The China A Shares market
Since December 2002, foreign institutional investors have been permitted to invest in China A Shares listed on the Shanghai Stock Exchange and the Shenzhen Stock Exchange through the Qualified Foreign Institutional Investor (QFII) programme. The QFII programme allows licensed foreign investors to invest in China A Shares in the local currency provided that certain minimum criteria are met. The return on the investment, including dividends and capital gains, can be legally exchanged into foreign currency and repatriated.
The number of QFII licences granted by the China Securities Regulation Commission (CSRC) and the level of foreign investment in Chinese securities as a result has increased dramatically over the last two years in particular. At the end of 2011, more than US$20 billion was invested through this facility, by 112 licensed foreign entities (source: Wall Street Journal, Financial Times). These QFII licences are generally held by fund managers and institutional investors.
China A Funds
In line with the increase in QFII licences granted, we are seeing significant interest in the establishment of new Irish funds targeting China A Shares. This is also symptomatic of the increased attraction of the Chinese market from international investors and the opportunities this is opening up. China’s equities market has grown from $400 billion in 2005 to $4.2 trillion in the first quarter of 2011, albeit with a subsequent dip more recently.
While it is noted that fund structures in other domiciles (in particular the Cayman Islands) can also facilitate the China A Shares market, this article examines, in particular, the suitability of various Irish regulated fund structures in this context and considers briefly some of the key challenges to be addressed when structuring an Irish fund to access the China A Share market.
What is the most appropriate Irish fund structure to use?
In order to avail of the QFII licence, the fund will need to meet the conditions to be characterised as an ‘open-ended China fund’ in accordance with the laws of the People’s Republic of China (PRC) and the 2009 provisions issued by the PRC State Administration of Foreign Exchange (SAFE). This requires that it invests at least 70% of net assets in China A Shares and other PRC listed securities.
Ireland offers a range of regulatory structures that can accommodate a China A Shares investment strategy such as the Qualifying Investor Fund (QIF), the Professional Investor Fund (PIF) and the non-UCITS retail fund. The QIF provides the greatest flexibility for Irish authorised funds as the investment, borrowing and leverage restrictions which apply to Irish retail or professional investor funds are disapplied in full for a QIF. In addition, the QIF, with its pre-launch authorisation (without prior review), single depositary requirement and the Markets in Financial Instruments Directive (MiFID) equivalent investor eligibility criteria (€100,000 minimum subscription) is already closely aligned with the Alternative Investment Fund Managers Directive (AIFMD). This may be a particularly compelling factor for funds and managers looking to ‘opt-in’ to AIFMD in due course. The PIF, while still viable, is rarely used for new products due to the fact that its minimum subscription level matches the QIF and the QIF has much greater product flexibility.
Ireland is also a key jurisdiction for the establishment of Undertakings for Collective Investment in Transferable Securities (UCITS), a pan-European investment fund structure. UCITS is designed primarily for retail investment but is also suitable for institutional investors. These can be offered to the public throughout Europe under a passporting regime. Increasingly UCITS is being viewed as a key cross-border product for alternative investment strategies. However, one of the main product specifications for a UCITS relates to liquidity and this is problematic in the context of investment in China A Shares.
What are the liquidity challenges?
An initial three month lock-up of assets in the China securities and cash accounts will apply on new quotas. This commences at the later of (a) the date the full quota granted under the QFII licence is taken up; or (b) six months after the QFII quota was approved if it is initially taken up only partially. The net effect of this is that, depending on the launch timeframe, where a fund is utilising a new quota, a lock-up could be up to six months from the point of initial funding. For a fund that trades any more frequently than monthly, this would present distinct challenges, at least in theory, in the event of a large redemption.
Irish non-UCITS retail funds are required to deal at least monthly and meet a monthly settlement cycle (from the point of the deadline for redemption requests to the point of settlement). Open-ended QIFs are required to deal no less frequently than quarterly and meet a 90 day settlement cycle. A monthly dealing non-UCITS retail fund or QIF should be capable of meeting the liquidity challenges this initial lock-up presents - through the use of a redemption gate if necessary. Prominent prospectus (offering document) disclosure may be required to address the liquidity risks involved with this initial lock-up. A UCITS fund needs to provide at least fortnightly liquidity, so this initial lock-up may prevent an Irish UCITS from investing any significant amount in the China A Shares directly.
Ongoing monthly repatriation limit
Repatriation out of China by a QFII is only permitted on a monthly basis on the net level of subscriptions/redemptions and is subject to SAFE approval being granted in the event the repatriation amount sought exceeds US$50 million in any given month.
A monthly dealing non-UCITS retail fund or a QIF should be capable of meeting the liquidity challenges this monthly repatriation limit presents - through the use of a redemption gate if necessary. Again, this would be subject to prominent prospectus disclosure on liquidity risks. A more frequently dealing fund would possibly have challenges in maintaining liquidity controls.
The monthly repatriation frequency is another reason why a UCITS will not be suitable as a fund vehicle for significant investment in the China A market directly.
Another challenge from a liquidity perspective can arise if it is proposed to offer the QFII quota on a pooled basis to a number of funds/clients. Even where allocation is made equitably, the possibility of being required to limit monthly repatriations to a further extent due to outside activities of the QFII with its other clients will present particular challenges and issues for an Irish open-ended fund. However, utilising an existing quota on a pooled basis (or exclusively for that matter) does have the benefit of avoiding the initial lock-up issue referred to above.
