Private Equity in China
Inteview with John Fadely, a partner in the Hong Kong office of Clifford Chance. on September 9, 2009
Introduction
China has recently opened up to private equity firms, as foreign firms have finally been allowed to raise yuan-denominated funds.
This week we are pleased to talk with John Fadely, a partner in the Hong Kong office of Clifford Chance. John advises on the structuring, formation and restructuring of private investment funds, including private equity, venture capital, real estate and hedge funds, joint venture funds, onshore-offshore fund structures and managed accounts.
Sound off on this week's buzz in the Comments Section.
John, it has been reported recently that global buyout firms are rushing to launch yuan-based funds in order to facilitate deal flow in China, where approval for major foreign investments has not been easily granted. From your perspective, will you give us an update on this activity in China?
Recently several well-known private equity firms with sustained operating histories in China have announced plans to form RMB private equity funds to accept capital from Chinese investors. These funds may very well give their sponsors greater access to the growing (albeit still somewhat limited) pool of Chinese capital as well as to investment opportunities. Because they also won't need the pre-investment regulatory approvals that are required for offshore funds, RMB funds may be more nimble. However, if an RMB fund co-invests with an offshore fund, the offshore fund would still need to obtain regulatory approvals, effectively making it the "lowest common denominator."
These RMB funds are being established in cooperation with various municipal and other local authorities, to which the central government seems to have delegated approval authority for funds of RMB 5 billion or less. Although there is still no clear legal framework in China to support the establishment of these funds, some offshore sponsors have evidently decided that the "first mover" advantage outweighs the tax, regulatory and other risks involved in being a pioneer.
Also, it's worth remembering that foreign-invested venture capital funds (i.e., funds investing in "high or new" technology on an unleveraged basis) have been possible to form since 2003 and that over 50 have been established so far. By contrast, the recently announced RMB private equity funds are not expected to be limited to making unleveraged technology-related investments. Another important difference is that foreign-invested venture capital funds may pool capital from Chinese and offshore investors, whereas RMB private equity funds will only be allowed to manage the capital of Chinese investors unless new laws are enacted.
How much have the strong local currency and hopes for a turnaround in the economy contributed to this push by global buyout firms to increase their activity in China?
Sponsors of RMB private equity funds probably won't directly benefit in a meaningful way from any future appreciation of the RMB, but they may benefit indirectly. There are a few reasons for this.
First, RMB fund size is limited and the general partners of these funds are not expected to make large capital contributions, due in part to foreign exchange conversion issues in China. To the extent that these modest capital contributions will limit the size of the carried interest, the direct upside potential of any RMB appreciation would also be limited.
Second, China sourced carried interest and management fees would be exposed to full PRC tax unless the offshore sponsor manages to negotiate more favorable tax treatment with the PRC authorities. This tax leakage would at least partially offset any currency gains.
However, sponsors may hope that their Asia- or China-focused offshore private equity funds will be able to co-invest with their RMB funds. Any appreciation of the RMB against the U.S. dollar during the investment holding period of these offshore funds would raise their IRRs.
The short-term effects of China's bank-led fiscal stimulus have been positive but the medium- and long-term effects remain to be seen. From the private equity perspective, it is helpful that only a small portion of the stimulus has been loaned to small and medium-sized enterprises because this makes the stimulus less likely to crowd out private equity investors. However, the stimulus may have contributed to the stickiness of deal pricing, which hasn't fallen substantially. This raises the question of whether asset price inflation may be around the corner, particularly as more RMB funds are raised over the next few years.
Also, as part of the rebalancing of the global economy, China appears to be gradually expanding its domestic consumer market to compensate for lower consumer spending in the U.S. and other export markets. This may create investment opportunities for private equity (as opposed to venture capital), given that these investment opportunities would not necessarily be technology-heavy.
Has the recent approval for China's National Social Security Fund (NSSF) to invest in domestic private equity funds had any impact on the rise of yuan-based funds?
The impact has been limited so far, because apparently the NSSF has only invested in funds that have registered with the National Development and Reform Commission (NDRC). The NDRC hasn't allowed the registration of RMB private equity funds that are controlled by a (directly or indirectly) foreign-owned general partner. This means that, to the extent that the recently announced funds will use foreign-owned general partners, they might not be able to obtain NSSF funding. However, other sources of Chinese capital - including from local governments, corporations and high net worth individuals - should be available.
Can you comment on the A-share market and the new Shenzhen-based growth enterprise board and the attractiveness they offer investors as exit strategies?
There have been relatively few exits by portfolio companies of foreign-invested venture capital funds on China's domestic securities markets, so we don't have many data points. The resumption this year of initial public offerings and the recovery of China's stock markets make exiting on these markets look more viable for the time being. However, people understand that RMB funds formed this year will exit most or all of their investments several years later, and that it's the state of the capital markets then - not now - that will matter for these funds.
Talk to us about why you believe
The catalyst for change seems to have been competition among the various municipalities in China to attract offshore fund sponsors to establish local investment managers and/or funds. This pattern of local experimentation followed by national legislation is something we've seen in other contexts in China, as well as in other large economies, including the U.S.
You have stated that "Investors in offshore funds want transparency. Specifically, they want to know whether the sponsor, after establishing an RMB fund for Chinese investors, will give the offshore fund equal access to investment opportunities that fall within the investment scope of both funds." Will you expound on this statement?
"Cherrypicking" is a fundamental concern of investors in any offshore fund that co-invests with an onshore fund. Specifically, these investors may question whether the general partner of the onshore fund will share a fair portion of each investment opportunity with the offshore fund. To address that concern, the offshore fund investors often require transparency (e.g., disclosure to the offshore fund's advisory board of all of the onshore fund's investments). Offshore fund investors may also have other concerns about the onshore-offshore structure, such as whether the general partner of the onshore fund is able to assess investment opportunities without being unduly swayed by local interests, and whether the onshore and offshore decision-making processes are distinct enough to manage any risk that the offshore fund may become exposed to PRC tax due to the activities of the general partner of the onshore fund. These concerns arise in any onshore-offshore fund structure, although in the case of RMB funds the concerns will inevitably have "Chinese characteristics."
Do you share the sentiment held by many that Shanghai can become an international financial center?
Shanghai and, more specifically, Pudong, have recently been at the forefront of the development of the investment management industry in China. While Shanghai's prospects of becoming an international financial center depend on several factors, the development of a Shanghai-based investment management industry - and ideally one that invests on a national scope within China - should lead to synergies with other parts of Shanghai's economy, which could only help.
John, we thank you for your time and insight.
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