If you have no idea what RMB funds are, or if you’re interested in what our friends in the financial sector are doing in China these days, read Rebecca Fannin’s post on Forbes Asia. It’s a great little summary of the state of the RMB fund game, with an open question about whether this popular investment option will end in tears and frustration.

My opinion? Yes, it will end badly for some folks. Let me explain why after a couple of good quotes to set the stage:

The latest trend among private equity investors in China to set up yuan-denominated funds seems to have the classic makings of a bubble. In spite of questions about whether renminbi funds will work well, partners are angling to have a RMB fund of their very own. Except for talk of real estate prices in Beijing and Shanghai, no topic has managers of private equity funds more engaged and energized than RMB funds.

I started seeing RMB fund activity a couple of years ago. The big motivation here is to find an investment vehicle with fewer regulatory restrictions. RMB funds do offer advantages in this area, and since the government has been throwing up carefully placed roadblocks over the past few years, beginning with the M&A law in 2006 and continuing with restrictions dealing with foreign currency exchange, real estate investment, and “round trip” investments, foreign investors have been looking for options.

Enter the RMB fund, several flavors of which have been available for a number of years but are just now getting really hot. Troutman Sanders, which has a nice summary of China RMB fund law (PDF) penned by Edward Epstein and William Liu, lists the advantages:

After many years of hearing footsteps on the stairs, it seems that foreign participation in RMB funds is finally becoming a reality in the PE, VC and real estate industries. The advantages of RMB funds are clear: they can make investments without foreign exchange controls, they can raise funds from local investors, including high net worth individuals, onshore companies, government fund of funds (FOF), insurance companies and social security funds, and they can speed up the transactions because they are not weighed down by the baggage of foreign investment approvals.

Here’s another good introduction to the current state of the market from ZerotoIPO:

There are primarily two private equity deal structures, i.e. offshore deal structure and onshore deal structure. In the past, investors are accustomed to consummating transactions through offshore deal structure to overcome the inconvertibility of RMB and China’s market-entry restrictions. However, this structure recently began facing challenges from some Chinese regulatory changes restricting round-trip investment. Meanwhile, the onshore structure is encouraged by high returns from domestic IPO (especially in the GEM market) and various incentives offered by some local governments to attract private equity investors.

This is all well and good, and after years of jumping through a lot of regulatory hoops with offshore investment deals, you can understand the attraction of onshore investments. However, let’s keep in mind that these onshore investment options are not an idea that some enterprising fund manager or lawyer just came across one day. This sort of investment is not a loophole in Chinese law.

The government here has deliberately made other forms of investment more difficult so that it can funnel offshore funds into these types of projects. Readers of China Hearsay are familiar with my numerous posts on China’s industrial policy. Suffice it to say that all of this has been planned, and these onshore vehicles are the preferred option for China.

So one good question is why would China box foreign investors into this corner? What’s the attraction for Beijing and, more importantly, should the answer change the risk assessment of foreign investors?

Let’s keep it simple and take high tech as an example. China is trying to push innovation so that companies here move up the value chain. More automobiles and computers, less textiles and toys. An important part of China’s industrial policy is to develop local capabilities instead of having a continuous reliance on foreign technology.

As Chinese companies grow and innovate, the last thing the government wants is for foreign investors to swoop in and acquire these jewels, hence some of the M&A restrictions we’ve seen over the past few years. Neither does the government want foreign investors taking prominent positions in key industries (e.g. Internet, automobiles) without being saddled with local partners; FDI restrictions have taken care of that.

But money has a funny habit of finding its way to high-growth projects, by hook or by crook. Beijing is well aware, for example, of all the so-called Chinese Internet companies out there that are really owned by foreign entities via nominee deals.

These are just some of the concerns that Beijing has with key industries, which by the way also includes real estate. RMB funds are not a magic bullet for China’s industrial policy, but boxing in foreign investors in this manner will certainly help.

Although these funds obviate the need for a lot of regulatory filings associated with offshore deal structures, they also force investors to give up a great deal of control. In listing disadvantages of RMB funds, Troutman Sanders’ Epstein and Liu note the following:

There are also disadvantages: the legal structure is still unclear and foreign participation is still restricted, as is liquidity and exit strategies. Moreover, the lack of mature local limited partners and their expectations of high yields are limiting the development of RMB funds.

Fannin sums up the problems a bit differently, but potential problems with the local Chinese partner is emphasized:

The issues are pretty weighty ones: still-evolving Chinese government regulations for RMB funds by foreign investors, only one legitimate limited partner–China’s National Security Fund–to invest in the China funds, limited experience by first-time Chinese partners, and potential conflicts over how investment returns and deals can be divvied up among financial backers in both an investment firm’s dollar and renminbi funds.

It’s difficult to overemphasize the problems associated with local partners. Suffice it to say that there is a very good reason why so many foreign investors now utilize the wholly foreign-owned enterprise vehicle as opposed to a joint venture in China — it’s all about control.

So why do I think that this experiment will end badly for some investors in RMB funds? Let me count the ways:

1. Tolerance for Risk — After cutting my China foreign investment teeth on the Internet boom (circa 2000), I realized that the tolerance for risk among foreign investors (specifically folks in the financial sector) knows no bounds. If RMB funds, in addition to just China investment, is pronounced hot, the money will follow, legal risk be damned.

2. Legal Uncertainties — The law in this area is very new, which also plays into the hands of Beijing. Decisions will be made on an ad hoc basis, allowing the government, both central and local, to protect partners, investment targets, and key industries.

3. Protectionism — We’ve seen this all before. Beijing wants funds to flow in through these channels to help develop certain industries. Once this development has reached a certain stage, restrictions will mysteriously increase and exit strategies will become uncertain. This will most likely happen on a sector-by-sector basis.

There will be winners and losers in the RMB fund game over the next few years. Experienced players will make better calls and figure out ways of working with local partners and negotiating decent exit strategies. For those new to the game, or for those willing to play in either sensitive sectors or by partnering up with local governments, I wish you luck. You’re gonna need it.