Investment Management

Entering the Chinese investment management industry*

November 2006

Introduction

Overview

Chinas rapidly developing and increasingly liberalised investment management sector presents a huge opportunity for international financial services groups. The economy is soaring, markets are maturing and the countrys increasingly affluent citizens have built up household bank savings of $1.84 trillion. This represents a savings to Gross Domestic Product (GDP) ratio of 80%, a potential bonanza for investment managers. Early foreign entrants into the investment management sector have developed a head start through the development of joint ventures, local talent and business relationships. Yet, there is still considerable room for incomers to get in at the ground floor of what remains a fledgling market. Looking ahead, greater freedom in both who can operate and how funds are invested is set to take the sector to a whole new level.

Rising prosperity and increasing pool of savings are opening up considerable opportunities for the development of the investment management sector. The proportion of household bank savings ($1.84 trillion) to GDP ($2.28 trillion in 2005) is 80%. Post office savings account for a further $170 billion. Development of the investment management sector is progressing hand in hand with ongoing pension reform. Recent government initiatives include the licensing of new Enterprise Annuity Plans (EAPs) and, in July 2006, the authorisation of the first enterprise pension plan. To date, the government has awarded contracts for nine fund management companies (FMCs) to help manage the vast investment portfolio of the National Social Security Fund (NSSF). Such contracts are a prized source of business paving the way for managing institutional funds. Fund management investment was originally restricted to a limited pool of domestic securities. However, in April 2006, the government took the first step towards allowing FMCs to invest in overseas equities, which could greatly increase fund differentiation, potential returns and consumer demand. In the past, only domestic trust, investment companies and securities companies were allowed to set up FMCs. While banks dominated distribution, they were prevented from establishing investment management arms. However, the rules have been relaxed in recent years to allow banks to set up their own FMCs and insurers are likely to follow in time. Foreign financial services institutions have set up joint venture (JV) FMCs since 2002 and have made significant inroads in the investment management market. By August 2006, Sino-foreign JV FMCs managed 30% of the total assets under management in the investment management market. The ceiling on foreign holdings has been gradually increased (now 49%) in the wake of WTO accession and may eventually be eliminated. The early movers have gained a head start through access to a wide choice of partners and distribution outlets. However, the rapid pace of development in the investment management market continues to open up fresh openings for foreign entrants, either through build or buy strategies. Relationships with local partners and understanding of local language and consumer preferences are critical to success. Foreign financial services institutions will need to recruit and nurture local talent to succeed.

Entering the Chinese investment management industry PricewaterhouseCoopers 1

Investment environment

All eyes are on China. The country has been transformed into the factory of the world since beginning its transition to a market economy with socialist characteristics at the end of the 1970s. Growth has averaged more than 9% per annum over the past 25 years and China is now the second largest economy in the world on the Purchasing Power Parity (PPP) basis1. At current growth rates, its GDP will have overtaken the USA by 2050. Recent economic research carried out by PricewaterhouseCoopers suggested that Chinas economy is currently 76% of the size of the USAs in PPP terms and, by 2050 it will be 40% larger than the USAs. On the Market Exchange Rate (MER) basis, Chinas GDP will reach 95% of the USAs GDP in 2050. Economic expansion has gone hand in hand with the development of an increasingly prosperous and aspirational middle class that now numbers around 250 million citizens, 2 almost equivalent to the entire US population. The double-digit annual rise in Chinese consumers disposable income offers a huge opportunity for fund management companies (FMCs), both directly and through the investment of rapidly
Figure 1 - China: Key Facts (31.12.2005)

investment management sector. Nearly a quarter of Chinas population will be over 60 by 2030, according to the World Bank. Yet, the state pension fund in China is not sufficient to support a greying population. The government is therefore keen to open up further opportunities for the development of private pension funds and encourage more people to take out private pensions to help make up for the potential shortfall in state pension provision. Initial Public Offerings (IPOs) are helping to create a more developed capital market (see Figure 2). However, equities are still a relatively volatile investment. The retention of large government stakes and the reservation of share quotas for hard currency foreign buyers (B shares) also mean that the availability of tradable equities for FMCs and other local investors (A shares) has tended to be limited. The restricted choice has been a particular issue for FMCs as their investments have so far been confined to domestic securities. Now, in a strong boost for the investment management sector, a wave of flotations including the Bank of China, China Construction Bank and Bank of Communications, are increasing the range and volume of tradable shares. A further capital injection is coming from the introduction of Qualified Foreign Institutional Investor (QFII) schemes that enable foreign investors to invest in domestic A shares. The presence of the QFII is helping to make the domestic share market more investor-oriented. It is also helping to provide the impetus for the development of more modern corporate governance structures including greater protection for minority shareholders. Other recent government measures to help increase market liquidity include releasing some of its own holdings and beginning
Figure 2 - Growth in number of listed companies
1800 1600 1400 1200 1000 800 600 400 200 0 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Source: PricewaterhouseCoopers

