Asiamoney: China private equity goes local

Asiamoney, September 2010

There’s a common goal in Chinese private equity: going local. Raising billions of dollars in offshore vehicles is old hat. Today, the money that goes furthest in private equity is denominated in renminbi.

Foreign private equity houses have known this for years. “Structurally, it’s a totally different opportunity set,” says Stephen Peel, managing partner and group head of Greater China, Eurasia, India and southeast Asia at TPG Capital. “There are deals offshore money can invest in, and deals RMB money can invest in, and the two rarely cross.”

But it’s only recently that foreigners have been permitted to chase that domestic opportunity, and only in the last few months that real progress has been made.

Early last year, China allowed domestic, RMB-denominated private equity funds to be largely foreign-owned and managed for the first time, provided they were set up in partnership with a local institution. Two of the heavyweights of global private equity, Blackstone and Carlyle, quickly announced they would develop new funds, each aiming to raise RMB5 billion.  First, in August 2009, Blackstone announced a partnership with the government of Shanghai’s Pudong district, to launch a vehicle called the Blackstone Zhonghua Development Investment Fund, with priority for investments in and around Shanghai. Then in January Carlyle signed an MoU to launch an RMB-denominated fund in Beijing, the Carlyle Asia Partners RMB Fund, with full backing from the Beijing Municipal Government.

Little then happened until July 30 this year, when Carlyle announced the first closing of its fund after raising RMB2.4 billion. The fund will be run by an investment management joint venture owned by Carlyle (80%) and by one of the fund’s main investors, Beijing State-owned Capital Operation and Management Center (BOSCOMC), a holding company owned by the city government with interests from transport to coal mining and steel. Apart from BOSCOMC, key investors include Beijing Equity Investment Development Fund and several other large SOEs, private companies and individuals.

Then, in August, TPG announced its own plans to launch two RMB funds, again worth RMB5 billion apiece. TPG too has tied up with major municipalities: like Blackstone, it is in partnership with the local government of Shanghai’s Pudong district, and in its other fund it has teamed up with Chongqing for a product that will focus on Western China. TPG Western China Growth Partners I will set up in the Liangjiang New Area of Chongqing, an economic development zone in the style of Pudong in Shanghai or Binhai in Tianjin, and is expected to involve the Chongqing government as a limited partner investor. The Shanghai-based fund, TPG China Partners I, will make onshore investments to support medium and large companies nationwide.

For its part, Blackstone is still out there; Peter Rose in the manager’s New York headquarters says “we are still raising our fund and have not had a final close,” so declined further comment. But in the meantime it remains active as ever from its offshore bases, making its first major investment in Chinese housing in late August in a deal with Hong Kong developer Great Eagle. It doesn’t hurt that China Investment Corporation, China’s sovereign wealth fund, owns 10% of Blackstone; those in the industry expect a formal first close of the Blackstone RMB fund within the next few months.

It’s a time of great opportunity and expectation for foreigners looking at the local picture. “A key set of changes is coming,” says one private equity professional. “Legislation has been developing over the last 12 months and it is now sufficiently certain how these partnership structures owned by overseas entities will work: how they will be taxed, how they will be regulated.”

Why go local?

Why take this road? It’s not as if groups like Blackstone, Carlyle and TPG weren’t making plenty out of China already. TPG (originally through its Newbridge incarnation) is believed to have made than US$2 billion for its investors when it sold its stake in Shenzhen Development Bank to Ping An Insurance – that’s about a 16-fold return, and when it sells its stake in car dealership China Grand Auto, it might do better still. Carlyle, which has already put more than US$3 billion into 50 China deals, will probably make even more in dollar terms from its exit from China Pacific Life.

But going local opens a whole other set of options. “In the past two to three years we have increasingly realized that, given the establishment of the sovereign wealth fund, social security fund and other institutional investors in China, this country should not just be a recipient of foreign private equity investment,” says Yi Luo, managing director for China at Carlyle. “The country itself has tremendous potential to cultivate a private equity culture with a very strong LP base. And, obviously, with the convertibility issue of the currency, if you want to develop LPs in China right now it has to be through a local currency fund.

