Foreign PEs in China

China’s economic reform and growth provide foreign PEs with great investment opportunities. There have been two strategic opportunities for them in the past 10 years in China. The first one was in reforming SOEs. When China reformed SOEs to establish a corporation system from the late 1990s, there was a strong demand for capital, management experience and human resources. A huge opportunity thus emerged. Global PEs, such as Carlyle and KKR, entered China in the late 1990s. Some of them invested in China’s SOE reforms. For example, Carlyle Group, the famous global PE, entered China in June 2000. It focused on investing in SOEs. Carlyle has made more than 50 investments with an aggregate equity expenditure of $2.5 billion in China, the biggest single foreign PE investment. In 2005, it invested US$ 410 million in China Pacific Life Insurance for 24.975 percent equities. The investment was converted into a stake in its parent company, China Pacific Insurance, in 2007. When China Pacific Insurance was listed in the Hong Kong Stock Exchange in 2009, Carlyle received about six-fold profits. Mr Rubenstein, the CEO of Carlyle, constantly says that the Chinese market today is more favorable for PE capital than most other markets, and even much more favorable than the US. He even visited China three times within 4 months. Carlyle is now starting to cooperate with Chinese local governments to establish RMB-denominated PE funds. In 2010 it cooperated with the Beijing municipal government for PE investments.

The second great opportunity is from Chinese fast-growing small and medium-sized private firms and from China’s fast-developing capital markets, particularly the launch of GEM in 2009. China has plenty of small and medium-sized private firms, which have a strong demand for financing. Investing in them and exiting in 2 or 3 years by IPO on China’s stock markets with considerable returns is not difficult. Carlyle’s failed investment in Xugong Group Construction Machinery, a large Chinese SOE, has caused Carlyle and other foreign PEs gradually to switch their favorite investment from SOEs to Chinese private firms. Chinese private firms could be a gold mine for foreign PEs. Goldman Sachs Strategic Investments (Delaware) L.L.C., part of the Goldman Sachs Group, invested in Western Mining (601168: SSE) for RMB 96.15 million Yuan in 2006. Three years later, in 2009, it received returns of nearly 100 times. Goldman Sachs Direct Pharma Ltd, which is also part of the Goldman Sachs Group, invested US$ 4.9176 million in Hepalink (002399: SZSE), a pharmaceutical company in Shenzhen, for 12.5 percent stakes in 2007. The return was 103.7 times in 4 years. KKR, the famous global PE, made its first investment in 2007 through its subsidiary Titan Cement. It invested $115 million in China Tianrui Group Cement Company Limited, a leading clinker and cement producer in China in terms of production capacity and production volume. Tianrui was listed on the Hong Kong Stock Exchange on 23 December 2011, and raised funds of HK$ 91.6 million. It can be seen that foreign PEs prefer to invest in Chinese traditional industries. That may be explained by China’s advantages in traditional industries. In 2010, the PE investment in food and agriculture industries reached $2.6 billion, three times that in 2009.

To explore investment opportunities in private firms, localization is becoming more important than before for PEs. To obtain local resources, a good choice for PEs is to cooperate with local giant companies. Carlyle is starting to partner with domestic entrepreneurs. In 2010 Carlyle teamed up with Fosun Group, one of China’s largest privately owned conglomerates, to sign a strategic cooperation agreement. They jointly sponsor a RMB PE fund of $100 million, which focuses on SME company investments.

It should be noted that the size of foreign PEs’ capital is not large: 46 percent of them are below $1 billion. Those whose capital size is between $1 billion and $4.9 billion accounted for about 30 percent of the total PE funds. But, some foreign PEs are developing fast in China. Beijing-based Hillhouse Capital, for example, which was established in 2005 with only $30 million from the Yale Endowment, now manages almost $6 billion, largely from top university endowments in the US, due to its great performance. Hillhouse has a record of 52 percent compounded annual returns since it was founded. In general, foreign PE funds perform well in China. IPO is a main and popular exit strategy in China. From 2009 to 2011, the exit through IPO increased more and more after the launch of Chinese GEM (Table 4.1). The exit value increased from RMB 3.64 billion Yuan in 2009 to RMB 19.46 billion Yuan in 2011. Foreign PEs’ IPO in China’s A-share accounted for 11 percent of the total.

