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Historic Opportunities for Foreign Hedge Fund Managers in Mainland China

A series of regulatory changes of historic significance are being introduced in China that will have wide-ranging implications for foreign fund managers. This Investment Funds update explains some of those changes.

The Shanghai pilot for foreign hedge funds

The Shanghai Municipal Government Financial Services Office (FSO) is preparing to launch the Qualified Domestic Limited Partner Program (QDLP), a pilot program that will permit qualifying foreign hedge funds to raise RMB-denominated funds in mainland China. Under current law, domestic investors are not permitted to invest in foreign hedge funds without certain government approvals that are difficult to secure. The new QDLP measures are significant in that they will, for the first time, open the China market to fundraising by foreign hedge fund managers. Following implementation, QDLP is expected to have a major impact on international fund managers that are interested in China’s sizeable institutional market.

Under the QDLP, the capital raised in China must be invested in foreign markets. The QDLP is expected to operate for a period of six to 18 months. After that period, other hedge fund managers will be eligible to submit applications for approval to participate in the new scheme. The initial QDLP participants are expected to be limited in number. Recent media reports, as yet not formally confirmed by the FSO, suggest that the initial quota for the trial program will be US$5 billion and that this should see a stable expansion over the next five years to at least US$60 billion by 2017. After the pilot’s inaugural phase, it is expected that a higher number and wider range of hedge fund managers will be eligible to participate in the QDLP scheme. The QDLP rules are expected to be formally released during the next few months.

The Wenzhou Pilot initiative

In another historic first, echoing other new regulatory initiatives designed to open up mainland China to a broader range of investment possibilities, residents of the affluent city of Wenzhou in China will be permitted to invest funds abroad in a new trial scheme, the Wenzhou Pilot. Its current draft poses no restriction on the markets or asset classes in which eligible participants can invest. However, Hong Kong, London and the United States are expected to be key beneficiaries of this initiative.

The Wenzhou Pilot is currently pending formal approval by the State Council, China's highest decision-making body. It is expected to be rolled out to other key cities in China, such as Shanghai and Tianjin, if implementation of the new measures proceeds smoothly. Recent media reports speculate that there are approximately US$56 billion in bank deposits that can be deployed for investment abroad under the program.

The potential to secure a previously untapped source of new capital has been a boon to sales offices in Hong Kong by established hedge fund managers. Many of those managers seek to capitalise on this, and other important new regulatory initiatives that are expected to permit investors from mainland China to invest more freely in offshore investment arrangements.

The new ‘R-QFII’ model and the expanded use of traditional QFII quotes: unlocking China’s capital markets

Consistent with the P.R.C. Government’s focus on developing the RMB as an international currency, new regulations were issued in December 2011 (R-QFII Rules) that would allow the Hong Kong-based arm of major Chinese asset managers and securities companies to raise capital from foreign investors (expected to be offshore RMB) that they could then invest directly into mainland China’s markets. The R-QFII program quota has recently expanded from RMB20 billion (approximately US$3 billion) to RMB70 billion (approximately US$11 billion). The first exchange-traded funds were also recently approved under a widened application of the R-QFII Rules.

In similar moves designed to increase foreign investment flow into its capital markets, China has also recently increased the Qualified Foreign Institutional Investor (QFII) quota ceiling for foreign investors from US$30 billion to US$80 billion. Hedge fund managers and funds of hedge fund managers are expected to be eligible to secure a greater proportion of this QFII allocation in the longer term. This, in turn, is expected to enhance the scalability of China-focused investment strategies over time.

These initiatives have given the Asian hedge fund management industry a significant boost. Managers are moving to develop products that benefit both from the perception that new rules such as the Wenzhou Pilot will liberalise cross-border capital flows, as well as that the expanded QFII and R-QFII programs will improve access to China’s capital markets.

These developments are viewed as unambiguous signals of China’s intent to broaden overseas investment channels for investable capital in China and attract further foreign investment as a critical aspect of Beijing’s plan to internationalise the RMB. There is now a consistent message that liberalisation will occur more swiftly than has traditionally been the case.

This Sidley update has been prepared by Sidley Austin for informational purposes only and does not constitute legal advice. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this without seeking advice from professional advisers.

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