China’s LP problem

Blackstone was the first of major buyout firms to jump in, declaring plans in August 2009 for a joint venture fund said to be worth $731.9 million. Carlyle and TPG soon followed, and they have since been joined by the likes of Goldman Sachs and Morgan Stanley Private Equity.

The Shanghai Blackstone Equity Investment Partnership reached its first close in April 2011, but no foreign-managed fund has found fundraising easy. The market leaders are without question local private equity firms, which account for all of the top 10 renminbi funds by capital raised. The Shanghai Financial Fund, managed by GP Capital, heads the list, having attracted over half of its $2.9 billion target by the first close, according to AVCJ research. The largest fully closed fund is CITIC Private Equity's Mianyang High Technology Industrial Investment Fund, which raised $1.3 billion, 50% more than its original target.

Looking for an explanation for these contrasting performances, all threads seem to lead back to one issue - investor immaturity. Foreign participants from all corners of the industry note that China lacks the institutions capable of fulfilling the traditional LP role. And with lucrative short-term returns to be made in a red-hot IPO market, many investors are unwilling even to try, instead opting for looser conditions offered by local players.

"While there may be lots of money flying around in this country, qualified LPs are few and far between," said John Zhao, founder and CEO of Hony Capital, in his keynote address at AVCJ's China Forum in May. "For this market to develop not only do we need experienced and qualified GPs, we also need LPs who recognize GP-LP governance."

Limited partners are limited

It's no coincidence that the one name readily attached to nearly every foreign renminbi fund is the National Council for Social Security Fund (NSSF). China's state pension fund is, by most accounts, the only institution that acts as an LP in the Western sense, seeking long-term returns and willing to let GPs get on their job with minimal disturbance. Beyond this, there are no formal endowments or family offices and no corporate or state pension funds. Insurance companies, although permitted to commit capital to private equity, face severe constraints.

There are, of course, other government agencies with capital to deploy, as well as state-owned enterprises and an increasing number of wealthy individuals. In China's relationship-driven private equity industry, local renminbi funds inevitably enjoy better access to these investors. Cultural and nationalistic factors play a role, but concerns also remain that renminbi from overseas sources will still count as foreign capital and therefore be subject to more rigorous approvals and barred from participating in sensitive sectors such as natural resources. While the Qualified Foreign Limited Partner (QFLP) scheme is supposed to help resolve this issue, industry participants are no more than cautiously optimistic as the structure has yet to be fully tried and tested.

Dealing with domestic investors is a protracted process even for the local private equity firms. China International Capital Corporation (CICC), the country's leading investment bank, is nearing a RMB1.5 billion ($231.5 million) first close on a new renminbi fund, and the likes of the NSSF and China Development Bank, a state-owned policy lender, are among the potential investors, a source familiar with the situation told AVCJ. The full fundraising target of RMB5 billion ($771.7 million) should be easily met, the source added, but "state-owned enterprises are very slow due to their internal procedures."

Should a foreign fund make a breakthrough with a domestic investor, the two parties' would then need to agree on common objectives and a preferred method of operation. Potential pitfalls abound.

York Chen, founding managing partner of ID Techventures, says that taking on a government entity as LP may deliver faster approvals and tax incentives, but it exposes a fund to limitations as well. ID Techventures recently closed its first renminbi fund in Chongqing, with the local government contributing 20% of the capital. To secure this commitment, though, the fund had to agree to invest 60% of its total asset pool in the Chongqing area.

It is not unusual for local governments to offer incentives to foreign funds on the condition that management looks for deals in a specific geographical areas and sectors. Such arrangements fit in with the authorities' agenda to promote economic growth while at the same developing private equity as a new funding channel in a commercial landscape that has traditionally been over reliant on banks. The Blackstone renminbi fund, for example, reportedly received heavy backing from the Shanghai city government and a real estate firm responsible for office buildings in Pudong New Area's Liujiazui financial district. The fund's remit, according to the profile on Blackstone's website, is to "make priority investments" in Pudong, which "help to stimulate and support additional foreign and domestic investment in financial, transportation and industrial enterprises."