Summary – suitable vehicle from a liquidity perspective
If a retail investor base is targeted or if there is consideration being given to registering the fund for public offering (in Hong Kong, for example, or any other jurisdiction), the non-UCITS retail fund may be a consideration. It does not have the specific liquidity constraints of a UCITS and China A funds have been authorised under this regime. However, these funds tend to set dealing frequency to monthly in order to satisfy the Central Bank that the fund can adequately meet all liquidity challenges that may be presented.
If retail money is not being pursued, then the QIF (monthly or less frequently dealing) will be the most suitable structure. As mentioned above, in the set-up context, the QIF offers the particularly appealing element of requiring no prior product review by the Central Bank prior to authorisation.
Tax and other factors
The tax position of the fund as regards China will be an area to examine in each particular case. All regulated Irish funds benefit from a range of features:
They are exempt from Irish tax on their income and gains;
Non-Irish resident investors are exempt from Irish tax in respect of distributions from the fund or redemptions of units in the fund, provided either an appropriate investor declaration or certain procedures at fund level are put in place;
No Irish stamp duty arises on the issue, sale or transfer of shares or units; and
Certain services which the fund receives, such as qualifying investment management services, are VAT exempt.
The entitlement of an Irish regulated fund to avail of the Ireland/China double tax treaty needs to be examined on a case by case basis. This issue is subject to the particular investment structure, and to Chinese law and SAFE circulars regarding treaty entitlement. Where access to the Ireland/China treaty is available, the treaty provides that Chinese withholding tax on dividend payments to an Irish company is reduced to 5% provided the recipient holds 25% of the voting power in the Chinese company and is reduced to 10% in all other cases. The double tax treaty can also relieve an Irish resident company from Chinese capital gains tax on sale of shares in a Chinese company, other than a company which consists principally of Chinese land.
It is also worth highlighting the memorandum of understanding entered into in 2008 by the Central Bank of Ireland and the CSRC and the China Banking Regulatory Commission (CBRC). This formalised the relationship and co-operation between the two jurisdictions.
How does the custody element operate?
Irish funds are required to appoint an independent custodian located in Ireland with primary responsibility for safekeeping of the fund’s assets. This entity will engage the local custody provider in China by way of a sub-custodian arrangement. On a day-to-day basis, the investment manager will engage directly with the local sub-custodian on the trading side. Assets (held in a securities account and a cash account in China) will be fully segregated and recorded in the joint names of the QFII and the fund. In the event of insolvency of the local sub-custodian or the QFII, the fund’s ownership of the assets is thus assured. An opinion from counsel in China on the specific arrangements may be necessary for the Central Bank to be assured of proper safekeeping arrangements.
Third party investment adviser structure
The entity that operates the QFII licence will generally also act as the investment manager to the fund. Accordingly, this entity will need to be cleared by the Central Bank to manage Irish authorised funds.
If the main QFII/investment manager engages a local advisor, this entity will also need to be cleared by the Central Bank to manage Irish authorised funds (unless the appointment is on a non-discretionary basis).
China operates a single broker model that could potentially undermine the Irish regulatory requirement to obtain best execution for the fund. However, it is generally understood that, given this is a regulatory element affecting all participants in the Chinese market, this is most appropriately addressed by disclosing the details of the arrangement in the prospectus and referencing the possibility that best prices may not always be achieved due to this system. Procedures can be put in place in the context of the single broker arrangement to ensure all steps are taken to achieve the best available price, taking into account all circumstances - including the single broker restriction.
Conclusion Gaining access to the China A Shares market is increasingly becoming a priority for asset managers with global portfolios and an international investor base. The Irish non-UCITS funds regime present a range of compelling options for fund structures to access this space.
Stephen's primary areas of expertise are asset management and investment funds. He advises clients on the establishment and operation of investment funds. He has strong expertise in UCITS, in particular in the area of UCITS alternative investments funds, traditional UCITS and ETFs. Stephen also has significant experience in non-UCITS (QIFs) with hedge fund strategies and fund of funds. He also advises on derivatives, inward marketing of investment funds in Ireland and the regulation of investment services in Ireland under MiFID. Stephen joined Maples in 2010 from a large Irish corporate law firm, where he was partner and head of investment funds. Stephen is a member of the Legal & Regulatory Committee of the Irish Funds Industry Association and participates in various initiatives involving direct engagement with the Central Bank of Ireland on funds regulatory matters on behalf of the Irish funds industry. Stephen regularly speaks at investment funds conferences and seminars and is published in a range of leading financial and legal publications.
Maples and Calder is a leading international law firm advising financial, institutional and business clients around the world on the laws of Ireland, the Cayman Islands and the British Virgin Islands. Our clients include many of the world's foremost corporates, banks and financial institutions as well as private equity funds and growth companies. The Maples Group comprises over 800 people globally with offices in nine jurisdictions, 175 of whom are based in our Dublin office. Maples and Calder is known worldwide for the quality of its lawyers. This extensive experience, the depth of the team and a collegiate approach are main characteristics of the firm, enabling the firm to provide the highest quality legal advice on a wide range of transactions. The firm's affiliated organisation, MaplesFS, provides specialised fiduciary, accounting and administration services to finance vehicles and funds. For more information, please visit www.maplesandcalder.com and www.maplesfs.com.
This article first appeared in AIMA Journal (Q1 2012, Pages 19 – 21). For more information, please visit www.aima.org.