Major changes coming for China's investment banks and private equity funds

Survival of the fittest

Last Friday, two impactful consultation papers were announced by China Securities Regulatory Commission (CSRC). One has to do with the publicly raised funds (mainly mutual funds), while another one concerns privately raised funds (mainly private equity). Why are these regulations significant? What structural changes shall we expect to see in China's financial services industry in the future?

Behind the fine print of both documents, for both mutual fund and private equity industries in China, we can identify one biggest theme for the future: industry consolidation. Let me explain.

The Context

At Baiguan, we always talk about the context first. So in order to understand these two pieces of regulation, we will have to explain the context first.

First, let's talk about the securities fund management industry. Similar to the West, there are two key players in the industry. One is the "sell-side". In China, we call it "brokerage券商", analogous to an investment bank in the West. Another player is the "buy-side", specifically, the "Publicly raised securities fund公募基金", which is similar to a mutual fund in the West. As in the West, the buy side is responsible for managing client assets. The sell-side works closely with the buy-side to provide execution services, finance and research services. (For this discussion we will exclude "Privately raised securities funds私募基金", somewhat similar to the hedge funds, because those private funds are much less significant for the China market.)

Here are some key features of China's fund management industry:

1.It's much more fragmented than in the West, especially on the sell side. According to Guolian Securities, the top 5 of Chinese sell-side companies account for ~40% of industry assets and profit, while the top 5 investment banks in the US (such as Goldman Sachs and Morgan Stanley) account for over 86% of profit and over 70% of assets. This is because China's securities market is young, and each province and/or financial conglomerate has an urge to get a brokerage license. (This is effectively China's unique fiscal federalism manifesting itself in the financial sector.)

2.The whole industry is bred by trading commissions. Trading commission, which is the transaction fee brokerage charges, are the biggest source of revenues for the industry. According to CICC, at close to RMB 20 billion (~$3b), mutual funds' trading commissions accounted for on average ~40% of a broker's revenue when working with mutual funds. For some brokers, the ratio could be as high as 70-80%. This money is roughly 30% of the institutional equity trading commissions in the US, despite the fact that the total size of China's stock market is only ~20% of the US.

3.Industry becomes volume-driven, not value-driven.

More trades certainly generate more revenues for the sell side. To induce buy-side to do more trades with them, sell-side teams not only provide research services (as the sell-side should do), but also all types of "services". It is also commonplace for the sell-side to purchase expert network services and data services on behalf of the buy-side, (which is also commonplace in the West outside of MiFid II zones). It is also industry common practice for sell-side sales to provide various "extra-curricular activities" for buy-side portfolio managers and their families, bordering on bribery. When a "research report" by a sell-side firm on how to find the best restaurants in Shanghai, or how to play a new style of poker, was circulated among chat groups, nobody thought it was unusual, even though we all know it is ridiculously funny. When a sell-side firm announced that they were organizing a research trip for its clients to Hainan island, which included a visit to inspect local duty-free malls, we know it's an euphemism for a shopping tour.

The buy-side also has its own desires, foremost of which is to raise more funds. For this, they usually rely on the distribution channels of the sell-side. To induce the sell-side to help them more funds, the buy-side will make under-the-table promises to the sell-side, guaranteeing more trades (and so more commissions) for them in exchange.

The end result is, everyone has an incentive to do more trades than necessary, making China's fund managers have among the highest trading turnovers in the world. A vast amount of commissions are earned, but none of which is actually related to the true purpose of the industry: managing and making money for the clients. In a nutshell: incentives are screwed.

As for the so-called private equity and venture capital (PE/VC) industry, we also need to understand that this industry in China is VERY different from that of the US. The biggest difference is the profile of limited partners (the LPs), who provide funding to the managers (the GPs)

In the US, LPs are mainly professional fund managers, such as pension funds, college endowments and ultra-high net-worth individuals. Also, because the market is highly developed, funds are usually set up as a "blind fund", in which the LPs commit funding without knowing what assets the fund will invest to. They basically trust fund managers to do that.

In China, however, funding sources are mainly either government and retail investors. Also, since many investors don't trust fund managers enough, it is common practice to set up the so-called "case fund", which is designed to invest in specific targets (usually just one target). Also the bar for setting up a case fund is low, leading to cases where many middle-class investors, who actually have no ability to make investment judgments, investing into those very illiquid assets. In short, risk profiles are misaligned.

The Proposed Rules

For the fund management industry, the biggest change is a much lower cap on the trading commissions. According to the proposed rules, the buy-side's trading commission is capped at 2 times the average rate of the whole market. This translates to around 30% lower than the previous rate. Taking into account some necessary costs that must be incurred, the actual profit pool for the whole industry is shrunk by almost half.

There are also harsh wording forbidding bundling of trading commissions with marketing efforts, bundling of trading commissions with non-research services, etc. There is also a new clause limiting trading commissions at any brokerage to account for no more than 15% of a fund's total trading commissions. It is clear the core goal of this regulation is to try to disentangle the volume-based symbiotic relationship between the sell-side and buy-side, so the industry can hopefully go back to the original purpose of helping clients manage money, instead of incurring unnecessary trading costs at clients' expense.

For the private equity industry, the biggest change is raising the bar for individual investors. Now, an individual is required to invest no less than RMB3 million (~$450K) in a private equity fund, rising 3 times from the previous requirement. The biggest blow is on investing in "case funds". Now, to invest in a case fund (officially defined as a fund in which any investment target accounts for more than 80% of a fund's value), an individual investor will have to put up at least RMB10 million (~$15m). It is clear not many people other than ultra high net worth individuals will consider investing in private equity now.

My Takeaway

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