According to a Zero2IPO Research Centre report, Chinese private equity (PE) firms are likely to encounter difficulties in fundraising and tougher regulations this year. The report also noted that the expected extension of regulations nationwide will force some firms to start cleaning up their operations to avoid breaching the new rules (please see box: Regulatory update).
Chinese PE funds are expected to undergo a period of reshuffling in the coming eight months owing to several market factors. These include the decrease in domestic initial public offering (IPO) valuations, the increased sophistication of companies seeking financing, and the resulting increased emphasis on value-add that PE funds are able to provide, says Han Kun Law Offices partner James Wang. “As a result, many domestic PE funds will be getting more pressure finding good investments with an attractive price-to-earnings ratio; have a harder time trying to exit their investments through IPOs; and will have to explore other ways to exit such as trade sales or secondary sales to other PE funds,” he says.
The funds will need to diversify their investment strategy from growth capital and pre-IPO to other strategies like earlier-stage investment, consolidation or special situations play. Unlike in mature markets, most Chinese fund managers, including venture capitalists, have until now only focused on pre-IPO deals, betting on listings that would typically boost the value of their investments. Currently, 90 percent of exits are made through IPOs. Wang says Chinese PE funds should also become more specialised in terms of industry focus, and equip themselves with specialised professionals. “PE funds that cannot meet such challenges will find it hard to survive,” he says.
The year 2011 saw China's PE market experiencing a boom. According to Zero2IPO data, 323 new funds were launched in the mainland from January to November; a growth of 204 percent from the total in 2010. The total amount of funds raised in the Chinese mainland in 11 months was $26.4 billion, a surging increase of 237 percent from the total in 2010. Zero2IPO estimated that new PE funds raised in 2011 may have reached $30 billion. However, the report cautioned that fund raising by PE firms will become more difficult in 2012 with tightened liquidity in the market.
Boom times are over
The Zero2IPO report coincides with a Reuters analysis from December 2011 that said the boom of thousands of PE funds in China appears to have come to an abrupt end. The proliferation of domestic fund launches since 2008 was sparked by the prospect of quick and easy money, and returns as high as 400 times on a cash investment. But domestic market weakness, a tight monetary policy, and growing economic uncertainty made both fundraisings and exits for PE firms increasingly difficult.
As a result, many speculative funds which invest in companies just before an IPO, only to sell out soon after their listings, could be wiped out."China has about 3,500 PE funds and that's an awful lot," said Gao Jianbin, a Shanghai-based partner at PricewaterhouseCoopers, to Reuters."At the end of the day, only those with management expertise and the ability to grow invested companies can survive," he said, adding that many funds would be forced to focus on venture capital and mergers and acquisitions businesses.
China's PE boom started immediately after the 2008 global financial crisis spurred by two things: a flurry of IPOs following the launch of the Nasdaq-style ChiNext board on the Shenzhen exchange, and the $586 billion economic stimulus package Beijing put in place to ward off financial contagion.
According to fund consultancy ChinaVenture, 1,084 yuan-denominated PE and venture capital funds, including those of global buyout giants Carlyle Group, Blackstone Group and TPG Capital, were launched in China over the past three years, raising a combined $68.7 billion. Comparing this figure with Thomson Reuters data revealed that 925 funds were launched in the United States during the same period, raising $236 billion.
However, fund raising has become difficult as local governments, which typically provide seed capital for new funds, are now struggling to manage debts worth more than 10 trillion yuan ($1.57 trillion) that have accumulated over the past few years. Private entrepreneurs, another important investor base for Chinese PE firms, are also feeling squeezed by slowing business conditions and tightening credit. As such, there is no official data on the sector and latest available industry figures are outdated because they do not reflect the current fundraising environment. But fund managers say the sharp downturn in the sector has been evident.
Natural selection
Industry analysts told Reuters that for survival, PE managers will need to do more than just bet on IPOs to win investors. "Investors would require that fund managers have a profound understanding of the businesses they invest in," said Vincent Huang, partner of global PE fund-of-funds manager Pantheon, at a financial conference in Shanghai in December 2011."This is what made TPG, Bain and KKR global giants. But 90 percent of Chinese fund managers are not equipped with that ability."
Juan Delgado-Moreira, the Asia managing director of PE management firm Hamilton Lane, says the inexperience and missteps of some new Chinese fund managers will benefit those more established and mature Chinese PE players. “The good news for those funds with a full complement of skills is that those without are likely to fade from the competitive set as market tides turn, as it currently seems to be happening,” he says.