Foreign PE investments’ return in China is tending to increase, while the Chinese PE market’s average return is tending to decline (Table 4.2). In 2009, the average book return for Chinese PE industry exiting through IPO on China’s main board was 13.8 times, while foreign PEs’ average book return in China was 6.9 times, which was much lower. However, in 2011, the average book return for the industry had declined to 7.6 times, while foreign PEs’ average book return reached 8 times. In the first half of 2012, foreign PEs’ book return exiting through IPO on China’s stock market reached 12 times, compared with 5.1 times for the Chinese PE industry.

Foreign PE funds have advantages in management team and management experiences, while Chinese PE funds have the advantages of understanding Chinese conditions and rich local resources. Having realized their weaknesses, some foreign PEs, such as Carlyle, have started to localize their operations and develop good relations with local governments. Carlyle was the first foreign PE to set up an office on the mainland to handle public relations, strengthen communication with local media and reshape its corporate image in China. However, foreign PE funds face some restrictions on investing in China. They are not allowed to invest in some sensitive industries, or investment may be restricted. Their investments sometimes cause concern to the public and central government. For example, in 2007, Carlyle’s investment in Xugong Group Construction Machinery was rejected by the Ministry of Commerce (MOFCOM). Carlyle also failed to invest in Guangzhou Development Bank and Chongqing Commercial Bank. The establishment of foreign PEs should obtain approval from the central government. In March 2009, the MOF decided that, for those PEs whose capital size was no more than $100 million, local approval was enough; approval from the central government was no longer necessary.

The PEs with local and central government background

Both Chinese central government and local governments support the developing PE industry. They have financed the establishment of many PE funds. Local governments normally have two ways of sourcing capital to establish PE funds. One is through fiscal budget; the other is to cooperate with national policy banks. On 28 November 2010, China Development Finance, part of China Development Bank, established a fund of fund, or FOF, in cooperation with Suzhou Industrial Park Government. The total capital is RMB 60 billion Yuan for 12 years, of which RMB 40 billion Yuan would be focused on investing in growing companies and RMB 20 billion Yuan on startup companies. The fund takes limited partnership and is registered in Suzhou City.

Some Chinese local governments have established guiding PE funds. Since 2006, local governments have established about 90 funds in 24 provinces; the total capital is more than $45 billion. They are FOFs and finance the establishment of PEs. The largest one may be the Beijing Private Equity Development Fund, established in September 2009, whose capital is about to be RMB 10 billion Yuan. Zhejiang Province and Jiangsu Province, where private economies and investments are very active, set up 21 and 13 PEs respectively. The quantity of PE funds ranks at the top two in the nation. In 2009, Beijing Government announced a “1+2+3+N” strategy to develop the PE industry. “1” means that Beijing Government would establish a guiding fund of RMB 10 billion Yuan. “3” means that, under the guiding fund, capital funds would be established for three industries, focusing on high-tech, green and cultural creativity industries. “N” means investment in many companies.

PEs established by SOEs

SOEs have a strong financial background with rich capital supply. Many large SOEs have their own investment companies or banks. Some of them have established PEs. On 28 December 2006, several large SOEs, including BOC International Holdings Limited, Teda Investment Holding Co., Ltd, China’s National Council for Social Security Fund, Bank of China Group Investment Limited, Postal Savings Bank of China Co., Ltd, Tianjin Jinneng Investment Company, China Development Bank Capital Corporation Ltd, China Life Insurance (Group) Company, China Life Insurance Company Limited, and Tianjin Urban Infrastructure Construction & Investment (Group) Co., Ltd, established the first industrial capital fund in China, which was named Bohai Industrial Investment Fund Management Co., Ltd, with registered capital of RMB 200 million. It is a pioneer of the Chinese PE industry, and unique in terms of strong support from Chinese government as a state-owned investment platform while operating in line with market practice.