“Increasingly,” he adds, “We think China will be a country that is going to supply capital to the domestic industry and even invest outside of China.”

That’s the big picture. More pragmatically, there are a host of practical reasons a local fund has a lot to recommend it. Most obviously, there’s approvals: getting a foreign-led private equity purchase over the line in dollars has been known to take 18 months (and others have taken longer and still never reached final approval). It’s true that new regulations, allowing any investment below $300 million to get approval at the provincial rather than the state government level, ought to make this a little easier, since central government approvals alone can take three to six months. But there’s no question that a locally incorporated business, buying an asset in RMB, should get an easier ride.

Additionally, taking dollar investments is not always appealing for a Chinese company. “In some deals we look at, the investee company will tell us they may not want dollar investment because once they take it, they become a foreign invested company, and then face some regulatory issues,” says Yi. “In that situation, if we have an RMB vehicle we should be able to do an investment. If we only have a dollar vehicle, we would lose that opportunity.”

Partnership with a local municipality obviously has a lot to recommend it too. The principle reason Carlyle got from announcement to first close in six months – and it expects to get to the full RMB5 billion close by the end of the year – is the support of the Beijing government. “They were the biggest anchoring investor in the first closing,” Yi says. Being alongside a local brings cash, acceptance, credo with the regulators – and presumably opportunity. One can imagine how many juicy deals come up when one is the preferred investment partner of the People’s Government of Shanghai Pudong New Area, for example, as Blackstone and TPG will be; elsewhere, the Carlyle fund will be entitled to preferential policies from Beijing Municipal Government. BSCOMC already had RMB760 billion by the end of 2009 and is tasked, among other things, “to make investments according to government’s strategic plans, raise funds from capital markets, promote SOE reform, orderly consolidate investments and exits of state-owned assets, promote investments in pioneering and technologically-innovative industries, manage equity holdings in companies that are listed or partially listed, restructure debts for enterprises and solve historical corporate issues.” With a mandate that broad, it’s clearly going to throw up a few opportunities.

There is, though, a question of just how forceful these municipalities will be in suggesting deals. Yi says in the Carlyle fund: “The Beijing government has committed that they will not be involved in the investment decision-making process at all. They will let us decide how to make investments. They will probably recommend good deals from time to time, but whether or not we make that investment is entirely up to our professionals.”

No longer off limits?

This combination of local incorporation and strong state partners ought, in theory, to allow these vehicles into industries that have previously been off limits. Fundamentally, going local is about looking more Chinese: the industry is rife with stories about foreign purchases being brought down because of local competitors trying to derail them, often successfully, on the grounds of national security. It is tempting, for example, to wonder if Carlyle’s bid for Xugong Machinery – surely the gold standard of Chinese private equity intransigence and frustration, abandoned after years of expensive effort and negotiation – might have received a different reception had it come from a locally incorporated fund.

“Some industries that may be off limits to foreign funds may be available to this fund,” Yi says, who won’t be drawn on Xugong. The hope is that it combines local appearance with international expertise. “If companies want an international brand name to invest to give them credibility, but their hands are tied about taking US dollar funding, we can use our RMB fund to invest and our global network to add value.”

For Yi to be right, a central question must be answered in his favour: will these vehicles operate on a level playing field with local competitors? This question covers a host of elements from access to tax, but the foreign firms active in setting up local vehicles believe they will not be disadvantaged.

It is to be hoped that they are right, because the local competitive landscape is becoming more powerful by the day.

Homegrown power

In January, for example, Citic Private Equity Funds Management closed what is believed to be the largest local currency private equity fund in China – RMB9 billion, a sign of the growing strength of the homegrown private equity industry. At the time of the launch, RMB2.4 billion of it had already been invested in 10 deals, through its formidable 60-strong team of investment professionals. Groups like this can be exceptionally powerful both in scale and connections. Bohai Industrial Investment Fund, for example, which was launched in 2007 as part of Tianjin’s economic development push, is approved to go up to RMB20 billion and has an enviable roster of fund-holders including the National Council for Social Security Fund, China Development Bank, Bank of China and China Life. Or consider New Horizon Capital: its co-founder is Winston Wen – son of Chinese premier Wen Jiabao.