The looming shake-up is seen by many as a natural and necessary step in developing China's nascent PE market, and not necessarily a death knell."There's so much wealth in China that this industry will not die out as many commentators predict. But it needs to be managed," says one senior executive at a Western PE firm. “Developing core disciplines found in the most successful and time-tested Western and Chinese groups — rigorous investment diligence, responsible capital deployment, sophisticated management and operational improvement strategies — will become critical success factors for RMB PE players as well,” says Moreira.
Shanghai-based Boss & Young partner Hubert Tse, who has worked with PRC and global private equity funds, views the development of the PE funds market as beneficial to the legal space. “As Chinese PE participants mature, they will need to become more professional and sophisticated to get funds from LPs to make good investments and get good returns,” he says. “That means lawyers will be more involved, and relied upon more, to assist them on closing deals.”
Strong get stronger
Despite a dulled outlook for PE funds as a whole, the growing group of sophisticated and prominent Chinese sponsors which includes CDH Investments(a spin-off of China Investment Corp), Hony Capital, Citic PE, FountainVest Partners, Fosun International, Legend Capital and New Horizon Capital, continues to flourish.“A few offshore funds of high-profile PRC players don’t use placement agents,” says Hong Kong-based Debevoise & Plimpton partner Andrew Ostrognai. “My guess is that they have developed this product on their own over time, and have done so well they don’t need doors opened anymore; they have done it themselves already.” In fact, these high-profile funds continue to raise record amounts for their onshore and offshore funds, and to announce new launches in the coming months.
This is big business for fund formation law firms in Hong Kong. Ostrognai regularly represents CDH Investments and Hony Capital on offshore fund formations. Simpson Thacher & Bartlett’s Hong Kong-based partner Philip Culhane says that the key drivers of his business are local indigenous GPs with Asia-based investment committees and Asian investment professionals. “Clearly, there are going to be homegrown competitors. We see this as our key market,” he says. His team counts New Horizon and NewQuest Capital as clients.
On Feb. 16, according to Reuters, government-backed Sailing Capital International launched a 50 billion yuan ($7.93 billion) fund in Shanghai to aid overseas acquisitions by Chinese companies, and build the commercial hub into a global financial centre. The fund will back Chinese companies' overseas expansions through loans and equity investment, with the yuan as the preferred currency for pricing, transaction and settlement in cross border investments. Investors in the newly-launched Sailing Capital International fund include both state and non-state owned enterprises, listed firms and financial institutions, the Shanghai government said without disclosing details. Shanghai vice-mayor Tu Guangshao says that launching the fund "meets Chinese companies' strategic needs to venture out, and would also play an important role in building Shanghai into a center for asset management and cross border investment denominated in yuan."
Reuters reported on Feb. 27 that China-focused PE firm HAO Capital planned to launch its third U.S. dollar fund this year, as it eyes more exit opportunities in China for its portfolio companies amid sluggish markets overseas. Founder and partner Elaine Wong, who previously worked at the Carlyle Group, gave no timetable for the fund launch, but said two-thirds of HAO Capital's second dollar fund had been invested, adding that she expects two portfolio companies to conduct IPOs in China this year.
Earlier in January, Hony Capital said in a statement that it had raised nearly $4 billion from investors, defying the increasingly tight fundraising climate. It raised close to $2.4 billion for its fifth dollar fund, and 10 billion yuan ($1.6 billion) for its second local currency fund. These numbers are almost double the sizes of previous dollar and yuan funds for Hony Capital, which is backed by Legend Holdings Ltd.
"Changes that were not found in foreign markets over the past two or three decades are taking place in China," says John Zhao, the CEO of Hony. "The emergence of China provides rare opportunities for China's PE insiders to explore a new way with Chinese characteristics, based on our experience in the Chinese market." The speed of Hony's fundraising - which began in September 2011 for the dollar fund with a target of $2 billion - underlines the appetite of international investors for investing in China through funds like Hony, which have an established track record. With its dollar fund, Hony said it will continue to focus on reform of China's state-owned enterprises, as well as growth capital investments.
In the aftermath of the 2007 and 2008 global financial crisis, China stepped up efforts to promote international use of the yuan in a bid to reduce reliance on the U.S. dollar, and it encouraged domestic companies to acquire crisis-hit foreign companies. It has also been aiding acquisitions through government-backed funds and commercial banks. For example, state-owned policy banks have invested in PE funds such as Mandarin Capital Partners and Infinity Group to aid outbound investment.
