In China, the advent of large, foreign institutional buyout funds and venture capitalists has inexorably changed the economic landscape.


The early days of China’s ascension into the World Trade Organization (WTO) in 2001 coincided with serious difficulties at “orphaned” state owned assets, newly privatized firms and other enterprises that realized they cannot turn to Chinese banks for capital. Inefficient state-owned enterprises (SOEs), for example, were no longer able to borrow from equally inefficient banks. Due to new regulations governing bank loans – mandating, for example, that loans actually had to be repaid — the tap, for all practical intents and purposes, was turned off. Chinese firms, consequently, were desperately seeking capital. It was precisely at this time that the world’s major private equity firms, flush with liquidity, decided to enter China in a significant way. According to the Zero2IPO Research Center, the amount of China-specific PE/VC money grew 136% annually, from US$500 million in 2002 to US$15.5 billion in 2006.


“Broadly speaking, China has benefited from the private equity industry, as local firms received expansion capital, management support and best practices,” says Erik Bethel, Managing Director of ChinaVest, a Sino-American merchant bank that is considered one of China’s venture capital pioneers. “I would like to think that our firm has contributed to helping Chinese companies, as we’ve invested roughly US$500 million in local firms since 1981.”


Beijing’s Changing Attitude

Recently, however, Chinese regulators’ attitude toward foreign financial buyers has evolved from a welcoming attitude to one of cautiousness.


Notable examples of transactions that have failed due to increased regulatory scrutiny include the China Securities Regulatory Commission’s (CSRC) rejection of Goldman Sachs’ investment in Fuyao Glass. Fuyao, listed on the Shanghai Stock Exchange, announced on November 2, 2007, that the CSRC had rejected its application to Goldman. The deal was penned on November 20, 2006, at a price of RMB 8 per share. Roughly one year later, after a long period of regulatory delays, Fuyao’s share price grew to RMB 31. The application was rejected on the grounds that the share price had risen too high and that the valuation of Goldman’s original deal was therefore inadequately low.


Another high profile case is the Ministry of Commerce’s (MOFCOM) decision to turn down The Carlyle Group’s purchase of Xugong Machinery, one of the biggest Chinese machinery firms. This was a deal in which Carlyle initially proposed to acquire an 85% stake in the construction equipment maker. After a humiliating public rejection, Carlyle subsequently agreed to acquire a smaller stake in the firm for a higher valuation. The deal is still waiting for regulatory approval.


“Chinese regulators have become increasingly wary of foreign private equity firms for a few reasons”, notes ChinaVest’s Bethel. “The first is purely nationalistic. It relates to a concern that foreigners could own ‘famous,’ or well known Chinese brands. Frankly, this happens in almost every country, whether it be Pepsi’s bid to acquire Danone in France or Dubai Ports acquiring P&O. But possibly the most important reason is that China no longer needs foreign capital. With roughly US$5 trillion in domestic savings, China may actually have to export capital in coming years.”


As a result of multiple concerns, Beijing created obstacles to foreigners seeking to acquire Chinese companies. One obstacle is setting percentage limits on ownership. Certain industries have pre-defined limits. For example, foreigners can only own 19.9% of banks and 25% of airlines. Other industries, however, are not so well defined. In those industries, depending upon the size of the investment, China requires government approval.


At the epicenter of the regulatory process is the Ministry of Commerce (MOFCOM). A foreign fund may find itself dealing with MOFCOM’s central office in Beijing, with MOFCOM’s provincial or local branches, or potentially with both. Adding to this challenge, a foreign fund will also have to gain approval from the relevant industry regulator. The industry regulator can reside at the central government level, the provincial level, or the local level — and often at all three levels simultaneously.


Increased regulatory scrutiny has not slowed PE investments at all. In 2007, PE funds invested US$12.8 billion in 177 deals in China, according to Zero2IPO. “In 2008, the global credit crisis may actually increase foreign PE activity in China. If banks in developed countries stop lending, or if the cost of capital goes up, buyout deals could dry up in the U.S. and Europe. And this, coupled with the fact that China’s economy is relatively insulated from global economic turmoil, may spur even higher interest in China,” says Ray Yang, investment director at US$400 million Orchid Asia Fund. Yang further adds that while China might seem to have a lot of liquidity, the percentage of private equity capital to GDP is still much lower than in developed economies. “There are some sectors which are overheated, but if you look at the overall picture, there are still many more opportunities/deals than money,” says Yang.


In 2007, international private equity funds, facing ever more intense competition for deals, adopted new investment strategies, including bridge loans, PIPE deals (in which private equity firms acquire stock in public companies) and mezzanine financing (convertible bonds and other quasi-equity financing). According to industry experts, this past year, there were 22 bridge capital transactions. Notable examples include a US$100M Carlyle deal in Kaiyuan, China’s largest hotel management company, and Merrill Lynch’s investment in property developer Guangzhou Hengda. PIPE investments also grew by 16% in 2007. Meanwhile, nine mezzanine capital deals totaled US$842.8 million.


