What has changed, and what does the future hold for the RMB100 trillion asset management industry in China now that new rules are firmly embedded? Frankie Wang reports

Does that old saying, “cash is king”, hold true in the current sluggish economy? Business tycoon Warren Buffett is the champion of cash; his Berkshire Hathaway had stockpiled US$137 billion at the end of the first quarter, with a net loss of US$49.75 billion for the same period. Ray Dalio, the founder of the world’s largest hedge fund, Bridgewater Associates, who once famously said that “cash is trash”, has also witnessed a slump of 20% by the end of the first quarter for the company’s flagship fund Pure Alpha II, as reported by Bloomberg.

China’s asset management sector is struggling against the Sino-US tussle and the pandemic. The cashflow of financing parties is tighter, the expected rate of return of asset management products is falling, and heightened regulations also pose great challenges.

In April 2018, the Guidelines on Regulating the Asset Management Business of Financial Institutions was issued, and anticipated to set off a new era of “mega asset management”, when the whole sector would be under standardized regulation. The guidelines explicitly prevent banks from providing financing to clients through third-party trusts or asset managers (or the so-called channel service, where third-party trusts serve as channels to funnel the funds from the banks to companies), and also to prevent financing platforms from making guarantees of full repayment to the investors when borrowers default and require deleveraging.

Even with such heightened regulation, by the end of 2019’s second quarter, the size of assets under management in China was still as high as RMB115.83 trillion (US$16.55 trillion), according to the statistics of PY Standard, an asset management data company.

Since then, detailed regulations of the guidelines have been promulgated, and these asset managers have embarked on transitions at varying speeds. Tony Wang, a senior partner at Wintell & Co in Shanghai, believes the guidelines serve two purposes. “On the one hand, it unifies the regulation, reducing the opportunities of policy arbitrage, while on the other hand, it aims to curtail the size of non-standard financing to decrease the possibility of a systematic financial risk,” he says. “The whole sector is advancing towards these two goals steadily.”

王同海 Tony Wang 瀛泰律师事务所 Wintell & CoZhu Zhitong, a partner at Hylands Law Firm in Beijing, adds: “The regulators and judicial organizations now have more refined targets for supervision, and attach greater attention to whether the sector really services the real economy, asking the sector to re-commit themselves to basics.”

Well intended as this may be, some legal experts don’t think that the new rule will fundamentally change the fragmented regulation picture in China, where the China Banking and Insurance Regulatory Commission (CBIRC) or the China Securities Regulatory Commission (CSRC) intervene whenever the issuer fits within their purview.

“Different regulators have different standards, and different understandings and implementations of the guidelines; these differences exist even in the same sub-sector, since the asset managers and their products are different, leaving room for regulation arbitrage,” says Chen Zhen, a partner at Fangda Partners in Beijing. “Appropriate differences might be necessary, but it needs further elaboration whether those differences should be based on the nature of the asset managers or of the products.

In February this year, Cao Yu, vice chairman of the CBIRC, expressed an intention to extend the transition period for some institutions that cannot complete corrections to their existing products beyond the original deadline of the end of 2020.

In 2020, where black swans (unexpected events with severe consequences) and grey rhinos (neglected threats) co-exist, how have the asset managers shifted their investment preferences? What are the concerns for compliance, and what does the future hold for the industry?

朱志彤 Zhu Zhitong 浩天信和律师事务所 HylandsOPPORTUNITIES IN A CRISIS

It is natural that conservative investment approaches, such as bank deposits and insurance products, are gaining in popularity, but the pandemic hasn’t put a halt to other investment, and this holds true for asset managers. Zhang Fangxue, a partner at Shihui Partners in Beijing, says there are still demands for project financing and investment. “As far as I can see, neither the fund, nor the trust, nor the personal finance has stopped,” says Zhang.

Opportunities may come for the sector if China can gain victory over the pandemic, in its current phase, ahead of the world. “Supporting policies at national level include not only short-term pandemic preventative measures, but also ones that can have a long-term impact on the industry,” says Chen from Fangda, “and the new economy does not pause because of the pandemic.”

She also believes that some companies with solid fundamentals have become attractive investment targets, since their valuations have been suppressed because of low liquidity.

