The battle is lost, but the war may yet be won

A recent government ministry ruling was hailed as a test case for the attitude of China towards foreign institutional investment in its private equity industry. Some saw it as an opportunity for the Chinese authorities to bury the contradictions of the past and fully embrace sources of non-domestic capital. They will have been hugely disappointed. But they will also have been guilty of losing touch with reality and also, perhaps, failing to appreciate the bigger picture.

The “test case” focused on the Qualified Foreign Limited Partnerships (QFLP) rules, under which pilot schemes have been established in Beijing and Shanghai allowing foreign general partners (GPs) – including Blackstone Group and Carlyle Group – to manage renminbi-denominated funds, as long as the fund managers’ own commitment equals no more than 5 percent of the fund’s overall capital and the rest of the fund’s capital is from domestic sources.

Some interested parties who shall henceforth be referred to as The Optimists had hoped that, through these schemes, it would be possible for a fund to accept a large proportion of capital from foreign sources and still qualify for treatment by the authorities as a domestic fund.

This was an important issue for two main reasons. Firstly because, on a practical level, foreign funds find investments in certain sectors prohibited or restricted and generally have a much higher level of bureaucracy to deal with than domestic funds. Secondly, on what might be termed an ideological level, the outcome hoped for by the The Optimists would be a sure sign of China throwing open its doors to foreign investment. Given the potential size of China’s private equity market, that would be a glittering prize indeed. 

Perhaps because of this, expectation reached a rather excitable level based on little more, it would seem, than hearsay and the occasional hyped press report. “Some were talking about a change that would have been truly revolutionary,” says Andrew Ostrognai, corporate partner and chair of the Hong Kong private equity practice at law firm Debevoise & Plimpton. “There was speculation that maybe you could have as much as 50 percent foreign capital and a fund would be treated as domestic. That was simply not going to be the case.”

The Optimists had hoped that QFLP would be viewed by the authorities in a similar light to China’s existing Qualified Foreign Institutional Investor (QFII) rules, which were introduced in 2002 to allow foreign investors to buy and sell RMB-denominated A-shares on the Shanghai and Shenzhen stock exchanges. However, the QFII rules – although allowing a new form of foreign investment for the first time – have hardly ushered in a free-for-all. The bar for qualification was set high and only relatively small numbers of blue-chip investors have subsequently been waved through.

In any case, what actually happened with regard to QFLP was that China’s central Ministry of Commerce (MOFCOM) issued a statement in March confirming (or re-confirming) that foreign RMB funds seeking to raise commingled foreign and domestic sources of capital would be treated as foreign investors under the foreign investment regime. It was a reminder that MOFCOM has the final say on such matters, however much the local authorities in Beijing and Shanghai might like to push the boundaries in seeking to make themselves the location of choice for international capital.

So should non-Chinese limited partners (LPs) wanting easier access to the Chinese market be in a state of despair? Not at all. For one thing, local MOFCOM officials, who are delegated decision-making powers, are considered to be closer to the local provincial authorities than they are to central MOFCOM. They may even agitate for a more liberal stance from central government, though this is once again to venture into the realms of conjecture.

Perhaps more significantly, domestic institutional investors want strategic partnerships not only with global sponsors, but also with influential foreign LPs such as the California Public Employees’ Retirement System (CalPERS) or Harvard University. Such partnerships are seen as a way to a bigger and more stable source of funding for Chinese private equity – and hence of benefit to the entire market. Furthermore, the likes of CalPERS are seen as effective at pushing for better treatment of all LPs, for example improved terms and conditions. Chinese LPs would like to have a CalPERS batting on their behalf, and they will make their feelings known on this. 

Finally, it’s worth considering that China can – and will – move forward at a steady pace. Foreign investors have suffered big setbacks before, notably when the authorities stamped on the practice of relocating Chinese assets offshore for tax purposes. But these setbacks tend to be against the grain of a gradual opening up of the market.

Let’s not forget that foreign GPs are now trusted to run RMB funds – a highly significant step in the right direction. No one should expect revolutions and, in doing so, The Optimists only have themselves to blame for any sense of grievance.