Cerulli Global Edge: Are foreigners ready to bail out of China JVs?

Cerulli Global Edge, May 2011

The queue of foreign fund managers waiting to get in to Chinese domestic asset management has always been a long one. There are now 35 Sino-foreign joint ventures (JVs), with five more awaiting approval, and if ever a partner steps aside because of a regulatory compliance issue, there is another willing foreigner to take its place. But in February, something very significant happened: a step in the other direction. For the first time, a foreigner announced plans to sell out of its JV.

KBC Goldstate Fund Management combines a Chinese securities broker, Goldstate, with the Belgian bancassurance group KBC. And in February, it became clear that KBC was seeking buyers for its 49% holding in the company.

It should be made clear that this will not be the first exit of a foreigner from a JV, but in most other cases the circumstances have been forced upon them. So, for example, after the various mergers, acquisitions, collapses and disposals of the global financial crisis, BNP Paribas found itself with stakes in three separate ventures. Since firms are not permitted to hold more than stake in a Chinese investment management company, BNP Paribas sold out: first of all shifting its 49% stake in ABN Amro TEDA to Manulife in November 2009, and then its33% stake in SYWG BNP Paribas to Mitsubishi UFJ the following year. However, BNP Paribas remains committed to the Chinese market and still owns 49% of HFT Investment Management, which it acquired through the assets it bought from Fortis.

In contrast with other foreign firms in China, KBC has taken a decision that it’s no longer a good idea to be involved in a JV of its own volition, rather than because of any regulatory tap on the shoulder. So is this a turning point? Will we see more foreigners deciding the pressures of being in such a fiercely competitive industry no longer make sense?

In answering these questions, it’s important to look at the KBC situation in context. This is arguably still a hangover of the financial crisis. KBC is not the strongest institution in Europe, and received a total of Eu7 billion in bailout funds from its government during the crisis. Like many banks – RBS is another example – it reached a conclusion in 2009 that it should downscale and rebuild based on what it is good at. KBC from now on will be first and foremost a Belgian institution and its growth momentum will come from Central and Eastern Europe. Correspondingly, China has become non-core – reflected by the fact that KBC closed a Shanghai representative office in 2009.

On top of that – and this perhaps has broader relevance to others in the industry – the venture has not been particularly successful. KBC Goldstate’s assets under management fell 60% to RMB1.3 billion ($197 million) last year. That made it the second smallest fund manager in the country. It has been around for a little over four years but has never really developed traction or critical mass during that time. The firm has a bond fund, two balanced funds and three small equity funds, and industry analyst Z-Ben reckons that probably only one of those is large enough to be consistently profitable.

KBC Goldstate is one of the very rare examples of a manager in China with no money market fund. Plus, it’s not in segments of the market that are growing: exchange-traded funds, index funds, or (though this is a mixed blessing) the qualified domestic institutional investor (QDII) products that allow Chinese to invest overseas. Z-Ben puts it like this: “Knock three years off its operational history and we might consider KBC Goldstate to be a greenfield operation that has yet to enjoy any good luck. Add them back on and what remains is the stuff of cautionary tales: fail to take risk and this is how far you’ll be left behind.”

KBC’s experience in China has varying degrees of relevance to other foreigners.  KBC is not the only international business to have suffered and to need to refocus, although one would assume that most of that sort of news is already out there now and playing out in disposals. So there could be others who decide that a China stake is non-core and perhaps a chance to raise some capital.

More significantly, the group’s failure to grow in a competitive industry is a widespread occurence. Including the locals – there are 62 fund management companies in China – only two Sino-foreign JVs (Harvest Fund Management and Bank of Communications Schroder) rank in the top 10 in mutual fund assets under management. The top five – China Asset Management, Harvest Fund Management, E Fund Management, Bosera Fund Management and China Southern Fund management – have more assets between them than the bottom 42 funds combined. It is lop-sided and ferociously competitive.

According to data from June 30 2010 – the year-end for many China businesses – KBC Goldstate was far from being the only JV with less than RMB10 billion in assets, which many consider a basic foundation for critical mass. Others included Axa SPDB Investment Managers (the smallest at that point), Lord Abbett China Asset Management, Lombarda China Fund Management, First State Cinda Fund Management, GTJA-Allianz Fund Management, HSBC JinTrust Fund Management and Morgan Stanley Huaxin Fund Management . And while some smaller ventures, like Minsheng Royal, in which Royal Bank of Canada is a partner, are simply young and expect to grow, there are others (Franklin Templeton could be added to the list) that would surely have hoped for more traction by now and must be wondering where their investment is getting them. Institutions like this are generally considering their options: commit more capital in order to grow the business to a point of critical mass, or leave them without additional capital injection and hope they thrive on the back of broader market growth.

There is another consideration, though. KBC still has to find a buyer for its business, and that’s not necessarily going to be easy. Goldstate is not considered a five-star partner and it has not proven itself as a group that will take a foreigner to the right places, though clearly in any JV it takes two to tango. It’s true that there is still a queue of potential new entrants, but they may prefer to go in as a greenfield manager seeking to build from scratch rather than taking over something of a tarnished legacy – that might well be cheaper, too. It does have on its side the fact that most new opportunities that come up do not grant foreigners a 49% stake, as this one will, but it won’t be with a trophy partner.

So if KBC can’t find a buyer, or sells out at a loss, what’s the message that goes to others who may be wavering? Probably that there’s no point in selling. They have already made their investment. The growth of the Chinese investment industry is inevitable, and might be enough to help turn around these flagging businesses. And since many of the institutions involved are engaging with China on a variety of fronts – for example, Morgan Stanley, which is attempting to bed down a new securities joint venture which is vital to the investment bank – they may feel it would look bad to pull out of a China business.

In other words, KBC is a test case on two grounds: first, as an example of a foreigner willing to come out and say it’s time to get out; but secondly, because its success or otherwise in making a sale might inform a lot of other decisions from peers. At the time of writing, no foreign names were being mooted as potential buyers; market talk was that the stake might instead be bought locally, changing the business from being a joint venture to a wholly domestically owned asset manager.  Unless a buyer is found, it’s unlikely any of the other foreigners involved in disappointing businesses would try to sell.

Then again, the dynamics of the business are undeniably tempting. Z-Ben puts the total mutual fund assets in China at just over RMB2.5 trillion as of February 28, a huge and growing industry; on top of that the non-mutual fund sides of the business show enormous potential as well. There is an argument for sitting tight and hoping that the rising tide really does lift all boats.

The successful Sino-foreign JVs are illustrative. Harvest, the biggest, is something of a special case, since it was given a host of international funds from Deutsche’s fund management arm, DWS Asset Management. But below that, the ventures that have shone have largely done so by building a comprehensive range of products and getting into the right areas. Bank of Communications Schroders, for example, which started out with a medium risk equity fund in 2005, has since built a strong product range attuned to market needs, such as a successful money market fund and, more recently, an ETF mimicking the SSE 180 index. CITIC Prudential, which is gradually rising through the ranks with a range of 12 Fidelity funds, is also representative of the diversified approach: as of March it had five stock funds, a hybrid fund, three bond funds, a classification index fund, a QDII fund (one which allows it to invest in international stocks for local clients) and a money market fund; it had RMB18.3 billion in assets under management at the end of 2010. So successful JVs have to take the risk to build a diversified product range that will perform no matter how market sentiment is changing.

Smart JVs will also be getting ahead of longer-term trends like corporate annuities, representing the gradual growth of a corporate pension industry in China, and positioning themselves for mandates from key state institutions like the National Council for Social Security Fund.