张芳雪 Zhang Fangxue 世辉律师事务所 Shihui partnersIn terms of foreign investment, Chen says China’s regulation had been steadily increasing even before the pandemic, while the international situation has caused foreign investors to be more cautious about investing in the country. “Foreign investors might have shrunk back from intensifying investment in China in the short term,” she adds.

On the other hand, she believes that the impact of Sino-US trade tensions may ease for China, which is becoming the first country to normalize its macroeconomic environment amid the global panic of the pandemic. Coupled with a national policy of continued opening-up to the financial and other sectors, “China might become a short-term safe haven for foreign funds and a long-term investment destination”.

陈瑱 Chen Zhen 方达律师事务所 Fangda partnersZhang, from Shihui, also mentions foreign funds’ investment interest in China. She says A shares and real estate may become prime targets for foreign investors, and some are already bargain hunting on domestic property. “[Foreign investors] reckon this is an opportunity, and are expecting lucrative returns from bargain hunting once the market turns bullish.”

But foreign direct investment may downsize, she adds, signifying the impact of the pandemic on the real economy, and that the Sino-US trade tensions still exist.

The pandemic is changing how people live and work, leading businesses to rethink and innovate their operational models. Long Haitao, a partner at Merits & Tree Law Offices in Beijing, says the pandemic has led to a prominent trend in digital operation and online sales of asset management products, and believes this momentum will continue after the pandemic.

PRIME FOCUS POINTS

With the promulgation of the guidelines, sub-sectors in asset management are downsizing and de-escalating. As Chen observes, banks, trusts, securities and futures-related products are shrinking, and at insurance companies, although the general size is stable, the percentage of non-standard products is also decreasing.

Trusts. These are the only financial institutions in China that are able to tap the money market, capital market and real economy at the same time. A licence of trust is called “a licence for all” in the market. Long, from Merits & Tree, says compared with other sub-sectors, trusts are more innovative and stock more non-standard products. Regulators are suppressing the so-called channel services, but trusts remain the major player, and that is why a recent draft of trust funds has received a lot of attention.

The deadline for public consultation on a new draft – the Temporary Rules on the Management of the Trust Funds of Trust Companies – was 8 June 2020. The new draft caps non-standard debt financing to one company and its related parties at 30% of the net assets and, at any time, the non-standard debt assembled funds trust shall not account for more than 50% of the entire trust plans of assembled funds.

Long says the sector is planning to increase the overall size of the trust plans of assembled funds so that non-standard debt assets can maintain their current scale to the largest extent. At present, the businesses being considered by the sector to expand include standard investments and non-standard equity investments. “Everyone is now working hard to increase their denominator [size of trust plans], at least before the official promulgation of the regulations,” he says.

Long says another potential solution being discussed is reshaping the business so it can qualify as a service trust, which is excluded from the application of the draft.

Distressed assets. Some companies hit hard by the pandemic are struggling to repay their debts, causing an increase in distressed assets. “Distressed assets are now particularly concentrated in the real estate sector, and some are related to infrastructure, including co-operative businesses carried out by trust companies and governments,” says Long. In the infrastructure sector, he says default risks not only come from trust loans, or the purchase and sell-back of rights to yields, but also from urban development investment corporation bonds.

“From an industry perspective, the distressed assets business is still fledgling in China,” says Long. “Its size might step up significantly in the next two years.”

龙海涛 Long Haitao 植德律师事务所 Merits & Tree Law OfficesTHE FUTURE IS TECH

The experts also touch on asset management plus technology, since the pandemic has catalysed the online boom. This trend is not yet in good shape, but has been in existence for a while.

Ping An was top of the rankings in a 2020 global fintech patent report issued by the World Intellectual Property Organization (WIPO), with 1,604 fintech patents filed, while Alibaba came in next with 798. Traditional financial institutions were winners in this list, with the top three being Ping An Life Insurance, Bank of China and Ping An Property Insurance. In the sub-sector of trusts, according to statistics from the China National Intellectual Property
Administration, Ping An has filed 46 patents, while Everbright Trust has filed 11, mostly in storage media and big data analytics.

