Shanghai’s dark cloud

The ability of China’s largest city to become a major global fund formation centre hinges on the unpredictable attitude of central government, writes Andy Thomson.

What is clear is that Shanghai is trying its hardest to lure private equity funds to its Pudong financial district.

The local government has introduced various incentives, such as the relaxation of investment rules and lower taxes, in an effort to persuade international investment firms that Shanghai should be their location of choice rather than the many other regional centres in mainland China keen to assume the same status. It certainly appears that the efforts of its officials are bearing fruit judging by the recent news that the Blackstone Group and Hong Kong’s First Eastern Financial, among others, are currently putting together RMB funds in Pudong.

Andy Thomson

There is, however, a dark cloud hovering over any mainland Chinese city or province – Shanghai included – that wishes to promote itself as the international fund location of choice. Namely: the greyness of the law when it comes to fund structuring.

There are at least four different ways of launching an RMB fund, and none of them – on the face of it – allow foreign participation. They are as follows: state council-approved funds (given special dispensation by central government because they address domestic political concerns); investment companies (not attractive to foreigners as not tax-efficient); FIVCE-registered funds (tax-efficient but only apply to early-stage investments in technology companies); and partnerships (which, at present, only domestic investors are allowed to establish).

It is the fourth of these options currently generating interest. While only local funds are explicitly allowed to raise RMB funds through partnerships, draft proposals were drawn up some time ago that appeared to pave the way for Chinese partnerships managed by foreign entities. But these proposals have never been formally ratified. In Tianjin, one of Shanghai’s main rivals for fund business, the most sophisticated attempts at achieving this have been attempted (through the so-called “Tianjin structure”, a convoluted process involving the establishment of three subsidiaries).

The problem with the Tianjin approach is that such structures have not been specifically ruled in or out by central government (it has stayed silent on the issue). Hence – sources say – many international GPs have shied away from them. Although they would obtain first-mover advantage, they might also put in jeopardy the long-term future of their Chinese franchise for the sake of one fund – a gamble to say the least.

Shanghai knows that if it is really to see an explosion in fund business, it needs to give foreign GPs like Blackstone confidence that they will be treated the same way as domestic managers. Hence, it is currently seeking clarification on the legality or otherwise of Tianjin-like structures from the relevant regulatory authorities.

Whether such clarity will be forthcoming is, however, open to doubt. Enticing foreign capital may be a pressing concern for China’s provinces – in Beijing’s halls of power it’s much less of a priority. It may therefore be premature to assume Blackstone’s move will inspire a wave of imitators.