For much of 2006-2007, many private equity veterans think that the environment for foreign private equity firms in China was pretty tough. It was marked by high levels of competition, increased regulatory scrutiny, high valuations, and, most recently, a new competitor: the domestic PE fund.


The Emergence of the Local PE Fund

While foreign funds previously competed with each other in China, they are now facing a new threat — Chinese domestic funds. In 2007, these local funds accounted for 19% of the total funds raised. Only a few years ago, there were no local funds. Today there are 12.


Local Chinese private equity funds have raised money from increasingly wealthy corporate, government and individual investors. “And today, with Beijing’s support, local PE funds are emerging as viable competitors,” says Bethel.


There are a number of variations of local funds. One common denominator, however, is currency. The trend in China during 2007 was to raise RMB-denominated funds. The government wants investors to use RMB as their investment currency. When they exit, investors are encouraged to conduct an IPO on mainland stock markets, rather than on overseas stock exchanges, where Chinese citizens are still not allowed to invest. The problem is that most foreign investors have Limited Partners (LP’s) who require U.S. dollar (or other freely convertible currency) returns. This means that foreign investors usually require an offshore holding entity to own the assets of the PRC firm. The offshore entity can then exit in the U.S. market via an IPO or a merger or acquisition, and the PE firm can then provide dollar returns to its LPs.


Unfortunately, recent regulations in China have made it extremely difficult, if not impossible, to create offshore entities. This has provided further obstacles for foreign PE funds in China.


The Chinese government is also behind the creation of “industrial development funds.” The Bohai Industry Investment Fund, founded in late 2006, was the first. With roughly US$2.7 billion under management, the fund is aimed at spurring industrial development in the city of Tianjin, a port city located near Beijing. Bank of China owns roughly 50% of Bohai. The National Social Security Fund, with US$30 billion under management, is also an investor. In September 2007, another five industrial funds with a combined value of RMB56 billion (roughly US$7.8 billion) received regulatory approvals. These funds include the Sichuan Mianyang High Technology Fund, Guangdong Nuclear Power and New Energy Fund, Shanxi Coal Fund, Shanghai Financial Fund and Sino-Singapore Hi-tech Industry Investment Fund.


There are also a handful of local PE funds that raised offshore capital in foreign currencies. These funds are known as “international domestic funds,” but for all practical intents and purposes, they are viewed to be Chinese. One is Legend Hony, the investment arm of the parent company of computer maker Lenovo. Another is CDH Investments, a spin-off of China International Capital Corporation (CICC-China’s first joint venture investment bank). CDH has US$2 billion under management and has been an extremely active investor.


Brian Doyle, a partner at CITIC Capital, another large international domestic fund, is a strong proponent of local funds. “At the end of the day, local funds make decisions where they live, in the markets where they operate, whereas foreign funds have to report back to New York, Connecticut, London, etc. Our investment process is much more streamlined and as a result we have made six investments in 18 months.”


Local funds are here to stay. And while these funds have certain advantages, they still face obstacles.


KC Kung, a managing partner at US$1.5 billion MBK Partners, an offshore buyout fund focused on making investments in China, Japan and Korea, notes that “local funds have two theoretical advantages – less regulatory scrutiny and fewer ownership restrictions, both of which are often issues with foreign funds.” He adds, however, that, local firms face hurdles as well, such as potentially adverse tax implications on exit, “at least 20% or 25% of the capital gains.” Orchid Asia’s Yang adds other concerns: “While local funds may have better access to deals, a potential problem is that their incentive structure is not as sophisticated as the international funds so it’s hard to retain a professional team.” 



China‘s financial system remains flush with liquidity. It is also relatively insulated from the international credit crunch related to the U.S. sub-prime market. As a result, industry experts predict that China’s PE market will remain vibrant in 2008. However, the private equity landscape is changing, and foreign funds may find themselves at a disadvantage. Beijing is increasingly cautious about turning over control of assets to foreigners. Therefore, local private-equity funds, with few ownership restrictions, strong government support and less regulatory oversight, may represent a key challenge for foreigners in the future.


However, putting too much emphasis on the local private equity industry could be dangerous. According to an industry insider, “In the past, Chinese banks, securities houses and state-run investment funds came under pressure from local government officials to invest in projects that failed to produce returns. Furthermore, Beijing’s domestic bank bailout drained the country’s coffers by hundreds of billions of dollars.”

Raphael (“Raffi”) Amit, a Wharton management professor who interacts frequently with many PE investors in China, notes that “the rapid transformation of the PE market in China, from one that is dominated by foreign PE firms to a market in which the domestic RMB denominated funds play a major role, reflects the maturation of the Chinese PE market.” He adds, “The emergence of a new generation of top notch Chinese PE professionals, available local liquidity, superior access to transactions and fewer regulatory hurdles provides these firms with a competitive advantage and good prospects for investment returns.”