QDLP: In search of the holy grail

October 18, 2012  

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After almost a decade-long wait, China’s Qualified Domestic Limited Partner (QDLP) programme is a game-changer for international hedge fund managers

Hubert Tse
For the global hedge fund community, China’s Qualified Domestic Limited Partner (QDLP) programme seems nothing short of a game-changer. After almost a decade-long wait, for the first time the programme allows international hedge fund managers to set up shop in the country, undertake renminbi-denominated fundraising from local investors and invest it abroad

Earlier this year, China opened its doors to foreign hedge funds by announcing the Qualified Domestic Limited Partner (QDLP programme). The opportunities thrown up by this landmark initiative, being undertaken by the Shanghai Municipal Government’s Financial Services Office, are tremendous. For global managers it opens up a promising new market and a conduit to tap the Chinese institutional capital, and for the local China hedge fund managers, it provides a platform for gleaning significant skills and knowledge related to hedge fund investing. While at the initial stage, the QDLP market is supposed to be limited, the growth potential here is significant, thanks to the rising affluence and deployable capital at the Chinese institutions.

Says Hubert Tse, a partner at Chinese law firm Boss & Young in Shanghai, "Note that the QDLP programme is the first time ever that any foreign financial institution – not just hedge funds – can raise assets in China from domestic Chinese investors in RMB terms and invest the proceeds in offshore markets via an offshore hedge fund vehicle."

Tse, who acts for leading Chinese and global managers in China and advises a number of US and European hedge fund managers on the Shanghai QDLP programme, adds, "These are still early days and managers in general are busy getting a feel of the market, getting familiar with the regulatory and business environment and establishing distribution networks with big/private banks for future business. They are also focused on creating local relationships as well as a manager profile for themselves in the China market." Since QDLP involves funds being invested offshore, this programme will also make managers better positioned to launch funds investing in the Chinese market as and when that door is opened.

The QDLP programme is initially expected to be small, with a limited RMB-USD quota, and only a few managers are expected to be approved at the first stage. A shortlist of managers is understood to be in the works, with reports of global giants such as Och-Ziff Capital Management, Blackstone and Oaktree Capital being the front-runners. The programme is anticipated to get bigger as it is proved that a model such as this can work, and there is more interest from managers. However, several issues remain to be clarified – for example, the tax treatment, how the QDLP funds will be distributed, and the repatriation of capital.

The first batch of QDLP approvals may well come by the end of this year. Foreign managers moving into the QDLP business in China will need to have an office and one senior management person stationed in Shanghai. It is expected that they will need to set up two entities – manager and fund – both subject to Shanghai/PRC regulation and supervision. It is also expected that they will be able to access investors all across China, and not be limited to Shanghai for clients.

Target audience and distribution

Over the past decade, wealth creation in China has been nothing short of explosive, with the total wealth of Chinese households estimated at $20.2 trillion by 2011, according to Credit Suisse’s Global Wealth Report. This wealth is largely concentrated in urban areas and in the hands of high-net-worth individuals (HNWIs). Under the QDLP programme, global hedge fund managers will be able to access capital from these high-net-worth individuals. Also allowed to be tapped are certain institutions such as insurance companies and a few other large institutional investors, as per the QDLP rules. However, the institutional scope is limited at this stage and managers are wondering whether QDLP would be an effective enough programme for foreign hedge fund managers to access broad-based Chinese capital. Many also wonder whether a separate but similar programme, designed solely for institutional investors, will also be rolled out by China.

Given the target audience, getting the right distribution will be key for global managers. To begin with, the government is expected to approve only a handful of distributors, most likely banks, asset managers and broker/dealers, to distribute hedge funds, says a Shanghai-based industry observer. "The managers will need to evaluate several areas when finalising their domestic distribution partners, since many of these banks have extensive experience in distributing mutual funds. They are still new to the concept of hedge funds, and managers will need to assess their product know-how, staff capability, client profiles, infrastructure and operations, and the economics involved, in addition to their distribution capability."

Depending upon the regulation, managers will also have to decide whether to have multiple distribution partnerships or exclusive agreements.

Challenges ahead

While exploring the benefits of participating in the QDLP programme, foreign hedge funds need to be aware of the considerable challenges that come with entering a new market such as China. "What managers often forget is that this will require a multiple-year commitment and even a loss-bearing ability in initial years, as seen from the growth of the mutual fund market," says the Shanghai-based source. "Then there is the question of truly understanding the Chinese investors, who can be quite different from their global counterparts in terms of their return expectations, risk tolerance and even in terms of their appreciation of hedge fund strategies."