“Fintech, including AI, robo-adviser, blockchain and big data, is a boost to efficiency for this sector, but it also brings ethical issues,” says Jason Xia, a partner at Wintell & Co in Shanghai. “Its use and regulation will be the top concerns of future compliance.”

夏辉 Jason Xia 瀛泰律师事务所 Wintell & CoZhang, from Shihui, says technology itself has been maturing in this sector, and legal departments can help establish a management process. “Legal risks are involved in every step because now it is like the whole contract review process is put online,” says Zhang.

Long, from Merits & Tree, says there are already some clients taking the initiative to approach their lawyers for the establishment of a data-compliant risk management system. “Some companies have gradually realized this problem, albeit a few,” he says.

Chen, from Fangda, adds: “In China, most of the asset managers are defined as financial institutions; even the private funds, which are not clearly specified as financial institutions, are also required to perform the duties of anti-money laundering and anti-tax avoidance checks based on the self-discipline rule. In this new tech-enabled environment, the asset managers enjoy convenience, but how to effectively tackle money laundering and tax avoidance in this environment will be the new pain points of compliance.”

PEAK PERFORMERS

With standardized asset-backed securities (ABS) exempt from new regulation and China’s public Real Estate Investment Trusts (REITs) tipped for exponential growth, the asset management industry has its new champions, writes Frankie Wang

China’s asset-backed securities (ABS) market is massive and its stellar growth shows no sign of slowing, with offerings totalling RMB2.34 trillion (US$334.41 billion) and the market inventory surpassing RMB4 trillion last year, according to the 2019 Asset Securitization Development Report issued by China Central Depository & Clearing.

The Guidelines on Regulating the Asset Management Business of Financial Institutions have affected the industry from every aspect, but standardized ABS are exempt from this regulation, leading to the innovation of ABS products and their structures.

Payne Huang, director of Hui Ye Law Firm’s Shenzhen office, says the types and structures of ABS products are constantly being innovated and diversified. Apart from the ABS traded in the Shanghai and Shenzhen stock exchanges, and asset-backed notes (ABN) traded in the National Association of Financial Market Institutional Investors, the Shanghai Commercial Paper Exchange Corporation, among others, is also robustly developing quasi-ABS products.

At regulatory level, the new Securities Law, which came into effect in March this year, explicitly brings the issuance and trading of ABS within its range. Pan Xinggao, a partner of Commerce & Finance Law Offices in Beijing, says that since the State Council has not yet issued specific regulations on ABS, “in practice, ABS is still supervised by the People’s Bank of China, the China Banking and Insurance Regulatory Commission and the China Securities Regulatory Commission (CSRC), respectively, with no fundamental changes”.

潘兴高 Pan Xinggao 通商律师事务所 commerce & finance law officesAgainst the backdrop of greater pressure on economic growth and frequent defaults in the market, risk control requirements for the underlying assets of ABS have been further increased. In June 2019, the Asset Management Association of China issued a series of due diligence working rules, with assets involved including financial lease claims, public-private partnership (PPP) project assets, and accounts receivables of companies.

“Under the tightening regulations to corporate ABS, the types of underlying assets may be gradually reduced,” says Wang Lihong, a senior partner at Dentons in Beijing. “The introduction of working rules will facilitate the corporate ABS to be more standardized, and help to achieve a healthy market.”

The era of C-REITs

On 30 April, the CSRC and the National Development and Reform Commission (NDRC) jointly issued the Notice on Work in Relation to Advancing the Pilot Project for Infrastructure REITs. On the same day, the CSRC followed with the Guidelines for Public Offered Infrastructure Securities Investment Funds (for Trial Implementation) (Draft for Comments).

The rules explicitly stipulate that the relevant authorities shall give priority to supporting key geographic areas such as the Beijing-Tianjin-Hebei Economic Zone, Yangtze River Economic Belt, Xiong’an New Area, Guangdong-Hong Kong-Macau Greater Bay Area, Hainan, and the Yangtze River Delta. They will also support national-level new areas, and qualified national-level economic and technological development zones in carrying out the pilot programme.

“For a considerable period of time in the future, there will still be a large investment demand for infrastructure, but at this stage, China’s infrastructure investment is financed by fiscal spending and bank debts, and capital markets can provide little,” says Wang. “Infrastructure REITs, as a relatively suitable ABS product for funding, can reach a trillion-dollar market size in the future.”

