The Blackstone Group’s recent joint venture with the Shanghai government may well mark another important turning point in the domestic private equity (PE) landscape.

Blackstone, which with $93.5bn of assets under management is among the world’s largest PE firms, has signed a memorandum of understanding with the government of the Pudong New Area. The global PE powerhouse, one of several to now have a presence here, will set up its first regional renminbidenominated PE fund in Shanghai, called the Blackstone Zhonghua Development Investment Fund. It will raise RMB5bn (US$732m) for investments in Shanghai and neighbouring areas.

The indicative significance of this joint venture has many PE lawyers excited about the market’s prospects. “This groundbreaking development sees a major global PE firm showing serious commitment to the market. It will help grow the PE industry in
China and has the potential to even change the landscape of this industry,” says Richard Xu, founding and managing partner of Shanghai-based HanYi, a law firm that has a primary focus on PE transactions.

Allowing a top-tier global PE house to form and manage an RMB investment fund will also set a good example and model for the domestic players and other local governments in different cities. In the view of domestic lawyers, this JV will help raise the bar for the entire industry.

“Opening the domestic market to quality global players will help China build an orderly private equity industry, as well as foster corporate governance and strengthen capital markets,” says Jeremy Dai, a partner of Zhong Lun. “It’s a good chance for domestic PE managers to gain the institutional know-how and technical skills from their international counterparts on PE practices.”

Similar to Blackstone, many other leading foreign PE companies – which are usually ahead of the curve in spotting developing business trends – are refocusing on or expanding their presence in this market. International law firms are also seizing the opportunities by simply following their clients’ footprints.

US PE heavyweight Kirkland & Ellis (K&E) has recently opened an office in Shanghai, its second one in Asia after Hong Kong. The Shanghai office, co-managed by senior partners Li Xiaoyang and Li Chuan, focuses on complex transactions involving China for international PE firms and corporations and will represent Chinese entities active abroad.

“For a very large number of PE clients, particularly those in Asia, China is increasingly their core focus, and they are making long-term investments here. So our China strategy isn’t creative at all; we are simply doing what they are doing,” says
David Eich, senior partner in K&E’s Hong Kong office and the head of the global PE practice in Asia.

“The opening of our Shanghai office allows us to be closer to a larger set of managing directors in the Greater China market. It’s amortising our existing assets and resources across a large pool of potential clients,” Eich says.

Recovery on the horizon
While the PE scene in other parts of the world is still relatively quiet, there is no doubt that the worst of the GFC is over for PE in China. Funds managers and lawyers have all sensed that the market is recovering, as deal flow has started to gradually pick up from the second quarter of 2009. Domestic PE houses such as Hopu, Hony Capital and CDH are leading the recovery. “Many dominant international PE funds have been very quiet in the past 18 months. This has provided good opportunities for the domestic PE firms to thrive. Some of the domestic players have been very active in the market during a period when deal activity witnessed a significant downturn,” says David Blumental, partner of Vinson & Elkins in Beijing.

The strong performance of the PE practices of domestic firms has breathed life into law firms. “We’ve experienced an increase in work load starting from the end of the second quarter. Prior to that, most of the mandates were for restructuring and exit strategies, but now we’re involved in more new deals, due diligence and deal executions,” says Xu.

Deal activity slowed down dramatically in about September 2008, and until the second quarter of 2009 many PE firms were largely reviewing existing projects; only a few new investment deals were closed.

To some, K&E’s expansion in the supposedly uncertain present may look risky, but the firm’s China business has turned out to be “surprisingly” encouraging. “We are in the right place, even at the wrong time. We are increasingly busy here. The view is clear – at least in Asia, especially China that the market has turned and some kind of bottom has been reached. It seems the disability in financial markets has ended and people are now investing again,” says Eich.

Although things are looking up, challenges remain. One of the main issues that stop transactions being closed is valuation. “We are at a time where some level of uncertainty is still swirling around the market and global economy. In many cases, it’s difficult for the founder and the investor to reach an agreement on valuations,” says Blumental.

An advancing and more sophisticated legal framework, meanwhile, has slowed down the pace of deal making. “In the more developed and regulated legal environment, PE investors are more careful and are spending more time and energy on making sure they don’t overlook any major PRC compliance issues, and are paying more attention to evaluating investment risks,” says Xu. Many PE managers reportedly now engage many specialists in different fields to examine target companies more thoroughly.

“PE clients now demand an increased level of skills and attention from more experience lawyers. Lawyers have to be more careful when they advise
on transactions, and need to be more updated on regulatory changes and how these changes are practised in China,” he says.

NEXT: Positive regulatory changes

Positive regulatory changes
A number of encouraging regulatory changes that have been – or are about to be – issued have signified the fact that the government is trying to foster the growth of the PE sector. These changes will create all the mechanics required for PE funds to do deals more efficiently, channel liquidity into promoting private investments and drive economic development.