Population GDP in 2005 Growth GDP per capita Bank deposits Residential savings Mutual fund/GDP Mutual fund/savings

1.3 billion $2,279 billion (MER) 10.2% $1753 (MER) $3,752 billion (01.01.06) $1,838 billion (01.01.06) 2.7% 3.1%

Growth in number of listed companies

Sources: PricewaterhouseCoopers and the National Bureau of Statistics of China

Shenzhen Shanghai Total

accumulating bank deposits. According to the National Bureau of Statistics, the bank savings to GDP ratio at the end of 2005 was a staggering 80%. Yet while household savings had reached $1,838 billion by the end of 2005, only $58 billion was invested in mutual funds, clear evidence of the considerable room for growth in what is still a fledgling market. The potential to be tapped includes the $25 billion NSSF, which is expected to reach $123 billion by 2010. There are also $123 billion in insurance fund assets, an increasing proportion of which can be invested in domestic shares. Pension reform and the greying of the population are providing further catalysts for the development of the

1. China is the second largest economy in the world on a Purchasing Power Parity (PPP) basis and fourth on a Market Exchange Rates (MER) basis. 2. The Chinese Academy of Social Sciences defines middle class as having family assets of between RMB150,000 and RMB300,000 (circa $18,750 and $37,500). There are around 250 million such citizens.

2 Entering the Chinese investment management industry PricewaterhouseCoopers

Investment management development

As a relatively young industry, FMCs are generally leaner, more market-oriented and technologically-enabled than some of their counterparts in other financial services sectors. The regulations that govern them are also more uniform, up-to-date and effective. The development of commercial investment management in China effectively began in 1998 with the launch of the first retail closed-ended funds (CEFs), followed by open-ended funds (OEFs) in 2000. Growth since then has been rapid, with assets under management in retail funds nearly tripling between 2003 and 2005 (see Figure 3), despite a downturn in share values on the Shanghai and Shenzhen Stock Exchanges (see Figure 4). There are now more than 50 FMCs managing over 200 funds that range in size from $6 million to over $5 billion (see Figure 5). Institutional asset management is also developing at pace, with assets under management in the recently launched EAPs having reached $12.5 billion. Although entry into the investment management market was originally restricted to domestic trust, investment companies and securities companies, the rules have been relaxed in recent years to allow any large fit and proper Chinese institution to own a majority state in an FMC. Since 2002, foreign companies have been able to set up JVs with local FMCs, though their stakes are limited to 49%. In 2005,
Figure 3 - Growth in total AUM (US$ billion)
70 60 50 40 30 20 10 0 1999 2000 2001 2002 2003 2004 2005

Figure 5 - Growth in fund management companies

60 50 40 30 20 10 0

Growth in fund management companies

Domestic JV Total

1998

1999

2000

2001

2002

2003

2004

2005

Source: PricewaterhouseCoopers

Chinese banks were given the green light to establish their own investment management arms and insurance companies may follow in time. The governments support for the development of FMCs recognises the investment management sectors importance in strengthening the institutional investor base (FMCs own 46% of tradable shares) and helping to make up for the shortfall in state pension provision. Government backing includes tax incentives for investment management fund investors. It is also hiring selected FMCs to help manage the NSSF, a prized mandate within the sector. Although the margins on the NSSF contract are limited, the prestige and experience they confer will provide an important competitive advantage as the nascent institutional fund management sector develops and expands. The accelerating liberalisation of the investment management sector is highlighted by the recent go-ahead for the NSSF to establish the countrys first Qualified Domestic Institutional Investor (QDII) scheme. This groundbreaking move allows the NSSF to buy shares on the Stock Exchange of Hong Kong (SEHK), which could pave the way for other funds to invest overseas a number of FMCs are known to be preparing applications to establish QDII funds. The wider choice of investment and possibility of higher fund yields that will result from QDII schemes could attract an influx of new custom for investment management businesses. Access to international markets would also enable Chinese FMCs to develop derivative and other more effective hedging strategies than they are able to use at present. At the same time, the government recognises the importance of strengthening consumer confidence and bringing rules and regulations up to international standards. This includes new requirements on governance, disclosure and risk management.