Interfering in operations

A more pervasive problem is LP interference in the investment process itself. Once they have contributed capital, Chinese investors usually like to have a say in how it is deployed, sitting on the investment committee and taking an active role in identifying targets. This encroachment on GP territory is in part the result of a blurring of traditional roles. Whereas in the West a GP might contribute 1% of the capital to a fund it is managing, in China the figure rises to 10%, and in some cases 20%-30%. "The LP wants to see you have much at stake," Chen explains.

At the same time, investors are paying a premium to participate in a financial vehicle that is expected to deliver stellar returns within a relatively short timeframe. According to Conrad Yan, partner at Campbell Lutyens Asia Pacific, Chinese high net worth individuals investing in domestic private equity funds are paying a placement fee as high as the front-end load - a sales fee paid in advance of purchasing shares in a fund - commanded by US mutual funds 20 years ago. In return, LPs are extracting promises from GPs that they will get all their money out in the first year and only need to pay a fee on first-year investments.

"Is it fair?" Yan asks. "It's fair because there is the retail market for private equity in China, even though such a market doesn't exist anywhere else in the world."

Chronic short-termism is expected to last as long as the market remains in bubble territory. Several speakers at AVCJ's China Forum mentioned the phrase "quanmin PE," which roughly translates as "everyone is a private equity firm." It sums up the current industry trend: with some companies trading on ChiNext and the Shenzhen SME Board at price-to-earnings (P/E) in excess of 100, even inexperienced investors can look to make healthy returns on their capital.

As a result, a huge number of "investor collectives," unsupported by any formal GP-LP structure, are looking for pre-IPO deals. They identify one or more target companies and raise the required funds largely through personal contacts on the basis that an exit will be possible within two years.

"You see people jumping into deals with 20x forward P/E and they think they're lucky because comparable companies listed in Shenzhen are trading at 120x. The back-of-the-envelope calculation is that they'll make 4x," Zhao says. "That is an unsustainable trend. While this may kill many private equity players' dreams, it will create a more rational background for true private equity to develop."

In making predictions about the prospects for renminbi fundraising in China, some industry participants point to the situation in the US after the global financial crisis. The typical fundraising window went from 12 months to 18 months or more and greater emphasis was placed on due diligence. In the Chinese version, the trigger is a mini crisis of confidence among LPs in response to a handful of pre-IPO funds discovering they can't exit from deals at multiples that justify the initial investment.

Waiting for reform

Opinion is divided as to how quickly reforms will take hold. Frank Tang, CEO of FountainVest Partners (Asia), contends that around half of all domestic private equity funds could be gone in five years' time, with renminbi funds demonstrating a much higher failure rate than US dollar funds. Andrew Yan, managing partner at SAIF partners, is more wary, describing a worst-case scenario in which 95% of the funds - and 100% of the associated problems - are still in place come 2016.

For foreign-managed renminbi funds, change can't come quickly enough. Jie Gong, executive director of Morgan Stanley Alternative Investment Partners, sees it as the point at which the market pivots and investors accept that private equity and fund of funds should be left in the hands of professionals. Fiduciary duty will come to the fore and LPs will start to behave in a more hands-off fashion, with emboldened insurers, pension funds and other institutional investors leading the way.

Such a transformation may be driven by the market, but government participation is crucial in ensuring that the momentum is carried through. There is no reason to think that the Western GP-LP model, which has evolved over a period of several decades, should be replicated exactly in China. Yang notes that the Western system itself differs by market: Canadian pension funds, for example, stand out in the modern landscape as they are willing to make direct investments in real estate and infrastructure, motivated primarily by cost considerations. In the same way, China is likely to be pragmatic. If other areas of financial services are anything to go by, policymakers will not import a model wholesale but take certain features and add them to a domestically conceived solution.

Judy Ye, director and head of EMAlternatives Asia, envisages a hybrid system of the family offices and endowments that typically dominate the private equity LP ranks in Europe and the corporate and state pensions prevalent in the US. EMAlternatives Asia launched its first renminbi fund last year, one of the first private equity fund of funds to do so, and in the process come to appreciate the nuances - positive and negative - of the China GP-LP relationship.

"If you can't beat it, join it - that's our thinking," she says. "By managing renminbi funds we can see what is going is happening on the other side. We feel the pain the GPs are feeling and we see the difficulties. At the end of the day, we all want the same thing - healthy growth for the sector and good returns.

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• Topics
• Greater China
• Hony Capital
• The Blackstone Group
• TPG Capital
• The Carlyle Group
• Morgan Stanley