Looking outward
As China’s top tier PE funds search for new ways to deploy capital, industry analysts have recognised a growing outbound trend. “A potential medium to long-term opportunity for law firms could come from increased outbound investment activity from China,” says John Fadely, a Hong Kong-based funds partner at Weil, Gotshal & Manges. “Probably in more varied industries than the natural resources focus we've seen until now, and with some of the outbound capital being channeled through the PE industry,” he says. One way a Chinese PE fund may get involved is by looking at investing in a domestic company that has plans to expand to a foreign country, making the fund’s asset offshore.
According to a Reuters analysis, after years of focusing on their home turf, Hony Capital and other China funds are also beginning to expand abroad. A small portion of the Hony fund may be used for overseas investment, sources said. Zhao previously told Reuters that technology companies in the United States, Europe and Japan could improve their value significantly if they could get their products into China.
“The outbound aspirations of China’s biggest sponsors are a terrific development for our practice area,” says Culhane. “It is one more piece of the puzzle that will lead to global best practices being the benchmark for significant market participants.” The aim of the funds is high, with managers stating their hopes to compete for investment dollars as well as deal opportunities with Western giants like Blackstone, TPG and the Carlyle Group. The barriers are high as well, as expanding overseas is always difficult, and the acceptance level of Western executives and fund of fund investors for Chinese players is still fairly untested. Intense competition for deals at home in addition to international ambitions of Chinese companies like consumer goods group Bright Food, is fuelling the move to send China PE businesses across borders. “As China continues to climb up the value chain over time, it wouldn’t be surprising at all for China’s outbound investment activity to diversify into other industries,” says Fadely.
PE executives in China stress the move is gradual, though whatever the speed, it's happening. "As the world's most vibrant economy, China has attracted the world's best companies, resources and wealth," said Zhao at a Shanghai ceremony in September 2011 that was attended by local government officials, as well as scores of overseas institutional investors. "Chinese companies have also started sailing abroad. This is Hony’s opportunity," he had said.
The venerable Chinese sponsor is not alone in its international plans. Citic Capital, owned by China sovereign wealth fund China Investment Corp (CIC) and the state-backed conglomerate Citic Group, has a Japan fund and an international co-investment fund. The firm has done five deals in Japan and is closing in on a seventh deal in the United States. In addition to seeking deals that they and Chinese corporations can take part in, the cross border push of Chinese firms such as Hony, Citic and CDH Investments has another motive: attracting overseas investors into their funds.
Home advantage
In luring money from Western institutions such as pension funds and banks, analysts say some Chinese firms have an advantage over their much larger global rivals. This is because of their strength in the China market - an area the Western institutions want exposure to. Some Chinese firms now have both a dollar and a yuan fund at their disposal, which gives them an advantage over firms with only a U.S. dollar fund. During the past two years, at least six homegrown Chinese firms, including Fortune Venture Capital and Jiuding Capital, have launched or plan to launch their first dollar funds, according to Zero2IPO data.
Highlighting the fundraising ability of Chinese firms, Citic PE Funds Management Co raised $1 billion in May 2011 in its first dollar fund after attracting foreign demand. The fund, which was heavily oversubscribed, obtained investment from 39 overseas institutions including sovereign wealth funds, pension funds, endowments, family offices and insurers. PE research group Preqin estimates that there are 538 Asia and global funds on the road looking for a total $177 billion in capital. That broad array allows investors to be choosy about who they fund. Some are expected to still be cautious about the fast growing, heavily regulated and unpredictable China market.
By launching dollar funds, many Chinese PE and venture capital firms hope to win more deals from foreign rivals, as many Chinese companies seeking an overseas listing prefer hard currencies funding. For example, many Chinese internet companies, including Baidu and Sina, used offshore structures to obtain foreign venture capital investments ahead of their Nasdaq IPOs to avoid rigid Chinese regulations. Foreign currency funding is also preferred by a growing number of Chinese companies seeking acquisitions abroad. Hony, for example, helped Chinese construction and mining equipment maker Zoomlion in its acquisition of Italy's Compagnia Italiana Forme Acciaio SPA.
The future of funds
“Convergence will happen, and to some extent, is happening,” says Culhane. When speaking to ALB, lawyers consistently bring up the term “convergence” to describe their funds market forecast for China. “What we are really waiting for is the convergence of offshore and onshore, where domestic and foreign investors commit to a common vehicle that receives domestic treatment,” says Ostrognai. “Right now, we have two types of funds - onshore and offshore - on two parallel tracks, trying to find a way to operate in harmony.” The combined product would be a fund that can have up to 25 percent of the right type of offshore investors, and still be considered domestic. Culhane offers another direction the market could take when he says: “I think the most likely outcome is that eventually there is a market with multiple product types and similar standards for those products, whether they are RMB funds or offshore funds.”
