset management product, but the second product should not further invest in another (third) asset management product other than a public securities investment fund. In light of this and under the rule of penetrative examination of investors, the past transaction structure (where ordinary bank wealth management funds further invest in the equity of unlisted enterprises and other such non-standard assets by investing in a private fund through a securities brokerage asset management product or fund account) does not comply with the provision on dual level nesting under the new regulations.
The new regulations additionally specify that a publicly offered product may not invest in non-standard credit assets or the equity of unlisted enterprises, unless otherwise provided in laws or regulations, or by the financial regulator. Under the principle of downward penetrative examination of underlying assets, the investment in non-standard assets by a publicly offered product through a nested private equity investment fund is prohibited.
Guaranteed principal and returns remain prohibited. Against the backdrop of the new regulations, the private fund manager of a fund that invests in non-standard credit assets or equity may not provide any manner of security or buyback undertaking, and a product divided into classes may not provide a guaranteed principal and return arrangement to the investors with the highest priority. Based on this, the specifying of such arrangements in practice as the allocation of preferential unit returns and penalty interest for early termination, or the lower priority investors or a third party institution making up any shortfall in the returns of the investors with the highest priority, or allocation to a risk reserve to make up any shortfall in the returns of the investors with the highest priority, etc. are not permitted. However, the provision to the fund by the target enterprise’s shareholders or actual controller or an affiliate thereof at the project investment end of a design for a divestment guarantee remains lawful and compliant.
Limits on leverage ratios. The new regulations unify the asset management product leverage level from the two aspects of product class leverage and liability leverage. In terms of product class, the new regulations specify that the class ratio of fixed return products may not exceed 3:1, that of equity products may not exceed 1:1 and that of commodity and derivative type products and of mixed products may not exceed 2:1.
It should be noted that there is a discrepancy between the new regulations and the provision of the “new eight baselines” for private asset management previously issued by the CSRC on the class ratio of private products that have non-standard credit assets as their underlying assets. Pursuant to the new regulations, a fixed return product with non-standard credit assets as its underlying assets may be designed as a structured product with a class ratio of 3:1. However, in the CSRC classification, investments in non-standard credit assets are classified in the “miscellaneous” category, and their maximum corresponding class leverage ratio is 1:1. Accordingly, for private funds that invest in non-standard credit assets, the design space for product classes is greater since the issuance of the new regulations.
With respect to liability leverage, the new regulations specify that the total assets of a private product may not exceed 200% of its net assets, and the total assets of a private product divided into classes may not exceed 140% of its net assets. In practice, from the perspective of risk control, private equity investment funds are generally prohibited from taking on debt; the liability ratio of buyout funds is subject to the upper liability ratio specified in the new regulations.
In the financial law field, whatever is not specifically prohibited in law is permitted. With respect to issues not expressly prohibited in higher level laws, such as the criteria for qualified investors, information disclosure, product classification, liability ratio, etc., the new regulations use such language as “shall”, “may not”, etc., so if a dispute arises revolving around these issues, it remains to be seen how court judgments will apply the relevant rules. From the perspective of prudence and risk control, private funds should apply the relevant rules strictly within the framework of the new regulations.
Ma Chenguang is the managing partner and Wang Xi is an associate at Co-effort Law Firm