Some see a distinction between two types of local competitor: private companies in the style of a foreign house, or funds that look a lot like government departments. Wu Yibing, the Citic PE president and former Legend Holdings chief, said at the time of his fund launch that “we have a strong institutional affiliation but in terms of how we run the company we may as well be Blackstone”. The difference is, even if target companies still see a local Blackstone fund as having a foreign shine to it, they’re not going to have any such qualms about a fund from what is chiefly still a state-owned entity.

Are local vehicles the future? Citic PE’s chairman, Liu Lefei, was quoted at the fund launch as saying: “Local funds will replace foreign investors in the future; that is the obvious trend.” Foreigners, for their part, expect a mixed bag of successes and failures from the homegrown industry. “What you have is a lot of managers with two or three years of experience who are doing their first funds,” says one observer. “There will be those that raise funds successfully and grow into large managers, and many who will not get beyond a first fund.”

The truth is probably that the two sides will move closer to one another. “We have a view that, over the long term, the China private equity market will be comprised of managers providing onshore and offshore capital, using a platform that manages both,” says Peel. “That includes those starting from an onshore heritage who have gone on to raise money onshore, and those like us whose heritage is offshore but have then raised money onshore.”

Foreigners may be helped by the fact that municipal partners appear to be using their deals to support their own claims to be leading financial centres. Certainly, the new foreign-owned funds appear to be enthusiastically backed by their municipalities. Lin Xu, standing member of the Shanghai Party Committee and Party Secretary of the Pudong New Area, lent his words to the Blackstone announcement last year, seeing Blackstone’s engagement as illustrative of Shanghai’s growing role as an international financial centre. Lin Xu was present again at the TPG announcement. JI Lin, the executive vice mayor of the Beijing Municipal Government, turned up on Carlyle’s announcement, again hoping to use the news of the fund closing to illustrate Beijing’s own strength as a financial hub. “By working with global firms such as Carlyle, we will leverage private equity investments to grow local enterprises and structurally transform local industries,” he said. “We also view this as an important step to solidify the foundation for rapid and healthy development of the private equity industry and the broader financial industry in Beijing.”

For there to be room for both local and foreign-spawned RMB funds to survive, there needs to be a refinement of the existing domestic investor base. It’s the belief that this is happening that has prompted groups like TPG to engage. “Our long term interest is in seeing an institutional domestic LP market in China, and it’s only very recently that what we think will be a key set of institutional investors – the insurance companies – have been permitted to invest directly in private equity,” says Peel.

Those who have watched the development of the industry have seen gradual progress in the availability of capital. “The initial pools of capital were high net worth individuals and the social security fund [the NCSSF],” says one person familiar with both local and international private equity in China. “That then broadened into SOEs and a number of other quasi-development capital organizations. What you would hope to see next is a broader institutionalization of the market.”

In Carlyle’s case, there already appears to be evidence of that. While the Beijing city government anchored the first close, “to our pleasant surprise we also raised funds from other LPs including private entrepreneurs, high net worth individuals, private enterprises, and state owned enterprises,” says Yi. “They all committed a huge amount of capital to us and enabled us to raise the fund in three or four months. We’re surprised and encouraged.”

BOX: Bankers next?

Both Goldman Sachs and UBS have been reported as considering private equity ventures; both declined to comment, although it’s already clear that their existing China vehicles, the Goldman Sachs Gao Hua and UBS Securities entities, wouldn’t be practical for use as private equity funds anyway. “The establishment of an RMB fund in China requires a separate JV arrangement so our existing JV platform is not particularly relevant,” says one Goldman insider. Nevertheless both houses are believed to be looking in to the idea, and it is likely they will consider using their global asset management businesses as the foreign partners in local funds.

In the meantime, one can barely move for senior Chinese investment bankers leaping from their employers to try to launch new private equity funds. Take a look at Hopu Investment, the impeccably connected Chinese private equity group that has been turning up alongside Temasek on Chinese deals: its founders include Fang Fenglei, who used to be Goldman’s key man in China, Richard Ong, also ex-Goldman Gao Hua, and Guy Cui, formerly of Morgan Stanley.