China fund administration: In or out?

For all the hype about Qianhai, the Shenzhen district designated as a laboratory for reforms that would make it easier for foreign investors to participate in local currency PE funds, words have yet to translate into meaningful action. CGN Private Equity is therefore an exception - the GP has raised capital from international LPs and deployed it across two deals in China's renewables industry.

CGN Capital Partners Fund III, which is incorporated in Qianhai under the Qualified Foreign Limited Partnership (QFLP) program, is a collaboration between China General Nuclear Power's investment unit, CGN Private Equity, and New Zealand-based HRL Morrison & Co. The fund reached a first close of RMB1.87 billion ($292 million) in August 2015 and is working towards a full target of RMB5 billion.

Several foreign institutional players came into the Chinese entity directly alongside assorted domestic investors, while a Cayman Islands feeder vehicle has been created to accommodate additional offshore LPs. All will benefit from a set-up designed to allow the rapid deployment of capital. Rather than wait for foreign investment approval on each deal, the CGN fund has blanket approval under QFLP: US dollar and renminbi capital calls happen at the same time, the two pools of money go into the same vehicle, and it is treated as local currency.

"Once the capital becomes renminbi we use it to set up subsidiaries, and if you structure them properly they will become domestically-domiciled vehicles, so we can invest like a domestic resident company," explains Ray Fung, the fund's CIO. Formerly of Ping An Insurance Group and Babcock & Brown, Fung was hired as part of CGN PE's efforts to internationalize its LP base and, as he puts it, "adhere to international best practice."

Countless other China-based GPs are looking to do the same. From established US dollar-denominated managers that want to upgrade their LP bases to renminbi GPs tapping offshore investors for the first time, the PE industry appears to be in a permanent state of transition. It is a clash of cultures, budgets and regulatory structures: Can a GP adapt to meet the requirements of international investors; is it willing to pay for the professional services that facilitate a fundraising; and in what way can the GP accommodate US dollar and renminbi investors simultaneously?

Whether a private equity firm opts for a complex multi-currency structure out of Qianhai or sticks to US dollar funds, an institutional upgrade means more back office responsibility. The next question is simple: do they outsource this function or handle it in-house?

History lessons

China GPs have different approaches to fund administration based on their longevity. The likes of CDH Investments and Hony Capital have always opted for internal solutions because when they started, the industry - and the service provider community - was less developed and the regulatory burden was lighter.

"Ten years ago, you could send out quarterly reports and everyone was happy. You had smaller in-house administrative teams and as demand ratcheted up you just made additions to those teams," says Andrew Ostrognai, a partner at Debevoise & Plimpton. "People who are starting today must meet these requirements - for more bespoke reporting, more data - immediately."

CDH's private equity business alone comprises five US dollar-denominated funds and two renminbi vehicles; the cumulative fees generated cover the cost of in-house administration. A middle-market manager just starting out with a $400 million fund would find it hard to build out a back office function.

Pinpointing where on a PE firm's evolutionary curve it makes sense to have an in-house team is complicated by various factors. While Ostrognai observes that several of his clients get past Fund III and continue to perform administrative duties internally, Alexander Traub, managing director for Asia at Augentius, has seen GPs go in the opposite direction. One firm used in-house resources for its first three funds but then outsourced for Fund IV.

"It's a numbers game: if you need to a customizable report for a couple of LPs that may be easy to do in-house; if you need to do it for a couple of dozen it's different. Mundane tasks, such as sending out the drawdown notices and chasing investors are up, lend themselves to being outsourced," says Javad Movsoumov, managing director in the private funds group at UBS.

And once that decision is made, for most middle-market managers there is usually no turning back, even once they achieve scale that might justify doing so. There is a generally a reluctance to alter a system that is already working. Andrew Read, partner and head of Asia at Langham Hall, notes that he has never heard a manager with progressively larger funds talk about taking administration back in-house. "As the job gets bigger and more complicated, the appetite for doing it in-house gets less and less," he explains.

What has changed for China GPs is the speed at which they are turning to outsourced solutions. In the past, private equity firms would often rely on LP contributions from friends and family for Fund I and gradually build out their administrative capabilities over the ensuing vintages. Industry participants say this is increasingly rare.

"In most of the cases we see, firms will outsource the administration from Fund I or Fund II," says Lorna Chen, a partner at Shearman & Sterling. "There are a lot of things to learn, and if managers are doing deals at the same time, they may not have the manpower or the knowledge. Administration might be one of the last things that gets considered, so they just outsource it."

