Written by: Stanley Zhou, Xiaoxue (Stella) Wang, Andrew Fei and Zhongyun Yi, King and Wood Mallesons
Recently, many foreign credit funds have their sights set on the Chinese market. With the further opening-up of the capital account and the Chinese government’s commitment to create a favorable business environment for foreign investment, there are now more channels and methods for foreign credit funds to invest in Chinese assets. The main asset types favored by foreign credit funds are Chinese real estate, non-performing assets and other types of credit assets portfolios, with investments being made using increasingly diversified structures. This article discusses the key channels through which foreign credit funds can invest in Chinese assets and the key PRC legal issues associated with them.
1. Direct financing and investments
Providing cross-border loans to Chinese enterprises and directly acquiring Chinese domestic assets have become the easiest and most convenient channels for foreign capital to enter the Chinese market. This is due to the gradual expansion of the types of eligible domestic borrowers, the gradual relaxation on the amount and currency of foreign debt that Chinese enterprises can borrow as well as the introduction of pilot programs to facilitate cross-border transfers of domestic assets. Having said this, investments into the domestic bond markets via QFII/RQFII, CIBM Direct and Bond Connect (which are not discussed in this article) are also very important channels.
Cross-border foreign debt
Below is a high-level overview of some recent regulatory developments in this area.
- Increased foreign debt quota
On March 11, 2020, the People’s Bank of China (PBOC) and the State Administration of Foreign Exchange (SAFE) jointly issued the Notice on Adjusting Macro-Prudential Regulation Parameters for Cross-Border Financing (Yinfa  No. 64), which increased the macro-prudential adjustment parameter in respect of foreign debt from 1.00 to 1.25, and further increased the foreign debt quota for domestic enterprises. This effectively allows Chinese enterprises to incur 25% more foreign debt than under existing rules.
On March 19, 2020, SAFE announced a series of foreign debt facilitation measures which, among other things, allows certain pilot zone enterprises that have significant financing needs and good development prospects (but insufficient net assets) to incur foreign debt within special quotas approved by SAFE.
- Easier access to offshore financing
A number of local governments have recently announced various foreign debt opening-up policies. For example:
- Beijing (March 9, 2020) – Relaxes restrictions on the types of currency used for contract settlement, withdrawal and repayment of foreign debt.
- Guangdong (March 30, 2020) – No need to register foreign debt on a case by case basis –a non-financial institution is allowed to register its foreign debt quota equal to twice its net assets with the local SAFE and borrow foreign debts within such quota.
- Shanghai (April 3, 2020) – Small, medium and micro high-tech enterprises are allowed to borrow foreign debt independently within a quota of USD 5 million.
These regulatory developments create incentives for domestic companies to directly access foreign financing. In our experience, in most cases the registration of foreign debt with SAFE should not constitute a material obstacle for the financing transaction as long as the amount of the debt does not exceed the foreign debt quota. Another advantage of domestic enterprises directly incurring foreign debt is that any security provided in respect of the foreign debt would not require separate registration with SAFE in respect of any cross-border security.
In light of the abovementioned policies, some Chinese enterprises that previously borrowed funds secured by domestic assets through offshore platforms (such as offshore holding companies under the red-chip structure and offshore platforms under the ODI structure) have started to consider incurring foreign debts directly through their domestic entities.
In addition, while cross-border asset transfers are not yet fully liberalized in China, some foreign credit funds, banks and other financiers are making investments by providing foreign debt secured by domestic accounts receivable such as micro loans and financial lease assets.
Despite these positive developments, foreign financiers need to carefully consider the following key issues in relation to cross-border foreign debt transactions:
- Registrations of mortgages over Chinese real estate may be difficult as some local registration authorities do not, as a matter of practice, allow foreign non-financial institutions (such as credit funds) to be registered as the mortgagee. In some transactions, foreign credit funds are exploring holding domestic security interests indirectly through domestic security agents.
- Some foreign debt settlement banks may have policies stating that the foreign exchange settlement funds in respect of foreign debts cannot be used to repay shareholder loans or intragroup loans of the borrower.
- Restrictions imposed by the Chinese government on Chinese real estate companies incurring foreign debt remain in place and have not been relaxed.
- Domestic enterprises incurring foreign debt for a maturity of longer than one year must be aware of the filing requirement under NDRC Circular No. 2044. These enterprises should consider their financing needs and timeline and prepare for the NDRC filing as early as possible.
