In Depth: China’s Proposed New Curbs on Private Securities Funds Spark Controversy

07 Jun 2023

By Yue Yue, Wang Juanjuan and Zhang Yukun

Proposed new rules to contain risks in China’s $2.9 trillion private fund sector have triggered concern that regulators are interfering too much in how funds are run and hampering managers’ ability to execute their investment strategies.

The Asset Management Association of China (AMAC), a fund industry group overseen by the country’s top securities regulator, released draft guidelines in late April targeted at one specific segment of the market — private funds that invest in securities including bonds and listed stocks. They set out requirements and restrictions aimed at ensuring fund managers diversify their portfolios to reduce risk, the AMAC said in a statement.

The guidelines put forward requirements for private securities funds (PSFs) related to how they raise money, and invest and manage their funds. They aim to stop illegal conduct including PSFs’ participation in structured bond issuances, and risky investment strategies like betting heavily on one company or asset. They also impose rules on the minimum size of funds.

Unlike mutual funds that are sold to the public and subject to strict information disclosure requirements, private funds target institutions and wealthy individuals. They operate in a less transparent and regulated environment which increases the potential for fraud and other types of wrongdoing.

“Managers have a lot of flexibility in how they run private funds,” said a source with connections to the AMAC. “If there’s a business that licensed institutions can’t get involved in, then it often goes to private funds, and some managers are prepared to act as conduits, which can create disorder and risks.”

Although PSF managers are not licensed financial institutions, they are still an important part of the market and any gaps in regulation need to be filled, the source said.

The draft guidelines should root out illegal or excessively risky activities among PSFs, advocates say.

For example, caps on their exposure to bonds aim to prevent highly concentrated investments, which are often a cover for illegal activities such as market manipulation and structured bond issuances, one private fund market source told Caixin.

Over the past few years, some private fund managers have facilitated structured bond sales, which involve an issuer with a less-than-stellar credit rating buying a portion of its own bond offering, or getting a third party to do so, to inflate the issuance size in the hope of attracting more real buyers, Caixin has previously reported.

Under the draft guidelines, any single PSF product, in principle, can’t invest more than 10% of its net assets in the same bond, or more than 25% of its net assets in bonds issued by the same company and related entities. Similar ceilings would apply to an individual manager of multiple PSFs.

The limits on exposure to bonds, together with other provisions in the draft guidelines, could be a death knell for many small PSF managers who facilitate structured issuances, industry insiders said.

Some market participants are unhappy about the draft guidelines, saying they are unnecessarily strict given the type of investor that private funds are geared to serving. The rules are similar to those governing the mutual fund market that needs tighter regulation because it’s dominated by retail investors who need more protection, they told Caixin.

“The threshold for investing in private funds is significantly higher than for mutual fund products, which is aimed at separating high-net-worth investors from the average investor who usually has a lower level of risk tolerance and professionalism,” said a source who works in investment research in a private fund management company.

The high barriers to investing via private funds help the development of a multi-layered investment market that is liquid, energetic and resilient, but the limits on bond exposure in the draft guidelines go against this objective, the same source said.

Similar restrictions on PSFs’ exposure to other types of assets are also proving controversial.

The guidelines stipulate that, in principle, a PSF’s investment in a single asset can’t exceed 25% of its net assets, and investment in one asset by all PSFs managed by the same manager can’t exceed 25% of the asset. Exemptions apply for certain assets, such as demand deposits and treasury bonds.

In recent years, some private funds have earned huge returns by betting on one asset, such as the shares of a particular listed company. The practice is not only risky but possibly illicit, as it may involve market manipulation, a veteran former regulator told Caixin.

But this view is disputed by several market sources who spoke to Caixin. They said going overweight in a single asset can be part of a strategy and holdings are always being adjusted, so a fixed limit on funds’ exposure to one asset can damage their ability to execute their investment strategies.

Some private fund investors want to make high-risk investments, the sources said, questioning whether it is the regulator’s job to prevent them from taking risks and make their investment decisions for them.

Risk prevention is important, but it’s debatable whether regulators should be setting standards for equity holdings for private fund managers, an employee with a midsize private fund firm in Shenzhen told Caixin, calling on regulators to rethink the limits on shareholdings in a single company.

“Regulatory authorities cannot tie the hands and feet of the entire industry just because there are a few bad apples or they want to avoid certain potential risks,” the employee said.

The restrictions on PSFs’ exposure to certain assets can have a positive impact, but can also disrupt investment strategies and be hard to monitor, said Wang Shu, director of legal affairs at Beijing Redbud Capital Management Co. Ltd., an investment firm that operates venture capital funds.

He proposed a compromise — regulators should allow exceptions to these restrictions in certain circumstances, such as when fund managers provide specific information disclosure and get investors’ agreement.

At the end of April, China had 8,658 PSF managers, roughly 40% of all private fund managers, AMAC data showed. The combined assets under management (AUM) of their PSFs — 5.9 trillion yuan ($830 billion) — made up less than 30% of the total.

The draft guidelines could threaten the survival of smaller PSFs due to the requirement that funds must have at least 10 million yuan in initial paid-in capital. PSFs with less than 10 million yuan in net assets for 60 consecutive trading days would be liquidated, unless changes in their asset value are caused by market volatility, according to the guidelines.

At the end of 2020, 47%, or 24,161, of China’s PSFs managed less than 10 million yuan, and their combined AUM — 82.6 billion yuan — only accounted for 2.2% of the total.

“There are many firms like us in the industry whose aim has never been to grow our assets, but to have flexibility in how we manage them,” said a source who works for a small private fund firm in Hangzhou. “What is wrong with operating a fund that has assets under 10 million yuan?”

But in the eyes of regulators, small funds tend to be the least professionally run, and a healthy private fund industry shouldn’t have too many of them, sources close to the authorities told Caixin. To get rid of the bad apples, a few good small fund managers might be affected, but they are a very small minority, they said.