Prior to the launch of the new rules, quasi-REITs had existed in the market for six years. Unlike REITs in mature markets as pure equity investment tools, quasi-REITs are mainly asset-backed securitization plans in the form of private placements, while the senior tranches held by investors are more like debts in nature.

Chinese REITs (C-REITs) adopt the structure of “public fund + ABS”. According to Wang Yao, a partner at Haiwen & Partners in Beijing, the new rules combine securities investment funds and ABS, and specify that the proportion of the fund’s investment in ABS is exempted from the “double 10% limit” (i.e., the fund may not invest more than 10% of its net asset value in the securities issued by any one company; the fund also may not hold, aggregated with the holdings of other funds managed by the same fund manager, more than 10% of the securities issued by any one company). “[The new rules] are the most practical and efficient way to realize a publicly offered infrastructure REIT without changing the framework of existing law,” he says.

王爻 Wang Yao 海问律师事务所 Haiwen & PartnersIn addition, the rules identify a number of infrastructure sectors, including not only highways and transport, water, electricity, energy and other utility facilities, but also “new infrastructure” assets such as warehouse and logistics, industrial parks and internet data centres. With information disclosure as the core requirement, the rules take an IPO’s sponsoring system and price inquiry system into account to achieve the best protection for investors and other participating parties.

However, legal experts showed concern over the challenges the REITs pilot programme may face.

Product structure. Huang, from Hui Ye, says that with the current pilot product structure, during the M&A process of the underlying project company, single infrastructure asset-backed securities cannot become the equity of the project company directly within the current company law framework, or in practice. It will be necessary to adopt the design of ABS + private fund or trust, under the current quasi-REITs transaction framework, to control the project company and hence increasing the financing cost.

Tax arrangement. Although the taxation rules vary across different countries and regions, tax incentives are introduced for all REITs. As to China’s public REITs, Huang says: “The only certainty with taxation is that the dividends of the public funds will not be taxed additionally, there are no tax credits introduced yet for the REITs’ establishment, asset restructuring and infrastructure operation and management. Tax planning can only be made through equity transaction and asset restructuring.”

黄其柏 Payne Huang 汇业律师事务所 Hui Ye Law FirmValuation. Wang Lihong, from Dentons, says that valuations will be different because of differing underlying assets. For example, as the franchising of road infrastructure has time limits, the valuation of related products will be discounted as the deadlines approach. But the asset valuations of warehouses and industrial real estate will increase year by year. Meanwhile, the different valuation methods used by sponsors and investors will also lead to different valuation results. “Valuation consensus will be a core issue for infrastructure REITs that needs to be addressed in subsequent laws and rules,” he says.

Few project companies qualified for the pilot programme. Huang also raises the problem of ownership deficiency. Many warehouses, logistics projects, toll roads, ports and other transport infrastructure have legacy problems, such as confused land ownership, revenue and expenditure, controversial ownership, etc. In franchised projects, not all cash inflow is generated through market operation – the majority comes from government subsidies. Therefore, project companies qualified for the pilot programme are rare and quality is low.

The division of rights and responsibilities of different managers. Wang Yao, from Haiwen, says the portfolio managers of public funds should take up full responsibility for the REITs. But as the new rules add two additional functions, financial adviser and third-party manager, and there is also a scheme manager, the regulators need to further elaborate the division of rights and responsibilities among different managers. To find a balance between the protection of investors and the professional decision-making of public REITs is another issue needing consideration.

王立宏 Wang Lihong 大成律师事务所 DentonsNevertheless, the new rules on REITs are favourable news for companies owning infrastructure assets, and the portfolio managers of public funds. Looking ahead, will REITs be extended to commercial properties? Zhang Fangxue, a partner at Shihui Partners in Beijing, believes this is the anticipated trend, but some prime commercial properties are already underlying assets of some quasi-REITs or commercial mortgaged-backed security products.

Zhang says that both the quantity and quality of commercial properties in recent years has been decreasing. When REITs are extended to commercial properties in the future, there is a chance that the quasi-REITs of commercial properties will be directly sold to public funds. “Profitability is fundamental if the products are to be recognized by the market,” she says.