Whether it is one common vehicle or multiple product types with similar standards, this is where the top offshore fund formation law firms will find a niche to market their international experience and familiarity with global standards. But market insiders agree that a common vehicle convergence – if possible – will take a number of years to reach, and would wholly depend on the promulgation of a regulation that allows funds to remain domestic by definition but have up to a certain percentage of foreign limited partnership. “Convergence of offshore and RMB funds has been a gradual process with the occasional partial breakthrough here and there, and full convergence doesn't appear to be around the corner, in part because it would probably have to unfold together with the opening of China's capital account,” says Fadely. Currently, foreign exchange controls and foreign investment restrictions are roadblocks for a converged fund model. “It may take five to ten years, no one can say,” says Ostrognai. “But when the (regulatory) switch flips, this is when the market will revolutionise.”
Optimism of this convergence becoming a reality buoys on the maturation of China’s PE market, and the government’s security in regulating it. One theory floated by a lawyer is that regulators will learn to trust foreign managers as they prove over time that they are not bringing in hot money. Right now, a foreign player can set up a domestic fund, provided it does not put in more than 5 percent of the capital. If the offshore sponsors continue to manage the funds prudently, the regulators will recognise this and raise the capital contribution bar for the right type of foreign investors.
Tse predicts a similar time frame of five to ten years before the market liberalises. “But it will change because market forces will bring more experienced and talented people into the market, and they’re going to raise the bar and drive convergence,” he says. “More importantly, new laws and rules will provide more clarity and transparency, bringing them in line with international standards. It’s going to take time, but I do believe that we’ll get there.”
#phb#
REGULATORY UPDATE
Circular 2864
On Nov. 23, 2011, the National Development and Reform Commission (NDRC) issued the Circular on Promoting the Standardised Development of Equity Investment Enterprises – commonly known in the industry as Circular 2864. This was released after the Circular on Further Regulating the Development, and the Administration on Filings, of Equity Investment Enterprises in Pilot Areas from Jan. 31, 2011 (Circular 253) and supersedes it as the first nationwide set of administrative rules on PE funds in China.
The new regulation was hailed by many in the industry as a step forward in the standardisation of PE funds, as it aims to provide clearer guidance on their establishment and operation. Its key features are: (i) The expanded scope of the filing procedure to include equity investment enterprises (EIEs) with a fund size of at least 500 milion yuan; (ii) Application to foreign-invested funds and fund managers; (iii) Foreign-invested EIEs are not extended national treatment; and (iv) The number and qualifications of investors will be verified to conform with China’s Company Law and Partnership Law.
The circular also requires mandatory registration of all PE funds in China and imposes stringent requirements on fund formation and registration. There is a 10 million yuan minimum investment requirement for any single investor, which, according to James Wang of Han Kun Law Offices, is very high compared to U.S. standards. Additionally, if funds wish to raise money from the national social securities fund, they must register or else they will not t be able to qualify for funding.
Despite the circular, industry insiders say registration numbers are still quite low. Only the larger and more prominent onshore and offshore funds have registered. A key reason funds (over 500 million yuan in size) refuse to register, as Hubert Tse of Shanghai firm Boss & Young points out, is because they would be required to disclose information to the NDRC. “Some investors may not want to be disclosed, and this may be one of the disincentives because when you file with the NDRC, the records are public,” he says. An additional reason, he believes, is due to the fact that enforcement of non-registration is non-existent. “Unless there is a strong enforcement mechanism in place or substantial penalties are imposed, it’s more just a policy guideline than law,” he says. Fadely agrees that it is not clear whether China has the regulatory resources required to enforce registration, which would be the first line of defence against fraudulent funds. However, he is optimistic. “China's PE industry has come a long way over the past few years through regulatory and tax competition at the local level. But now, the NDRC appears to be emerging as the key central government regulator of the industry, which might mark the beginning of a new regulatory phase,” he says.
New securities fund law
The PE sector in China has been very loosely regulated amid a power struggle between the securities regulator and the top economic planning agency, both of which are both eyeing control over what was once a fast-growing sector. China's current funds law came into effect in 2004, and though it did not list PE funds as a legal product, it did not ban them outright either. The law also bars individuals working in the securities mutual fund industry from trading stocks themselves. Particularly after the 2009 launch of China's second board for start up companies, typically the target of investments by PE funds, various circles in China's financial system have called for the quick promulgation of an amended law.
