Blackstone wants one. So do Macquarie and KKR. As do a growing list of leading global financiers.
Renminbi funds — private equity (PE) funds raised in China’s local currency — have been in fashion of late. Blackstone and its Western peers announced in Shanghai Pudong in August plans to set up their own RMB funds. Such funds have been underutilised but are now receiving renewed attention by foreign firms that are finding China’s PE market more attractive than ever. “Right now, the A-share market [shares denominated in renminbi] is so good, and IPOs in the growth market offer such a high price-to-earnings ratio,” says Joe Tian of DT Capital, a China-focused PE firm in Shanghai. Fuelling this interest is ChiNext, China’s first Nasdaq-style startup stock exchange, which was formally launched in Shenzhen on October 23 and trading starts on October 30, to the enthusiasm of fund managers and PE firms looking forward to having another avenue to exit investments at their disposal.
Meanwhile, a host of factors, including expectations that the yuan will strengthen against the dollar and China’s buoyant economy, are driving investors to explore onshore options in greater numbers. Global PE players hope that renminbi (RMB) funds offer a new way to be a part of the growth of Chinese companies at a time when changing regulations are choking the old channel of foreign-currency investing. Meanwhile, RMB funds allow them to tap a mounting pile of cash in China, a pile which is poised to grow even more.
A Big Step
China holds a special appeal for PE investors. DT Capital’s Tian notes that for overseas and domestic firms alike, it is hard to ignore the chance to make the ten times return on an investment offered by companies, such as the 28 about to be listed on ChiNext. Getting such returns anywhere else in the world is very hard, he says, adding “If you look at the top 10% of [companies in China’s] PE industry, their returns are more attractive than [those found in] other markets.”
Yet investors are frustrated, and not just because of the lack of deals. Offshore deals face a minefield of regulations. In the past, dollar investments have mostly been in an offshore entity set up by a Chinese company. However, new rules on mergers and acquisitions of domestic companies by foreign investors introduced in 2006 made the restructuring of local firms into offshore entities extremely tricky, thereby significantly limiting the offshore route.
This partly explains why more global PE players are turning to RMB funds. It’s generally understood that there are over 400 purely-domestic RMB funds as of May 2009 and foreign-invested venture capital investment enterprises (FIVCIEs), a type of RMB fund, climbed from a single digit to over 40 in the past two years, according to a recent report by law firm O’Melveny & Myers (OMM). The total size of FIVCIEs rose tenfold, to exceed US$1.5 billion.
This year, in particular, has been big for RMB funds. Although the lion’s share of capital still comes from the much larger foreign-capital funds, there were more local currency-denominated PE deals than those made via offshore companies in the second quarter of 2009, which is a first for the industry, according to Zero2IPO, a research firm in Beijing. Of the 13 deals in those three months, nine were denominated in local currency. And in August, new RMB-denominated venture capital and PE funds were launched with a collective fundraising target almost 300% greater than that of new funds established in July.
Why the upbeat pace? The impetus has not come from the central government, but from cities offering investors incentives to create local funds. It was also helpful that the Ministry of Commerce put its weight behind the local initiatives in March by devolving authority for approving foreign-invested venture capital to its provincial branches.
The steps being taken at various regulatory authorities “all point to a rapid movement in the legal framework that support the RMB fund as a platform for future investments in China,” asserts OMM’s report.
RMB Fund Benefits
RMB funds can be more attractive than the cumbersome offshore option. Notably, the simpler approval process of RMB funds investment can help foreign firms avoid some of the bureaucratic rigmarole, speeding up the process and minimizing the advantage that local investors often enjoy by not having to seek government approval as foreigners must, notes Lawrence Sussman of OMM. In addition, RMB funds should be able to convert foreign exchange faster than under the other types of onshore investment from abroad, he says.
“Pure dollar funds have difficulties in deal-structure and closing efficiency,” explains Michael Xu, a partner at a China-focused private equity firm Prax Capital in Shanghai. “In certain deal structures, you need to put in some RMB, which means we have to find a co-investor. If we have our own RMB fund, we have greater control over the deal.”
Moreover, some early-bird investment companies — like Prax, which was among the first PE players to be given permission by Shanghai’s authorities to establish a RMB-denominated fund and DT Capital, which set up one of the first RMB funds approved by Beijing authorities early last year — have used such funds to help them cement relationships with local investors.
Prax’s Xu says a growing role for local limited partners (LPs) “will be facilitated by the increasing liquidity in China and potentially increase LPs’ understanding of PE products, especially after they see the returns on some early RMB funds.”