Another important type of PE related to SOE are PEs established by insurance companies. Insurance companies have plenty of capital for investment (Table 4.3). However, they could not establish PE funds freely, and their involvement in the PE industry was restricted. In 2010, the CIRC issued “Interim Measures for the Administration of Utilization of Insurance Funds” and “Interim Measures on Investment of Insurance Funds in Equity” (PE Regulations), which provided guidelines and allowed Chinese insurance companies to invest in PE from September 2010. But there were still some restrictions. Each insurance company could invest no more than 5 percent of its total assets in direct equity investments in unlisted companies and no more than 4 percent of its total assets in private equity funds. But the aggregate of all such investments should not exceed 5 percent of its total assets. Under the regulations, insurance companies were only permitted to directly invest in insurance companies, insurance intermediaries, non-insurance-related financial institutions, and companies providing elder care, medical care and auto services that were closely related to insurance business. Furthermore, they were not allowed to use leverage. Also, investment in venture capital funds was prohibited. An insurance company was not allowed to set up a PE fund or a fund management company. In addition, the PE Regulations also require an insurance company to analyze and monitor the investment activities of PE funds in which it invests. In August 2011, China Life became the first Chinese insurance company to be granted a license to invest in PE.

On 16 July 2012, the CIRC issued the Notice on Issues over Investment of Insurance Funds in Private Equity and Real Estate to insurance companies and insurance asset management companies, stating that Chinese insurance companies, by approval, can invest up to 10 percent of their total assets in private equity, including private equity funds and direct private equity. Insurers will be permitted to invest up to 10 percent of their total assets in private equity, compared with 5 percent previously. That would potentially unleash about $50 billion of fresh capital into unlisted firms. The CIRC has now allowed insurance companies to directly invest in energy companies, resources companies, modern agriculture companies relating to insurance business, commercial trade and distribution companies adopting new business models, which meet China’s intention to develop the energy, modern agriculture and commercial and trading industries and encourage investment in these industries. But, Chinese insurance companies are still not allowed to invest in venture capital funds and low-technology focused funds. They have yet to gain approval to invest in offshore PE funds. China Life Insurance has involved establishments of three PE funds as a limited partner (LP), and China PingAn Insurance Group involved two PE funds as a LP.

China’s local PEs

According to research undertaken by the Industrial Bank and the Hurun Report Research Institute, China currently has 2.7 million high net worth individuals (HNWIs) with personal assets of more than RMB 6 million Yuan, and 63,500 ultra-high net worth individuals (UHNWIs) with assets of more than RMB 100 million Yuan. Among HNWIs with a net worth more than RMB 50 million Yuan, 13 percent of them invest in PE funds. Drawn in by the attractive returns of PE, Chinese high net worth individuals have crowded into the PE sector for the past several years. Many local PEs have been established, such as NewMargin Ventures and Jiuding Capital. NewMargin Ventures was established in 1999 with RMB 60 million Yuan and managed $2 billion by 2011, including five RMB funds and one US dollar fund. It invested in about 90 projects, of which 28 have been successfully exited by IPOs. The average return for each IPO is about 11 times. According to AVCJ Research, RMB funds attracted more than $24 billion in 2011, twice the figure achieved by their US dollar counterparts. The local PE funds are large in numbers, while small in size. They understand China’s conditions well and perform very aggressively. For example, Jiuding Capital takes a very aggressive approach to searching for investment opportunity and establishing nationwide branches.