Growth in total AUM (US$ Billion)

Source: PricewaterhouseCoopers

Figure 4 - Market capitalisation

6000 5000 4000 3000 2000 1000 0 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Source: PricewaterhouseCoopers

Market capitalisation

Shanghai Shenzhen Total

Entering the Chinese investment management industry PricewaterhouseCoopers 3

Products, customers and distribution

Relatively low rates of return from bank deposits are encouraging more and more savers to switch some of their assets to investment funds. Many banks are also themselves investing in funds for the same reason. Other key investors include the NSSF and the countrys industrial conglomerates, many of whom have been actively investing in both funds and the FMCs that manage them. The products on offer from the mainstream FMCs are mostly vanilla and long funds. Insurance funds and various types of companies products are operated by trust companies and securities companies, though the reputation of some of these institutions is not always good. A sign of the rapid evolution of the investment management sector is the take-off of OEFs over the past two years (see Figure 6). Their popularity has dampened demand for CEFs, which are now traded at an average discount of 27%. The Chinese government has no plans to promote CEFs or allow consolidation of OEFs into CEFs or vice-versa. CEFs will likely be gone once they have reached their maturities. However, certain aspects of demand do reflect what is still a young and for many consumers an unfamiliar market. A lack of understanding of equities and collective investments may, in particular, push consumers towards what they may perceive as safer money market funds. Such funds are particularly large and popular in China, as they are in many emerging markets.
Figure 6 - Growth in number of authorised investment funds
250 200 150 100 50 0

February 2006 the regulatory authorities introduced new rules to prevent banks from discriminating against other funds they sell and there has been no sign that competition from banks has led to a slowdown in fund launches by independent FMCs. The entry of insurers could open up an important new sales channel to both retail and institutional investors. Other as yet untapped outlets include such institutions as the postal savings. Management fees are generally competitive, ranging from 0.5% to 1.5%. However, returns are often low by international standards. Analysis of 100 share funds in the Shanghai and Shenzhen markets found that the average return in 2005 was only 3.8%. While one did manage to achieve a return of 17%, around two-thirds were below 5%. In Hong Kong, by comparison, the highest return was more than 100% and many funds achieve 30% or more. The performance of the Chinese funds reflects the decline in share values and limited availability of tradable equities, though share prices have rallied in 2006 and a number of new issues are in the pipeline. Up until now it has also been difficult to differentiate between funds and management styles, though this may change as the investment management market opens up and international firms begin to establish a stronger presence. The launch of new benchmark indexes and other dedicated market information services are also making it easier for consumers to compare performance.

Leading players
As Figure 7 highlights, the investment management industry continues to be dominated by the subsidiaries and associates of trust and investment companies. Huaan, one of the largest players, is a typical example. It was formed in 1998 under the sponsorship of Shanghai International Trust

Growth in number of authorised investment funds

Closed-ended funds Open-ended funds Total

Figure 7 - Top ten fund management companies

7 6 5 4 1998 1999 2000 2001 2002 2003 2004 2005 3 2 1

(As at 31 August 2006 ranked by AUM US$ billion)

Sino-foreign JV

Source: PricewaterhouseCoopers

Distribution of OEFs is dominated by banks, many of whom have also taken on the role of independent custodian required by regulation. Some fear that the recent launch of proprietary funds by a number of banks may reduce the access to market for independent FMCs. However, in

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Source: Z-Ben Advisors

4 Entering the Chinese investment management industry PricewaterhouseCoopers

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and Investment and four securities companies. Huaan has consistently been at the forefront of the market, launching Chinas first OEF in 2000. Although Sino-foreign JVs are beginning to challenge the leading players (see Figure 7), the local FMCs have continued to play a leading role in the market thus far. Merger and acquisition has so far been inhibited by a one plus one rule that means that a company can only own one majority and one minority stake in an FMC. However, the first sign of what some expect to be wider consolidation has come with CITIC Trusts acquisition of a 41% stake in China Asset Management, the countrys third largest FMC. CITIC also owns part of a JV FMC with Prudential.
Figure 8 - Partnerships in operation

Access to the market

Another great advantage of Chinese investment management being a relatively young industry is that the investment needed to gain a foothold in the market tends to be far smaller than banking or insurance. As little as $12 million to $15 million has enabled foreign investors to establish a sizeable stake in a greenfield JV and play a significant role in its management and development. There were 20 authorised Sino-foreign JV FMCs in operation at the end of August 2006 (see Figure 8). A number of other JVs are in the pipeline (see Figure 9).