Cross-border asset transfers
Cross-border asset transfers is an area where the capital account has not yet been completely opened. In recent years, cross-border transfers of assets have been carried out sporadically by banks and financial asset exchanges on a pilot basis. However, since the issuance of the Circular of SAFE on Further Promoting Cross-Border Trade and Investment Facilitation (Huifa  No. 28) (Circular No. 28) which promotes (on a pilot basis) the cross-border transfers of domestic credit assets, we have seen a number of complementary policies being released (as illustrated below). Although at this stage the transferees in these cross-border asset transfers are mainly overseas affiliates of Chinese banks, we believe the types of transferees will expand in the near future. However, the key to facilitating further cross-border asset transfers is finding effective solutions to issues relating to foreign debt registration and cross-border enforcement and recovery.
2. Investments in domestic assets through the establishment of domestic platforms
The new Foreign Investment Law of the People’s Republic of China, which came into force this year, and the significantly shortened foreign investment negative list have also provided new opportunities for credit funds to set up long-term investment platforms in China.
In our experience, the two most critical issues in setting up these domestic investment platforms are: (1) whether funds can be seamlessly settled in onshore RMB; and (2) whether there are any restrictions on making domestic debt investments. The key lies in the scope of business for the domestic investment platform and the flexibility of foreign exchange settlements involving domestic capital accounts.
It is difficult for most foreign credit funds to establish their own licensed financial institutions in China because of the incredibly high barriers to entry for licensed financial institutions such as banks, trusts and consumer finance companies. However, it is possible for foreign credit funds to invest in quasi-financial institutions such as micro lending companies, financial leasing companies and factoring companies, and we been involved in some successful cases in the market. Under Article 4.5(2) of the China-US Phase One Trade Deal signed in January 2020, China has committed to allowing U.S. financial services companies to apply for local asset management company licenses. When additional national asset management company licenses are granted within China, China has committed to treat U.S. financial services companies on a non-discriminatory basis with their Chinese counterparts. This aspect of the China-U.S. Phase One Trade Deal has attracted a lot of interest, particularly from U.S.-backed funds looking to increase their exposure to Chinese non-performing assets.
In practice, it is more common for foreign credit funds to set up general foreign-funded enterprises with special business scopes. In our experience, setting up such a company requires the foreign investor to engage in regular and effective communications with local financial regulatory bodies, industry and commerce departments as well as SAFE. If the foreign-funded enterprise takes the form of a limited partnership, this would usually be done pursuant to a QFLP pilot program (as discussed below).
Qualified Foreign Limited Partners (“QFLP”)
First launched in 2010, QFLP pilot programs are intended to create domestic equity investment platforms for foreign investors. Since 2010, these pilot programs have been launched in more than 10 Chinese cities. Most foreign funds prefer to set up QFLP partnerships for tax reasons. QFLP rules in certain areas have been changed in light of the new Foreign Investment Law, revisions to China’s foreign exchange policy and the shifting demands of foreign funds. The QFLP rules previously issued by some local financial regulatory authorities are no longer valid and approvals are now provided on a case-by-case basis. Having said this, QFLPs can now apply for a more flexible scope of business and there is now greater diversity in the types of investments that can be made by QFLPs in China.
Key types of foreign-invested enterprises
As mentioned above, establishing foreign-invested enterprises in China is one of the most common ways for foreign investors to set up a domestic investment platform, especially after the release of Circular No. 28 in October 2019, which removed restrictions on domestic equity investments by certain foreign investors and made more types of investment structures available to them. In practice, we often see the following three types of foreign-invested enterprises being set up by foreign credit funds:
- Foreign-invested asset management companies: Since 2017, government authorities in the Shanghai Free Trade Zone, Beijing and certain other areas have approved, on a case-by-case basis, the establishment of wholly foreign-owned asset management companies in China by foreign credit funds, which are allowed to deal with domestic non-performing assets, but mainly in the secondary market.
- Foreign-invested companies carrying out property management, commercial development, and leasing and sales activities: With the significantly shortened foreign investment negative list, foreign credit funds can now set up foreign-invested companies in some areas of China that have a scope of business that encompasses property management, commercial development and leasing and sales activities that enable them to acquire and manage commercial property in China.
- Foreign-invested general consulting companies: The barrier to entry for setting up these types of foreign-invested enterprises is generally very low. They are also subject to relatively low establishment costs and are, in principle, allowed to make equity investments in accordance with Circular No. 28.
A common structure involving these types of foreign-invested enterprises is as follows:
As illustrated above, there are now more channels and opportunities for foreign credit funds to make investments in China. Building on our extensive experience in this area, we look forward to assisting more foreign credit funds with executing their investment strategies in the Chinese market.