PEs established by securities companies

In China, some PE funds are established by securities companies. There are two such kinds of PE funds. One is directly established by securities firms. As early as in 2007, the pilot program of PE investment by securities companies was launched. Securities companies could use no more than 15 percent of their own capital to set up a PE fund for PE investments. But raising capital from the public and other investors is not allowed. Meanwhile, the maximum number of investors permitted in any one fund has been capped at 50. The China International Capital Corporation (CICC) was the first securities firm to be approved by regulators to set up a PE fund. The PE was of RMB 5 billion Yuan. It was the first PE fund in China to be managed by a securities broker. After that, more and more securities companies begin to develop PE business. Some securities firms expect the revenue from PE investments to be 20 to 30 percent of their total revenue in the near future. A total of 34 securities firms have been approved to launch PE funds under the pilot program, and the Securities Association of China estimates that investments have reached RMB10.2 billion or $1.5 billion. Under new guidelines issued by CSRC, securities firms can incorporate these PE operations into their regular businesses. Any qualified securities firm can apply to CSRC for a business license to set up a PE fund. By the end of May 2012, more than 20 equity investment funds, valued at RMB 60 billion Yuan, that had been established by securities firms were disclosed. The other type of fund is transferred from securities’ direct investment business. In the Chinese PE industry, those investment firms established by securities companies are often called the direct investment business of securities companies. Some of them are later transferred to be PE funds. Those PE funds play an important role in the PE industry, because of their relationship with securities companies, which often serve as underwriters in IPO business.

LP and fundraising

In China, LP can be divided into two groups according to the source of their fundraising: foreign LPs and domestic LPs. Foreign LPs are mainly overseas institutional investors, which carry out fundraising abroad. According to Zero2IPO research, the top foreign LPs are foreign university funds, donation funds, FOF and corporate annuities. They accounted for 22 percent, 18 percent, 12 percent and 12 percent of foreign PEs in China respectively. Most LPs have quite a small capital size: 77 percent of LPs contribute less than $1 billion, 25 percent of LPs give capital less than $25 million, and only 11 percent of LPs contribute capital of over $5 billion (Figure 4.1). The reason may be that LPs are still cautious about PE investment in China. In addition, 44 percent of LPs investments are between $50 million and $999 million. Domestic LPs are mainly local governments, listed companies, securities firms, SOEs, and private investors. Listed companies account for about 20 percent of LPs and are the largest sources of PE fundraising. Listed companies normally have four ways of becoming LPs:

For domestic investors, when they want to become involved in establishing a PE, they often face a difficult decision: whether to be a general partner (GP) or a LP. Since China’s PE is still in its infancy, there is a lack of PE professionals. Some investors would like to establish PE funds by themselves. When LPs select different PE types for investment, the research indicates that more than 62.3 percent of LPs make a growth fund their first choice; 56.3 percent of LPs prefer to choose PE investment in start-up companies; and 44.4 percent of LPs make buyout funds their priority (Figure 4.2).

When an LP chooses a type of PE fund, the top six issues that concern him are management team, PE connections in its industry, investment strategy, brand name, performance record, and corporate governance. The first two issues are the most important for LPs’ consideration. Unlike in Western markets, Chinese LPs always want to be involved in PE management, which often brings GP management troubles and thus causes conflicts between LPs and GPs. There are few LPs who are not involved in PE management in China. LPs are normally involved in PE management in three ways. One is that LPs have memberships in the investment decision committee of the PE fund. Another way is that LPs establish an independent consulting committee to supervise GPs’ management. The last way is that the investment decision committee is made up of representatives of both LPs and GPs for investment decision making.

PE fundraising in China is mainly affected by three factors: monetary policy, economic environment, and available investment channels. From 2011, China’s poor economic performance and increasingly tight monetary policy have made fundraising more difficult than before. Banks and financial institutions are becoming the main sources of PE fundraising. Noah Wealth, China’s largest third-party financial planning institution, has made its investment focus on the PE field. In 2011, 48 percent of its customers were involved in PE investment. In private banking, some banks provide their customers, who have plenty of capital, with financial products related to PE fundraising. Foreign LPs often face two obstacles in investing in China. First, taking capital into China is much easier than bringing it out, because China has a foreign exchange control policy. Second, according to the NDRC, a local currency vehicle containing foreign capital loses its local status and is treated as foreign investment. Then its investment is restricted and it cannot invest in some industries, such as local PEs.