Sino-foreign joint venture fund management companies (operational) as at August 2006 FMC
Harvest Fullgoal ABN AMRO Xiangcai China Merchants Fortune SGAM INVESCO Great Wall Fortis Haitong Guotai Junan Allianz SW BNP Paribas China International UBS SDIC Hongtai Everbright-Pramerica BOC International Franklin Templeton Sealand AIG Huatai BoComm Schroders CCB Principal ICBC Credit Suisse CITIC Prudential HSBC Jintrust

Foreign partner
Deutsche Asset Bank of Montreal ABN AMRO ING SGAM INVESCO Fortis Allianz BNP Paribas J P Morgan Fleming UBS Pramerica Merrill Lynch Franklin Templeton AIG Schroders Principal Credit Suisse Prudential plc HSBC

Local partner
Zhongcheng Trust Fullgoal Northern Investment Trust China Merchants Fortune Trust Great Wall Haitong GTJA SW Shanghai ITIC SDIC Everbright BOCI Sealand Huatai BoComm CCB ICBC CITIC Trust Shanxi Trust

Foreign Equity
19.50% 27.78% 49% 30% 33% 49% 49% 33% 33% 49% 49% 33% 16.50% 49% 49% 30% 25% 25% 33% 49%

Main Loc.
BJ SH BJ SZ SH SZ SH SH SH SH SZ SH SH SH SH SH BJ BJ SH SH

Funds
12 10 7 7 7 7 5 4 4 4 4 3 3 2 2 3 2 3 1 1

Source: PricewaterhouseCoopers

Entering the Chinese investment management industry PricewaterhouseCoopers 5

Figure 9 - Sino-foreign JV FMC (in preparation or negotiation)

Banca Lombarda Lord Abbett Alliance Capital AGF AXA Investment Credit Agricole Asset Management DBS Asset Management United Overseas Bank KBC Asset Management Nikko Asset Management Royal Bank of Canada

Guodu Securities Yangtze Securities Pingan Group South China Securities Shanghai Pudong Development Bank Agricultural Bank of China Changsheng Fund Beijing Securities Jinyuan Securities Rongtong Fund Management Minsheng Bank

As Figure 10 outlines, potential entrants can choose between setting up a greenfield JV or buying into an existing FMC. The regulator would appear to favour purchase over start-up at present, though this may change as market conditions evolve. Possibly mindful of some of the setbacks experienced in other emerging markets, a number of foreign financial services institutions have established representative offices as a precursor to full market entry. This patient approach enables the investor to develop relationships, gain first-hand experience of the market and then target suitable partners. The early movers such as ABN AMRO, ING, SGAM and Fortis, have gained a significant head start. Early entry enabled them to have first or at least a wide choice of talent, JV partners and distribution channels. They have since been able to nurture this talent and develop the relationships that are so important in Chinese business.