QDLP will also require the involvement of multiple regulators, which makes the arena complicated. Global managers will also need to be aware of legal and contractual issues, remedies around dispute settlement and most importantly, work towards safeguarding their reputation in the Chinese market, adds the industry source.

Creating a domestic hedge fund industry

One of the key objectives for the Shanghai government with the QDLP programme is to establish a vibrant and cutting-edge onshore hedge fund industry in China. The regulators hope that the global managers will bring with them extensive experience and senior staff, thereby creating the right ecosystem for a skill and knowledge transfer to their local counterparts. Once the local managers acquire skills such as in shorting and leveraging, as well as expertise in different kinds of hedge fund strategies, they will be well equipped for the rapid pace of reforms in China that is set to deepen the short-selling market and pave the way for the creation of the first bona fide hedge funds in China.

"Currently, there is no hedge fund framework for domestic managers as this area is relatively new compared to, say, mutual funds and private equity funds. Even the relevant financial products and tools [for hedge fund investing] are limited, which makes it quite challenging," says Tse. "However, the environment is improving, and regulators as well as investors are becoming interested and educated regarding the alternatives world, in particular hedge funds."

The concept of hedge funds is also gaining ground as the days of mega returns disappear and wealth protection becomes more important for HNWIs amid today’s challenging and volatile global financial markets, adds Tse. "In short, there are challenges but also some great opportunities for hedge fund managers in China today and over the next five years. The launch of the first CTA in China by Winton and Lyxor is a good example of that."

How China benefits from QDLP

While QDLP is seen as beneficial for overseas managers, it also brings significant benefits for China and, in particular, Shanghai, which is piloting this scheme. To start with, the QDLP programme will undoubtedly establish Shanghai as the first Chinese municipality to attract foreign hedge fund managers that bring significant commitment in terms of senior management and local offices with them.

In order to truly understand the benefits of the QDLP programme to the local community, one has to look at the primary objectives of this programme. The government aim with this historic scheme is understood to be three-fold: give local investors a much-needed diversification/access to globally acclaimed hedge funds and appetite for risk associated with these products; develop the skills of local managers (in preparation for hedge funds to be allowed in the country) on the long/short side as well as in areas such as leveraging; and create an international hedge fund environment in China which encourages service providers and consultants to come in and help develop the knowledge base of local intermediaries and service providers.

Also benefiting from the move will be the distribution agents. In the first instance, established channels such as banks that sell mutual funds at present will be used – though it is widely anticipated that, later on, specialised wealth management platforms for hedge fund distribution will be created.

Deepening the short-selling pool

China has been taking baby steps towards the introduction of short selling from as far back as 2010, allowing short selling and margin lending in a small way. Earlier this year, it was reported that the country plans to set up a new entity called the Centralised Securities Lending Exchange. The exchange will facilitate stock borrowing to qualified fund managers in return for a fee. The stocks will be sourced from various institutions in China, such as banks and insurance companies.

The idea behind creating the new exchange is to deepen the country’s nascent securities lending market, and in turn give a boost to capital markets. The new body will have the China Securities Regulatory Commission, the market regulator, as its largest shareholder in the body, with other shareholders being the Shanghai and Shenzhen Stock Exchanges and a few brokers and institutions.

Short selling is viewed negatively in some markets because it can allegedly create volatility and destabilise markets, and China has been aware of this. What has kept short selling in China on a leash is a cautious approach by the Chinese regulators to its development as well as the limited number of shares that are available for borrowing by qualified asset managers.

The new centralised lending exchange will make shares available to qualified fund managers in China who wish to borrow them, for a fee. It will source the shares from institutions in China including banks, insurers and fund management firms.

Many believe that establishment of the new lending exchange will be a game-changer for the onshore hedge fund industry in China. "Up to now we have been restricted to borrowing stocks from a handful of brokerage houses and both of us need to maintain high asset requirements – that limits our options. If we look at margin financing, there are less than 300 stocks that can be traded on margin," says a Beijing-based manager. "Once these hurdles are removed, we will be in a much better position to execute real hedge fund strategies, and it will bring tremendous alpha-generating opportunities for both onshore and offshore hedge fund managers."

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