To non-Chinese private equity firms frustrated at not being able to compete on a level footing with local funds in the Chinese market, help may be at hand. This help is coming not from any apparent change of heart at central government level, but instead from competition at provincial level to become the leading location for investment funds in mainland China.
First, some background. China has four ways of establishing locally denominated RMB funds, which, because of favourable legislative treatment, are increasingly popular. One way is through state council approval – these are funds given special dispensation by central government for domestic political reasons and are, therefore, unlikely to be relevant to foreign investors. The second way is through setting up an investment company. Because such a company has none of the tax efficiencies granted a fund, it has little attraction to foreign investors. The third method is through the FIVCE registration scheme. This is tax-efficient but only applies to early-stage investments in technology businesses. The fourth approach is to set up a partnership. Unsurprisingly, this would be the preferred way for most foreign investment firms to launch a fund in China but – here's the hitch – only local GPs are allowed to.
Or – let's be specific about this – only local GPs are explicitly allowed to. Determined to establish itself as the pre-eminent funds centre in mainland China, Tianjin – under the enterprising leadership of mayor Dai Xianglong, a former governor of the Bank of China – cultivated what has come to be labelled the “Tianjin structure”. By way of complex fund structuring involving the establishment of no less than three subsidiaries, a foreign fund manager can succeed through this highly circuitous route in setting up a local partnership.
The problem with this is that such structures operate in a grey area of the law, having not been specifically ruled in or out by central government (it has stayed silent on the issue so far). Tianjin, in other words, has taken a bold gamble in its efforts to get a head-start over potential rivals. Some firms have utilised the Tianjin structure but many international GPs have shied away on the basis that any first-mover advantage in relation to setting up an RMB fund is outweighed by the risk that central government may ultimately disapprove of these structures. After all, these GPs have the long-term future of their Chinese franchise to think of – jeopardising good relations with the state for the sake of one fund may be viewed as a gamble verging on recklessness.
However, clarification on the legality of the Tianjin structure may be forthcoming thanks to Shanghai's ambition to assume supremacy in the race to become China's leading funds location. It believes that if foreign funds have comfort that they can use something like the Tianjin structure to set up RMB funds, most will choose to do so in Shanghai. Recent moves into Shanghai by a number of private equity firms such as Blackstone Group appear to give credence to this.
Therefore, Fang Xinghai, Shanghai's director general of financial services office, has requested clarity on the relevance to Tianjin-like structures of Circular 142, which was issued by China's State Administration of Foreign Exchange (SAFE) towards the end of last year. The circular followed the placing of restrictions on foreign real estate investors, which were designed to burst China's out-of-control property bubble. In response, foreign investors sought to exploit a legal loophole by establishing investment vehicles which breached the spirit, if not the letter, of the law. Circular 142 sought to put an end to this loophole.
The private equity industry noted with alarm that there were similarities between the kind of currency exchange issues taking place in the loophole-exploiting property funds and those within RMB-denominated private equity funds operating under the FIVCE regime. Noting that FIVCE funds had been properly established, SAFE provided assurance in an informal letter that Circular 142 did not apply to them. And it's that kind of assurance now being sought by Shanghai in relation to the Tianjin structure.
Of course, seeking assurance is one thing – getting it is another. Many private equity professionals see no compelling reason why central government will not simply retain its silence on the issue. There was once speculation that the Chinese government would do whatever it took to entice foreign capital into the country. Sadly for China's business-hungry provinces, that's not the common view today.