GPs and fund management

Since 2009, high returns of the PE industry on the mainland have attracted many of the financial elite to switch to the PE industry and become GPs. Most of them are professionals from public funds, securities firms, investment banks, or accounting firms. The strong demand for GPs and the fast-growing PE industry cause intensive competition for financial professionals who are qualified to be GPs, particularly with a background in multinational financial institutions. In 2009 and 2010, each year at least 23 senior managers of Chinese branches of multinational financial firms at partner or general manager level resigned. They either joined the newly established PE funds in China as GPs, or established new PE funds by themselves in China. GPs in China are often asked to invest 10 percent to 20 percent of their own capital in the PE they manage, which is higher than in Western countries. Similarly to foreign GPs, they normally charge a 1.5 percent to 2 percent annual management fees on the overall fund commitments, plus another 20 percent bonus on profits.

Since China’s LPs always want to be involved in fund management, conflicts between LPs and GPs are unavoidable. According to Mr Zhang Lan, a lawyer of Jin Mao P.R.C. Lawyers, a famous law firm based in Shanghai, for the past several years there have been more and more dispute cases between LPs and GPs. It is said that at least 50 percent of PE funds have conflicts between LPs and GPs. In addition, it is not uncommon to see some LPs default on their commitments to GPs. But GPs dare not sue them because that will hurt their reputations. Some people describe the relationship between GP and LP in a PE as like that of husband and wife in Chinese families, in which the wife always wants to manage her husband in every way, and the husband often has to report everything to his wife.

Structuring PEs in China

In Western markets, limited partnership is the most popular way of establishing PE funds, mainly due to favorable taxation, while in China PE funds have three popular structures: limited partnership, investment trust, and corporation. Limited partnership has just started in China and has not been popular. The first limited partnership PE fund in China was Shenzhen Cowin Capital, which was established on 26 June 2007. Most PE funds take either investment trust or corporation structure. Most PEs’ institutional investors, such as SOEs and local governments, structure PE funds by corporation, because this way is well defined and protected by Chinese Company Law and Securities Law. Private investors prefer to take the trust route. There are two operation models for trust-based PE. One is that a trust serves as LP for fundraising, and cooperates with another institution that serves as GP. The other model is that a trust serves as both GP and LP. Limited partnership can bring favorable taxation benefits in Western countries; however, in China, taxation on partnership PE funds remains somewhat uncertain, which is the main reason for the lower popularity of limited partnership PE funds in China. From 1 March 2010, The Administrative Measures for the Establishment of Partnership Enterprises within China by Foreign Enterprises or Individuals issued by the State Council came into force. PE funds in China could then be established by partnership. In addition, there is another structure, the contractual type fund, which is a structure between corporation and trust. Bohai Industrial Investment Fund Management Co., Ltd is structured in that way.

PEs’ investment strategy

In China, most PE funds invest in operating companies. Some invest in public equity and are often called PIPE (private investments in public equity). Investing in M&A is not popular. Secondary funds have not been developed. By studying PE investments from 2007 to 2011, it can be seen that in China four industries received more than 100 investments from PE funds. They were the machinery and equipment industry, the chemical industry, the electronic industry and the information service industry (Figure 4.3). PE investment deals in these industries reached 253, 122, 118 and 110, respectively. In 2011, the PE investments in the four industries were 61, 56, 36 and 44 deals, respectively. For the past 5 years, the compound annual growth rates of investment in the machinery and equipment industry were 63.8 percent. Each Chinese listed company in machinery and equipment had at least two PE funds involved. Meanwhile, the home appliances industry, which was the most popular industry 5 years ago, had gradually been abandoned by PE funds. Some other industries, such as textiles and building materials, are also losing their attractiveness.

