As analysts are trying to wrap their heads around the flurry of regulation happening in China, the China Securities Regulatory Commission announced a crackdown on private equity funds. The private equity fund industry currently has an overall management scale of over 18 trillion renminbi ($2.79 trillion) with 111,800 managed funds. Most firms on the Sci-tech Innovation Board and ChiNext have received funds from private equity and venture capital funds.
As the industry is relatively new, this is one area in which additional regulation is necessary, as financial risks continue to pop up in China.
The chairman of China’s securities regulator, Yi Huiman, stated at a recent Asset Management Association of China meeting that fund managers must not exaggerate the benefits of their products. Some private fund managers have misappropriated client funds, encouraged fund churning, or even set up counterfeit funds. Yi stated, “The coexistence of true private equity and pseudo-private equity, the coexistence of excellent managers and ‘fake’ managers, the coexistence of registration management and disorderly growth of the market, has damaged the image and reputation of the industry, and affected financial security and social stability.”
Some funds have engaged in false sales of wealth management products or public placement products as private equity funds. In some cases, the funds make money, but clients do not receive a profit. Companies have also lacked sufficient risk assessment mechanisms and offered excessive client incentives. Since the private fund industry is comprised of many funds of mixed quality, it is necessary to better regulate the sector.
Private equity funds have experienced issues in recent month. Several private equity fund managers in Shanghai, including Shanghai Yilong Wealth Investment Management Co. and Shanghai Xishang Investment Management Co, have experienced trouble in providing customer redemptions. This has amounted to a potential loss for customers of over 10 billion RMB across 150 private equity products. The custodian bank, Bank of Shanghai, has stressed that it is not responsible for the losses of these funds, as they were not issued by the bank. As a result of similar cases, many commercial banks have suspended custodial agreements with private equity funds.
Fuzhou Economic Development Zone Cooperative Equity Investment was also found to have violated regulations by failing to maintain records on two of its private equity funds. As a result, the Fujian Securities Regulatory Bureau took administrative supervision measures to correct this issue.
The private equity fund industry has been supervised by the China Securities Regulatory Commission since 2013. However, the industry has been facing issues with maturity mismatch and poor management. In order to combat this and other issues, private fund regulations have attempted to underscore the fact that both buyers and sellers are responsible. Investors must be able to identify and bear risk. There are five different categories that represent investor risk tolerance, and investors must be matched with products that represent their preferred level of risk.
The issues present within the private equity fund industry have arisen due to lack of higher level management experience and capability, as well as high levels of information asymmetry. Some of the information about poorly performing funds can be traced. For example, abnormal fund information can be found by examining the fund industry association website. This might include low levels of registered capital or a lack of annual financial data. Funds that have been in business for a longer period of time and have issued new products over this period are generally more reliable. Reliable, experienced managers are an asset to private funds, since they bring proven past performance. Still, for less experienced investors with lower levels of investment education, there is insufficient understanding of how to track abnormalities.
In sum, although there has been debate surrounding the necessity of some of the regulations included in the recent flurry of rules, the violations in the private equity industry may cause significant financial disruption for new regulations to be considered essential. Development of this industry will help to provide more outlets for finance and investment in China, which remains necessary. In this case, cracking down on fraud and mismanagement can help to improve the level of China’s economic development.