Autumn 2012

INSIDE VIEW: Seismic changes can be expected

QDLPThe past seven months have seen more action from China’s regulators than the previous ten years combined. Z-Ben Advisors’ Michael McCormack discusses the Qualified Domestic Limited Partner programme. This is nothing short of a seismic event in China, where markets can accurately be described as an equilibrium punctuated by regulatory change. Two little-discussed and imperfectly understood plans have emerged from Shanghai in the past six months. These are likely to change the way every foreign investment manager deals with Chinese clients.   The first is the National Development and Reform Commission/Shanghai Financial Office (NDRC/SFO) plan to turn the city into a global financial centre by 2020. The second is the Qualified Domestic Limited Partner (QDLP) programme. The policy connections between these two programmes, and how the China Securities Regulatory Commission (CSRC) – working behind the scenes – has adapted ideas from them for general use, give a clearer picture of the regulator’s new priorities and overall approach. Shanghai has become gigantically important as a means of comprehending regulatory and state council intent over the past six months. The NDRC/SFO plan, published on 30 January, has been given little more than lip service outside China. Yet it should now be seen as the starting gun for an audacious attempt to re-establish the city as the most important China-related trading and investment centre in the world. According to the plan, Shanghai will become the locus of efforts to bring market reforms to China’s industrial structure, its monetary policy and banking rules. It will also become ground zero for cross-border investment, by establishing itself as the premier hub for interactions between international financial firms and domestic customers. That bold plan requires support from the CSRC, among other bodies, to achieve substantial improvements within the city in two key areas: people and process. Regulators, by any standard, have been unsuccessful in their attempts to convince foreign companies operating in China to contribute much of either. The CSRC has recognised why those failures were inevitable: they are the key weaknesses of the joint venture model. We ask: What does your head office really want from its Chinese outpost? Put another way, what characteristics of a notional mainland subsidiary would give your C-suite real comfort that they had established a multi-use, multi-option local base, one that that maximises their opportunities for current and future earnings while minimising their external risks? We suspect their list would likely include outright control over budgets, staff and intellectual property; the ability to sign clients, contracts and partnerships – whether in China or abroad; the right to use the firm’s hard-earned brand; the right to engage in any form of business open to their Chinese competitors and a thoroughgoing regulatory blessing on their efforts. Those protections and opportunities are likely to form the core of any wish-listed mainland dream. (A low entry price would not hurt either.) Why have Chinese regulators not done more to make these dreams come true? In part, joint ventures have been the governing model for regulatory thinking for the past decade. The joint venture structure offers wide-open doors to foreign entrants, while reserving greater control (and less explicitly-controlling engagement with Chinese senior staff) for regulators. In equal part, because the balance of negotiating power has been overwhelmingly on regulators’ side for that same decade. Significant constraints on foreign entrants’ freedom to act could be imposed when those entrants accept almost any terms for the right to own something in China, even if that something is a minority stake in a newly-established financial firm. Why will regulators’ offering to foreigners improve – to include almost all of the wish list expressed above – faster than most head offices expect, or are ready to react to? The Shanghai plan requires it as the necessary concession to attract better people and processes. The first example of regulatory willingness to ensure Shanghai gets what it requires can be found in the second little-noticed programme: QDLP. QDLP, an invention of SFO, will mandate offshore hedge funds to open fundraising and servicing offices in China, attracting domestic capital to offshore-operated/domiciled funds. SFO states, in the black letter of the regulations, that participants will be required to open a Shanghai-based Wholly Foreign-Owned Enterprise (WFOE). A WFOE, under Chinese law, is 100% owned by the foreign manager; capable of seeking, signing and billing clients; and able to use the foreign owner’s name, brand, trademarks and hard-won reputation in pursuing those clients. It is the preferred platform, which will be used to service domestic clients and report to regulators inside the QDLP programme. Few other details of the programme have yet emerged from regulatory communications. However, the invitation-only pilot programme is expected to see as many as a dozen of the world’s largest hedge fund managers given quota to raise onshore capital. Those investors are likely to be existing customers of domestic hedge fund equivalents – China’s private fund managers  – and will certainly be high-net-worth individuals or institutions with substantial investing experience. QDLP marks the first time that the WFOE structure, long promoted as an optimal platform by Z-Ben Advisors, has ever been required from a foreign participant in China’s capital markets.  We cannot stress enough how significant a breakthrough this is for foreign firms. QDLP offers a broad preview of what all foreign asset managers will need if they truly wish to expand their institutional business in China. In assessing all major Asian markets, it is clear that a quid pro quo relationship has developed. Only by making a real commitment to a given market – office, talent and best practices – does it remain possible to compete for institutional mandates. China has been the one standout exception. But will this remain the case for the foreseeable future? No, we believe that foreign asset managers’ future in China (at least on the institutional front) will be contingent on establishing a WFOE.   Michael McCormack is an executive director at Z-Ben Advisors ©2012 funds global

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