Foreign industry players face a new wave of competition from yuan-denominated funds in mainland
Private equity in the mainland is undergoing a paradigm shift and foreign firms are having to adapt by undergoing more rigorous approvals, taking smaller stakes in target companies, avoiding strategic investments and, like Victoria Capital, creating their own domestic yuan funds.
'For a long time in China, the foreign funds really had the trump card because they had the cash,' said Kathleen Ng, managing director of the Centre for Asia Private Equity Research. 'But the equation is starting to change. With approval of yuan-denominated funds, we're seeing the beginning of a new wave.'
At the front of the domestic wave is the Bohai Industrial Investment Fund, sponsored in part by the Tianjin municipal government. Bohai, scheduled to reach 20 billion yuan and other domestic funds like it have a key competitive advantage over foreign funds in getting deals. They are primarily industry funds that focus on particular sectors such as clean technology that the government wants to develop.
Fund executives are local, have a network of contacts and are already in sync with government policy. 'It's a healthy development that China has the capital and the structure to create these pools,' said Ms Ng. 'Now, if you're waiving dollars, you have to make sure you have other capabilities to provide. And as the Asian economy grows, it becomes more competitive, separating the men from the boys.'
Foreign private equity firms have never had an easy time of it on the mainland. The yuan is not easily convertible, making it difficult to repatriate profits. The legal structure is only now developing and the approval process is complex and opaque. Exit vehicles - initial public offerings, trade sales, recapitalisations - are limited.
Normal exit strategies also have been complicated by government restrictions on offshore or special purpose vehicles. Meanwhile, the mainland's booming stock exchanges have created a red-hot initial public offering market for local companies.
But the biggest barrier to foreign private equity has been political sensitivity. 'The main problem has been that the mainland does not like the prospect of control passing into foreign hands,' said Paul StJohn Mackintosh, managing editor of Asia Venture Capital Journal.
'Especially with buyout funds, it's in their DNA to want control. But you'd have to give a pretty convincing case to the mainland before they would allow formerly public assets to be passed to foreign private hands. Why would they? They don't believe that gives them the kind of knowledge transfer they are looking for and it lays them open to the charge that they're selling China assets on the cheap.'
Hong Kong's Victoria Capital is taking a different route from the typical foreign private equity fund. After the mainland instituted new merger and acquisition rules in September last year, Victoria set about getting a licence for a domestic yuan-denominated fund.
Managing director Johannes Schoeter said it took a year to set up and receive a licence for the China New Enterprise Investment but the fund now has raised US$113 million, mostly from overseas. Mr Schoeter describes China New Enterprise as a growth capital fund that looks for well-established, profitable companies that are market leaders but still growing at 30 per cent to 100 per cent a year.
'Having a licence from the Ministry of Commerce has several advantages,' said Mr Schoeter. 'We don't need government approvals for most investments, domestic exits are easy and we have a capital account that allows us to convert dollars into renminbi and vice versa.'
The benefit Mr Schoeter and fellow managing director Xiaoyang Yu see in this structure is legal certainty. 'And,' he said, 'it gives you a huge time advantage over Cayman Island funds. For each deal, they need government approval, which is getting more restrictive.' Cayman Island funds are offshore investment vehicles.
Complete figures for total private equity investments in the mainland are hard to come by. But data provider Zero2IPO Research Centre reported that US$5.79 billion in capital was raised for 15 new Asia-focused private equity funds in the second quarter, up 102 per cent from a year ago, though down 24 per cent from the first quarter.
It is a difficult market, admits Richard Pyvis, chairman and chief executive of CLSA Capital Partners. But, he added: 'I'm quite positive on China. You have to be cognisant that there is a propensity for sudden shocks. A propensity to surprise. But there is such a strong underlying growth trend in GDP and consumption. Long-term growth is exciting.'