On Feb. 26, Reuters reported that China may promulgate a revised securities fund law this year. A draft of a revised Securities Investment Fund Law has been completed and has been submitted to the State Council, or the cabinet, for deliberations. The draft law had been in existence for more than a year now. But legal practitioners are optimistic that it will come to fruition later this year, after the National Congress in the autumn. “The CSRC has been pushing through new reforms with the new chairman on board. He has issued many new policies including IPO reform, and is trying to build confidence and stability into the local stock markets, and promulgating the revised funds law is expected to be an item on the agenda,” says Tse.
As the current PE legal framework is inconsistent, leaving many PE players operating in a grey zone, the amended law would provide clearer provisions on the definition, set up, and operation of their funds. PE funds are not officially under any authority’s supervision, even though the NDRC moved forward to bring them under its wing with its promulgation of Circulars 253 and 6824. So, a key revelation of the new securities law would be if it will bring PE funds into its jurisdiction, making the CSRC their main regulator rather than the NDRC.
CULTURAL DIFFERENCES
Chinese characteristics of RMB funds
Prior to the 2008 financial crisis, industry experts estimated the total size of the entire global industry to be around 3,000 to 4,000 funds. But the definition of a PE fund in China compared to the rest of the world can be quite different. PE deals normally involve a firm putting a small amount of cash down for a takeover, and borrowing the rest. After streamlining the company, the firm sells it at a premium and pockets the money, keeping part of the profit and handing the rest back to institutional investors.
In China, ownership restrictions are widespread and leveraged finance markets are still in their infancy. As a result, the vast majority of deals are done in cash and for a minority stake. In that sense, it is often hard to tell the difference between a PE, venture capital, and hedge fund deal in China. Chinese funds generally lack the kind of institutional backing that their Western peers have. “True PE funds make investments in private companies; it is equity. But private funds can mean a lot of things – it could just be people pooling together funds and investing in everything which can reap profits,” says Shanghai-based Boss & Young partner Hubert Tse, who describes his experience with hybrid funds – which are private, but not focused on PE – as an example of the lack of a clear definition of what exactly constitutes a PE fund onshore.
Apart from a blurry understanding of how Chinese PE funds are delineated, there are also peculiarities – “Chinese characteristics” – of these onshore funds. “RMB funds can have features that diverge from the PE model as generally understood outside China, and the variations can be major because they affect the typical PE incentive structures,” says Hong Kong-based Weil, Gotshal & Manges partner, John Fadely. One distinction between western PE funds and Chinese ones are the time horizons: the life terms, investment periods, and post investment periods are generally shorter due to the quick exits through domestic IPOs and shorter investment outlooks of limited partners (LPs). Partner James Wang of Han Kun Law Offices explains another chief variant when he says: “The capital call mechanism typical for international funds is significantly twisted in the China context, with most funds requiring capital commitments to be contributed in one lump sum or at predetermined time intervals.” Fadely says that due to the different mentality of Chinese investors, many sponsors have decided to call all the capital down at the very beginning of the fund in order to eliminate default risk later on. As the blind pool fund remains a novel concept to Chinese investors, sponsors have been identifying the portfolio assets early on and marketing these, giving investors security and compacting the investment period.
Why Chinese funds ask for a lot more capital up front could be a result of several things. One is that they tend to have a lot more high net worth individuals as investors as opposed to institutions. It would likely be burdensome for individuals to receive constant capital calls and so it is likely that they prefer to provide their money in just a few tranches. “Chinese investors may find it operationally easier to fund less frequently in larger chunks,” says Hong Kong Debevoise & Plimpton partner Andrew Ostrognai. Another reason is that because the default rate on these funds can be quite high, sponsors are keen to get their money upfront. “It is a little bit of protection on the manager and GP (general partner) side, to precall some capital and have a cushion against default,” he says.
For Chinese investors, it is a significant philosophical step to relinquish control over their investment decisions to someone else and many are not yet comfortable with this. “Most Chinese LPs and high net worth individuals are still getting accustomed to giving money to others to manage or invest, and they have yet to go through the volatility of certain investments,” says Tse. “They may not fully comprehend and understand the possible downside risks involved, but only think of the upside as they have not really experienced the kind of downside risks associated with more sophisticated investments. So, it will take time for them to get used to this, and become more mature in their investment philosophy.”
Wang says the variations of Chinese PE funds make his team’s work more interesting because “not only is international experience highly relevant in this field, but also we become part of the force that is shaping the PE fund industry in China with unique China characteristics.” ALB