It is partly a sign of maturity in Chinese private equity as executives spin-out from established firms to set up on their own, taking best practices with them. A second reason is there are simply a larger number of managers in the market and so fundraising is more competitive. Thirdly, the compliance environment has changed markedly in recent years.

Any Chinese GP raising capital from foreign investors for the first time must assess how many of its LPs fall under the US Foreign Account Tax Compliance Act (FATCA) and set up systems so that the US revenue authorities can keep track of these investors' assets.

It places a greater burden on firms that may already be struggling to complete anti money-laundering (AML) and know-your-client (KYC) due diligence on offshore investors, and the weight of compliance will only get heavier. Several other tax disclosure-related initiatives are in the pipeline, including the Common Reporting Standard, which will require GPs to do for other governments what they already do for the US under FATCA.

Third-party administrators also see opportunities in middle office and front office reporting, which involves the communication of portfolio-specific information to LPs. "If you don't have a system that uploads these data and slices and dices them, it becomes useless," says Traub of Augentius. "We can show how the capital from a particular LP has been allocated, deal-by-deal and across different geographies and sectors. GPs are asking about this because LPs want more transparency."

This is reflected in the more detailed due diligence questionnaires and reporting schedules now circulating in the investor community. Managers are asked to disclose more information to LPs with greater regularity. Even if insufficient back office resources is not a deal breaker for most LPs, the presence of independent professional advisors means there is one less reason to pass on a fund.

"If you are going to raise money from institutional investors you have to pay attention to your back office," notes Niklas Amundsson, managing director at Monument Group. "It's an absolute tick-the-box measurement, not a relative play. The LP says, ‘Either you do what you say you are going to do, or you don't and then we have a problem.'"

Institutional upgrade

Banyan Capital is an example of a China GP that has moved quickly through the development phases. Within two years of the founders spinning out from IDG Capital Partners in 2013, it had raised two US dollar venture funds with aggregate commitments of more than $560 million. It also has a dedicated $100 million vehicle for follow-on investments in Fund I portfolio companies and two renminbi funds with RMB1 billion in assets.

The firm outsources some administrative functions but has a sizeable in-house operation as well, split into separate teams for US dollar and renminbi funds. This division applies from deal-sourcing and execution all the way through to back office legal and accounting work, so as to avoid any potential confusion or conflicts. The frequency and detail of fund reporting is dictated by the limited partnership agreement (LPA), while on the regulatory side, the dollar vehicle complies with international standards and the renminbi vehicle with Chinese requirements.

"You need external service providers, like administrative banks, law firms and accounting firms, to stay up-to-date with all the current reporting requirements. At the same time, you need to have someone in-house who tracks all these requirements and makes sure everything is done properly. It is ultimately the manager's responsibility to comply and we believe it is important to have a strong internal back office as well as integrated IT systems," says Catherine Wang, general counsel at Banyan.

This willingness to invest in the relevant competencies offers hope for administrators keen to work with GPs across all their products. Sanne Group is one of a handful of international administrators that has a presence in mainland China, having opened a Shanghai office in 2011. The move was driven by a Western manager that had entered into a partnership with a local GP and wanted back office consistency, but Sanne has since seen a gradual increase in demand from dollar fund clients that want renminbi coverage as well.

"The concept didn't exist in 2010 and the take-up has been slow, but outsourcing is growing as GPs start to realize the benefits," says Noel Walsh, Asia director at Sanne. "If a GP is entirely onshore then the attitude is still, ‘We can get an accountant to do it for us in house.' Managers operating parallel structures or a number of products of which renminbi funds are just one are more inclined to use a service provider."

Cost has long been a sticking point for China GPs, and it still is for many managers. But private equity firms that want to attract international investors, particularly when trying to leverage a track record in the renminbi space to raise a US dollar fund, may have little choice but to accept the costs of operating in a world they have yet to understand fully. Monument's Amundsson is working with a GP in this very position. There are onshore institutional investors in its renminbi funds but all the administration has been carried out in-house. For the US dollar vehicle, the manager is outsourcing.

"For the GPs I deal with - once they have made their minds up about business development - fees, provided they are reasonable, are usually not an issue," adds Langham Hall's Read. "They know they are playing catch up to the expectations of established international investors and they want to have the best possible chance. As such, getting the right professional advisors is a no-brainer."

For GPs making this jump - or for international administrators expanding into the renminbi space - reconciling the different requirements is challenging. Until relatively recently, China had little or no regulation in this area specific to private equity. "Sunshine funds," defined as privately raised pools of capital that invest in public securities, were obliged to use third-party administrators because they have to make regular net asset value reports, but other vehicles were not.