Source: PricewaterhouseCoopers

Figure 10 - Choices between setting up a greenfield JV or buying an existing FMC

Strategic decision

Market research

Entry options

Representative office

Greenfield JV FMC

Buy into an existing FMC

Greenfield JV FMC

Buy into an existing FMC

Partner search

Target search

Partner search

Target search

CSRC authorisation for JV FM & fund launch

Negotiate & invest

CSRC authorisation for JV FM & fund launch

Negotiate & invest

Incorporate JV FMC

Launch funds

Incorporate JV FMC

Launch funds
Source: PricewaterhouseCoopers

6 Entering the Chinese investment management industry PricewaterhouseCoopers

Regulation is clearly a key consideration. Although China has been gradually opening up the investment management sector to foreign investment since its accession to the WTO in 2001, foreign firms are still only allowed to hold a maximum share of 49% in a JV. Although the regulatory capital requirement is a relatively modest $12.5 million, proposed JVs must undergo stringent vetting by the China Securities Regulatory Commission (CSRC). Whether to move now or wait until regulation permits foreign companies to control wholly owned subsidiaries is very much an individual decision, which is likely to be based on a number of factors, including local opportunities, the groups overall China strategy and its risk appetite for entering emerging markets. Foreign investors should not under-estimate their local competitors. Although the local players may not have the expertise of their international counterparts, a combination of established relationships and cultural and linguistic understanding has given them a valuable head start. As Figure 7 on page 4 highlights, there are as yet no Sino-foreign JV FMCs in the top five FMCs. However, new opportunities are opening up for companies wishing to make their move. For example, the green light for banks to enter the investment management market in 2005 has considerably widened the choice of potential partners, as will the eventual go-ahead for insurance companies to set up their own FMCs. While the leading national banks offer the broadest access to customers, partnership with a city or provincial bank could prove an equally attractive option. Unlike the market leaders, many of which have already established their own FMCs, the smaller institutions may not have the resources or expertise to set up their own investment management operations and may therefore especially welcome outside support. It is also worth bearing in mind that several of the regional banks serve populations larger than western Europes. Moreover, a regional focus may be more practical in seeking to establish an initial foothold in such a vast, complex and diverse country. The development of the corporate pension market is opening up further opportunities. Of the 29 companies granted licences to set up EAPs in 2005, four are part-owned by foreign institutions. Other foreign firms have forged partnerships with state-owned industrial corporations. This includes Societe Generale, which formed the Fortune Trust and a subsidiary FMC with the backing of Baosteel, Chinas largest steelmaker. Such partnership can offer both considerable capital and a patient long-term approach to seeking return on investment. Indeed, the quality of relationships is critical, from JV partners through to distributors, customers and regulators. Several JVs are the fruit of ties built up over many years. Domestic partners can clearly benefit from the research, market experience and access to technology of outside firms, especially now FMCs are about to begin investing overseas. In turn, local partners offer the relationships and customer understanding that are vital for success. As the FMC develops, it will be critical to attract, nurture and retain local talent, rather than relying on expatriate expertise. Ultimately, patience is likely to be the watchword for success in what remains a fledgling market. While there are clearly advantages for companies able to establish an early foothold, further liberalisation and the development of greater consumer awareness may be required before the investment can come to fruition. Indeed, it may prove necessary to exploit short-term tactical opportunities in order to develop longer term strategies.

Entering the Chinese investment management industry PricewaterhouseCoopers 7

Contacts

If you would like to discuss any of the issues raised in this paper in more detail, please speak with your usual contact at PricewaterhouseCoopers or call one of the following:

Nick Page, Partner

PricewaterhouseCoopers LLP 1 Embankment Place, London WC2N 6RH, United Kingdom. Tel: + 44 (0) 207 213 1442 Fax: + 44 (0) 207 804 4907 Mobile: + 44 (0) 7808 633 248 nick.r.page@uk.pwc.com

Andrew Cann, Senior Manager

PricewaterhouseCoopers LLP 1 Embankment Place, London WC2N 6RH, United Kingdom. Tel: + 44 (0) 207 804 2814 Fax: + 44 (0) 207 804 4907 Mobile: + 44 (0) 7900 498 499 andrew.cann@uk.pwc.com

Yangchew Ooi, Associate Director

PricewaterhouseCoopers Zhong Tian CPAs Limited Company 11th Floor, PricewaterhouseCoopers Center, 202 Hu Bin Road, Shanghai 200021, P.R. China Tel: + 86 (0) 21 6123 2977 Fax: + 86 (0) 21 6123 8800 Mobile: + 86 (0) 1381 787 2897 yangchew.ooi@cn.pwc.com

Matthew Phillips, Partner

PricewaterhouseCoopers Zhong Tian CPAs Limited Company 11th Floor, PricewaterhouseCoopers Center, 202 Hu Bin Road, Shanghai 200021, P.R. China Tel: + 86 (0) 21 6123 2303 Fax: + 86 (0) 21 6123 8800 Mobile: + 86 (0) 1381 611 8614 matthew.phillips@cn.pwc.com

Nick Page and Andrew Cann are senior members of PricewaterhouseCoopers Financial Services Transaction Services team. Matthew Phillips and Yangchew Ooi are senior members of the China Financial Services Advisory (FSA) Services team. The team is dedicated exclusively to advising banks, insurers, fund managers, private equity houses and other financial services companies on market entries, acquisitions, disposals and IPOs. Services provided include strategy reviews, commercial due diligence, financial and tax due diligence, structuring, synergy reviews, operational due diligence, post-deal integration, vendor services and regulatory authorisation.

Subjects covered in the Financial Services M&A flyer series

1. Russian financial services M&A 2. Innovative financing: Life insurance securitisation 3. European banking consolidation

Recent financial services M&A related publications

Going for growth: the outlook for M&A in the financial services sector in Asia (2006) Financial services M&A: review and outlook for mergers and acquisitions in the European financial services market (2006) The new deal: FS M&A in an IFRS environment (2005) Focus on growth: Striking the right value balance within financial services (2005) Focus on restructuring: the drivers shaping the financial services sector (2004)

8 Entering the Chinese investment management industry PricewaterhouseCoopers

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