There’s also a need to tap different types of investors than in other PE markets. In the West, for example, pension fund and insurance companies are the major sources of capital for PE. That’s not the case in China given that both of those sources are subject to restrictions, notes Tian of DT Capital. That’s why PE practitioners have to look elsewhere — to companies and rich individuals — for capital.
However, China’s market needs to go through a period of adjustment. PE in China is still relatively young, explains Tian, and the idea of a 2% management fee and a lock-in of, say, ten years on investments can still put off investors. Nonetheless, he predicts that PE investment could become a big asset class in China’s fledgling wealth management industry.
Young, wealthy Chinese will be more willing than the older generations to accept high-risk, high-return investment products, Tian reckons. “This is an asset class that will be accepted by the market sooner or later.” There are already examples of medium-sized investments made via local currency funds that are earning good returns, he says. RMB funds represent “the beginning of a new era of opportunities”.
The era may belong more to locals than to overseas firms, however. For one thing, foreigners still face more regulatory barriers than the locals do.
As Chinese law stands, there is no provision for limited liability partnerships or non-legal entities (such as FIVCIEs) to open clearinghouse brokerage accounts that let them take a share in a listed company. This essentially means most RMB funds have lacked a mechanism to exit via the A-share market. “There has to be a new legal explanation,” says Xu of Prax. While a draft of a regulation that would pave the way for PE funds to exit in China’s domestic stock market was issued on October 13 for public comment, the wait could be long before a new law transpires.
The problem remains, however, that given the current regulations, foreigners cannot become general partners of RMB funds, points out Xu. Exceptions can be made, but they are at the discretion of local authorities.
As things stand, most RMB funds are locally owned, adds Peter Fuhrman, chairman of China First Capital, an investment bank and financial advisory firm in Shenzhen. “Very, very, very few foreign PE firms will be able to raise RMB funds in China anytime soon,” he asserts. Even in the U.S. or Europe, successful PE players can take three years to raise dollar funds from LPs with whom they have standing relationships. In China, the generally superior networks of local firms leave them better placed to find domestic investors, he says.
Indeed, Tian cites local knowledge as one of the top criteria for success in Chinese PE. “If you don’t understand the country or only half understand it, it’s going to be difficult,” he says. “Our team are all Chinese. We have been here for a relatively long time, so we understand China, including the people, networks, government relations and communication with local entrepreneurs.”
In the next few years, while foreigners try to set up their funds, domestic Chinese investment companies will be busy putting billions of RMB to work, notes Fuhrman. “Chinese firms have a huge, perhaps insuperable advantage.”
Many outsiders are likely to remain cautious about setting up RMB funds. “Foreign fund sponsors will not rush in the front door without knowing how these RMB fund vehicles will operate and the potential hassles that may be involved,” concludes OMM’s Sussman.
The Last Laugh
Despite such uncertainty, it’s clear that China’s entrepreneurs will benefit from growing local PE engagement, whether from foreign or domestic sources. As the fastest-growing major economy and beneficiary of a large pool of newly issued credit, China is awash with liquidity. Yet, given a banking system that strongly favours large and state-owned enterprises, the country’s small and medium-sized firms are starved of credit. The hope is that RMB funds will provide a way to channel more cash into the coffers of entrepreneurs.
Flourishing RMB funds could expand the scope of the PE industry in China. “The availability of RMB-denominated funds will broaden the range of industries and geographic scope in which venture capitalists invest,” predicts Raffi Amit, professor of entrepreneurship and management at Wharton. Data for the first half of 2009 suggests that over 95% of PE investments fell in three provinces, he says. “This is likely to change in the coming years.” What’s more, he adds, “the increase in supply of venture capital will have a profound impact on innovation in China.”
In this respect, PE firms have a lot to offer, beyond the capital that young companies need. “There is no shortage of innovative entrepreneurs in China,” says Amit. “Yet it appears that few have the training and experience to manage profitable growth and create world-class, resilient organizations.”
Such knowledge is even more critical for young companies wanting to get into shape for a public offering. “We also help get them more prepared for the public markets – improving their management practices, strategy, finance, marketing, human resources and corporate governance,” says Xu. “We see many companies that are not so disciplined in terms of paying tax, environmental protection and employee benefits. But for the purpose of going public, they have to improve these things.”
Aspiring Chinese entrepreneurs watching the launch of ChiNext will hope that the increased popularity of RMB funds will channel more of these benefits to them.