"It was essentially a self-regulated industry. There were not clear rules and so managers did things in different ways, from documentation to LPAs to management contracts, and the requirements of most domestic LPs were not as high as foreign LPs," says Nicholas Lou, a partner at Links Law. "Since the end of last year, AMAC [the Asset Management Association of China] has strengthened supervision on private funds."

From an administration perspective, a licensing system has been introduced for service providers, and the use of custodian banks by GPs - previously a recommended approach - is now mandatory.

The custodian relationship adds another twist to back office work in China. Fung describes CGN Capital's arrangement with its custodian as essentially that of a co-administrator alongside the in-house team. The bank manages the inflow and outflow of capital, checks the documentation for individual deals to ensure they fit the fund's remit, and reviews drawdown notices. It also intermittently reconciles the custodian bank administration accounts with the GP's management accounts.

Others position the relationship somewhat differently, with GPs leading the administration process in-house and passing information to bank custodians to book in. Still, it potentially enables the banks to offer administration as a value-added service. As a result, international players like Sanne tend to be called upon for advice on more complicated issues, typically AML and KYC requirements, which are becoming increasingly important on a domestic basis.

This dynamic also exists because much of the administration on the renminbi side is relatively low-level. Capital calls are a case in point. While a US dollar fund calls capital on a deal-by-deal basis, renminbi managers might draw the whole corpus on day one or in a small number of increments. This makes the administration simpler and also addresses concerns about defaults.

Parallel problems

These differences are not insurmountable. Indeed, if a manager has the internal and external resources to meet the administrative requirements of US dollar and renminbi funds investing simultaneously there is no conflict whatsoever.

However, should two funds invest in parallel with one another, the issue escalates from being one of capacity to one of practicality. The two pools of capital are separate legal entities with their own documentation, but they are supposed to enter the same special purpose vehicle making investments, and in some cases account for an equal portion of each deal.

This strategy presents three significant obstacles. First, foreign investment might not be permitted in the target industry. (According to Fung, this is of no concern to the CGN fund because its cleantech-focused remit means that all investments fall within areas where foreign investment is encouraged.) Second, the owner of the target company may not be willing to accept a combination of dollars and renminbi. Third, a wait of up to three months for regulatory approval on the dollar portion of an investment - versus two weeks on the renminbi side - could result in a GP losing out in competitive processes.

"There is hardly a perfect solution for making totally parallel investments from both vehicles," says Lou of Links Law. "The GP would have to create an adjustable mechanism that meets the expectations of both sets of LPs because it is difficult to maintain the same ratio for each investment."

Such a mechanism could involve the renminbi vehicle making the initial capital deployment and then selling part of its stake to the dollar vehicle so as to achieve parity. Alternatively, where pro rata investment is impossible, there may be a way of compensating US dollar LPs if they cannot receive the same economics. Whatever the solution, it requires clear explanation in the LPA and then a leap of faith from LPs if they are to approve a structure that gives the GP flexibility. Only the most experienced and in-demand PE firms are likely to get it, or indeed want it.

"It is a matter of trust and governance," says Shearman's Chen. "LPs are uncomfortable giving GPs total discretion and GPs are tired of explaining each time why the renminbi fund needs to go first. So they might just decide not to invest in deals like these."

The parallel fund conundrum may only be solved through full renminbi convertibility and a hypothetical roll-back of foreign investment restrictions. With respect to China-based GPs' purely administrative teething problems, and the willingness to pay a premium for outsourced services, international practitioners are hopeful of seeing a breakthrough sooner.

Much rests on the continued evolution of the domestic institutional investor base. There are already reports of LPs pushing back more during negotiations with managers and paying closer attention to issues ranging from reporting to governance to key man clauses. In addition, Chun Zeng, a partner at Gopher Asset Management, highlights the AMAC requirement that local GPs adopt fair-value accounting, which he sees as integral to promoting the use of third-party administrators.

Beyond that, nothing shakes up an industry like a sharp shock. "Institutional investors like to see independent administration - they see it as a strengthening of governance," says Peter Rioda, a director for private equity at Sanne. "In the West it was things like the Madoff scandal and various Ponzi schemes that drove that desire to see independent administration. In markets where there isn't that independence yet, difficulties, scandals and crises may end up having a similar impact."

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• Topics
• Greater China
• Advisory
• Fundraising
• professional services
• GPs
• Fund administration
• Augentius
• Sanne Group
• Langham Hall
• Banyan Capital