It should be noted that, since 2010, the biological medicine industry and the clean technology industry have gradually become the favorites of PE funds due to government support. In 2011, investments in biological medicine reached $357.5 billion. Many PE funds believe that the great potential of the industry will be achieved in the near future. In 2012, the industries of consumption, medical services, environmental protection and TMT (technology, media and telecom industries) are also preferred by PE funds. In addition, in a PE’s investment agreement, the PE often asks to sign a repurchase clause with the operating company. That means that, if the operating company cannot successfully realize IPO, the company will repurchase the equities that the PE holds. The repurchase price is normally based on either net asset or compound growth rate of the company. The big price gap between Chinese primary and secondary stock markets makes IPO on Chinese stock markets, particularly on GEM and SMEB, which normally have much higher P/E ratios than the main boards, the target of most Chinese PE funds. So, a pre-IPO investment model has become popular, which is the investment in an operating company before its IPO. From July 2009 to March 2012, there were 780 IPOs in China. Of these, 432 received PE investments, and more than 700 PE funds were involved. The total number of PE investment deals was 1137 and their floating profits reached RMB 171.5 billion Yuan. About 10 percent of the PE investments received returns of more than 100 times. Sixty percent of the PE investments received returns of less than 10 times. It can be seen that ten percent of those 1137 investments were made 1 year before the IPOs; 40 percent of the investments were made 2 years before the IPOs; and 74 percent were made 3 years before the IPOs. A typical Chinese PE investment is a non-controlling stake of less than 10 percent in an operating company. Few PE funds controlled more than 20 percent equities of the operating companies. PE investment value has been as much as $1600 million (Table 4.4). It should be noted that, in PE investments, valuation adjustment mechanism or cliquet has been widely used by PE funds to reduce the risks of their investments.

A PE fund normally has two ways to search for investing opportunities. One is by the PE itself according to its investment strategy; the other is by intermediaries, such as investment banks, accounting firms, etc. Since July 2009, many professionals switched from the intermediaries to PE funds. Thus, the PE funds have close relationships with the intermediaries. In investment, each PE has own policy of selecting investment projects. For example, NewMargin Venture has a four-step selection policy. In the first step, industries with high growth rates would be identified. In the second step, potential champions of the industry would be found. In the third step, the companies with differentiation advantages would be selected. In the last step, the PE would provide the selected company with value-added service. Each year, NewMargin Venture may analyze 3000 to 4000 candidate companies. On average, studying 300 companies may lead to one successful selection and investment decision.

Due to increasingly intensive competition in the PE field and poor economic performance recently, some PE funds are experiencing difficulty in finding an appropriate investment opportunity. They are starting to search for opportunities in secondary stock markets. Some PE funds involve the private placement or private offering of additional shares of listed companies. One of the largest local PE funds, Happy Silicon Capital Management, has invested in private placement for more than 30 companies since 2006. According to Mr Bao Yue, CEO of the company, its annual return on the investment was about 30 percent by the end of 2011. When Chinese stock markets perform poorly, PE funds often prefer to invest in corporate restructuring or M&A. But, some PE funds suffer serious loss in investment in private placement. In 2011, poor performance of China’s stock markets caused most PEs’ investments in private placement to lose money (Table 4.5). In 2011, PE funds invested in 82 private placements. Only 24 of them received floating profit, while 58 had floating loss. The investment return is determined by the stock performance, which is often uncertain and full of risks. For example, the PE investment in Star Lake (600866: SSE) had more than 55 percent floating loss by 19 December 2011 since the private placement finished on 22 April 2011, while Bohong Shujun, a PE based in Tianjin, received about 107 percent floating profit from its investment in private placement in Annada Titanium (002136: SZSE).

In future, with the New Third Board developed, secondary funds may be developed. Meanwhile, China’s poor economic performance is driving the development of some Chinese PE funds which focus on M&As. Another investment opportunity for Chinese PEs is in so-called orphan stocks. For the past 2 years, many overseas listed Chinese companies have been frequently sold short by some foreign research firms, such as Citron and Muddy Waters. These listed Chinese companies are called orphan stocks, because they may have been unfairly tainted by a raft of accounting and governance scandals. Then, many of those overseas-listed Chinese companies are looking to come home, where they can fetch much higher valuations than abroad. Taking the private companies to relist on China’s stock market offers an arbitrage opportunity for Chinese PE funds. Some PE funds are preparing buyouts of these orphan stocks. In addition, some Chinese PE funds, such as Hony of CITIC PE, are expanding abroad to search for investment opportunities in global markets.

PEs’ exit strategy