Among the new regulations and draft rules relevant to the PE industry, the draft of the Administrative Measures for the Establishment of Partnership Enterprises by Foreign Entities or Individuals in China (FIP regulations) has been regarded as the most
single important rule for foreign PE fund managers, investors and their lawyers. FIPs resemble the prevalent structure for most international and offshore funds, and will permit foreign investors to utilise a PRC partnership structure to form onshore RMB PE funds.

“Everyone is talking about RMB funds these days,” says Blumental. “RMB funds are now favoured by many founders of target companies, largely because the domestic capital markets enjoy a higher price-to-earnings ratio than overseas markets. And they are more nimble and faster, so they can have better access to good deals that need quick action.”

In the absence of a national legal framework for FIPs, cities like Tianjin, Shanghai and Beijing all adopted their own local rules and structures to promote formation of RMB funds, allowing foreign fund managers to participate “indirectly” through their direct or indirect subsidiaries established in China.

The latest draft of the FIP regulations allows a foreign investor, subject to governmental approvals, to directly form a PRC limited liability partnership (LLP) as a general partner or to directly invest in a PRC LLP as a limited partner. It has been approved in principle by the State Council, and has been returned to the Ministry of Commerce for further refinement. Many people are holding their breath and waiting to see what this new rule will look like.

“The FIP regulations will provide a much-needed national legal framework for foreign fund investors to put money into the hands of fund managers who are already living and working in China,” says Xu. “It’s interesting to see how the central government consider or perceive foreign investment coming into China in this form.
And there is still some legal uncertainty regarding the formation and operation of FIPs,
particularly issues surrounding foreign investment restrictions, tax and foreign exchange controls.”

The regulations that allow commercial banks to provide loans for M&A deals is another critical step towards a better legal framework for the PE industry. “From the PE perspective, permitting commercial banks to finance serial acquirers’ M&A transactions is a sea change ... Another piece of the soft infrastructure that China needs to have a real M&A and PE market has been created,” Eich says.

The government’s policy to broaden the investment areas available for institutional investors, such as pension funds, social security funds, banks, insurance companies and securities companies, is regarded as other positive initiative to the development of the industry.

“With more large, established institutional investors coming to the PE playing field, the market will be better regulated and more protections will become available for investors. Lawyers, therefore, will have a more important role to play in domestic PE fund formations and transactions,” says Dai.

NEXT: Deals pipeline strong 

 Deals pipeline strong
Although many in the industry doubt the mega-deals such as those of 2007 will be seen again for some time, lawyers have recognised many other opportunities which come out of the volatility of this market, such as distressed businesses, public securities arbitrage, PIPEs and Chinese outbound investment. In the meantime, opportunities will arise out of China’s continuous march towards one of the largest PE markets globally.

“I expect to see large-scale, traditional PE investments becoming more mainstream activities, compared to venture capital investments which were prevailing in the past decade,” says Xu. “Due to the growing size of domestic companies, the increased
scale of the economy and the more mature market conditions, more traditional PE deals are becoming visible, deal sizes and volumes are moving upward, and deal structures are changing quickly and becoming more sophisticated.” He also anticipates many PE investors will soon realise their gains through successful exits, as the capital markets stabilise and the currency becomes more convertible.

For local PE practices that want to keep up with the market, organic growth alone won’t cut it. They will need significant contributions and flows of expertise from international firms, for when PE has been a major practice for much longer. “Hopefully, many talents from foreign law firms will come to this part of the world, either working directly with foreign law firms or joining PRC firms, to help build up this emerging practice area in China,” says Xu.

International firms, meanwhile, will continue to focus on assisting international funds investing into China in the coming years. However, some large firms have started working on a new category of deal activity – globalising PRC companies forging strategic partnerships with global PE funds.

“As China-based world-challenging companies are looking to become world champion companies, they need to expand their global presence and business. They can benefit greatly by having a strategic partner that knows how to run a global business. It’s a neat fit for those companies to join force with North America or European global PE funds and together create a global business,” says Eich. “This area will see huge development in the future and it is just about to erupt right now.”

K&E are currently advising on several deals in this category, and Eich believes that a handful of large international firms that have the capability to deliver M&A across three time zones are also involved in a number of ongoing deals.

While PE firms are providing the much-needed capital, advice and management know-how to accelerate the growth of Chinese enterprises, their demand for quality legal services are also helping foster a stronger, domestic PE capability. “Lawyers are at the centre of PE transactions and should be PE firms’ closest partners,” says Peter Fuhrman, chairman of China First Capital, a Shenzhen-based boutique international investment bank focusing on China’s high-growth private small and medium enterprises.

Like elsewhere in the world, legal documents and contracts in a PE investment are extremely detailed and specialised. It requires very experienced and capable lawyers to be involved. However, as international PE law firms are barred from providing PRC legal advice and many lack local expertise, domestic PE transactions inevitably need to engage PRC lawyers who are familiar and skillful in this area of work.

“Currently, there is a drastic shortage of experienced local PE legal talent, given the tremendous growth in China’s PE market. I tell every lawyer I work with in China ‘if you want to have a successful future career, become an expert in PE’. The future for these PRC lawyers who have the skills in PE is just unlimited,” says Fuhrman.