By Bronwyn King (pictured) and Alex Last – Despite (or perhaps because of) global market volatility, the appetite of fund managers for all things Chinese, from investing in offshore RMB to trading on the domestic capital markets, continues apace. Recently, however, there appears to have been a shift in opportunities for both Chinese investors and global fund managers. Over the past decades, the focus for both foreign investors and Chinese regulators has been entirely inbound in nature. However, with the proliferation of domestic Chinese investors, the rapid accumulation of large pools of RMB capital, along with inadequate global liquidity, a subtle shift of focus to opportunities outbound has emerged.
A number of our Cayman hedge fund clients have sought to provide their investors with RMB exposure by investing directly or indirectly into companies which are domiciled in China with shares denominated in RMB and traded on the “A” Share markets. “A” Shares are issued by companies incorporated in China that are listed on the Shanghai and Shenzhen Exchanges.
Since 2002, hedge funds have been able to access these exchanges by investing in “A” Shares through licensed foreign institutions (typically prime brokers) that have obtained QFII status (or very recently through the RQFII programme, which effectively operates as the offshore RMB equivalent to the QFII programme).
The PRC authorities impose strict rules on the type of listed company whose shares can be purchased. This is designed to prevent the circumvention of restrictions on foreign participation in certain industries and there are limits on the stake that QFIIs individually and collectively may hold in a listed company.
Moreover, there are uncertainties as to the application of PRC tax laws and regulations on capital gains tax that may be imposed, which has caused concern in the industry amongst QFIIs and their underlying funds particularly regarding whether or not to accrue withholding tax in calculating a fund’s net asset value; there is anecdotal evidence in the market that the tax will have a retrospective effect which is likely to cause grave issues for hedge funds, particularly if the tax is imposed on gains as far back as the inception of the QFII programme in 2002.
Any fund manager should therefore bear in mind that an investment in the “A” Share market may not be as freely tradable, liquid or transparent as might have been expected.
In line with the rapid increase in China’s fledgling outbound investment market, Shanghai has indicated that it is planning to launch a pilot programme that will provide opportunities for certain qualified foreign hedge funds and private equity funds to raise RMB capital in China from domestic investors for deployment overseas.
The pilot programme, if implemented, will provide certain domestic investors access to investment opportunities outside China through qualified foreign investment funds. We understand the driver behind these changes is to provide domestic Chinese investors with an opportunity to participate in potentially high yield distressed or under valued assets overseas.
It is likely that, if implemented, admitting domestic Chinese investors into a typical Cayman hedge fund may bring with it special Chinese regulatory, taxation and repatriation issues that will need to be factored into structuring and may require the establishment of a separate feeder fund so that these issues and the costs associated are ring-fenced from the other feeder funds in the structure. At this stage the pilot programme is still in its drafting stage, no time-frame has been announced nor specific guidelines shared with the public.
In terms of structuring, the devil will be in the detail.
Bronwyn King is senior lawyer and Alex Last a partner at Mourant Ozannes (Hong Kong)