Chinese LPs: Untapped potential

CreditEase started out as a bricks-and-mortar operation that linked individual lenders to small-scale borrowers, typically the rural poor and lower income urban dwellers. The crux of its business model was a network of Chinese high net worth individuals (HNWIs) with an appetite for ventures that were higher risk but higher return. While the peer-to-peer (P2P) lending platform went online and went public, CreditEase doubled down on its client base, offering a range of wealth management services. Now the company wants to take these HNWIs into international private equity.

CreditEase and its domestic rival Noah Holdings are unique in China in that they have managed to harness private wealth that is often beyond the reach of the private banks. While the former used a P2P business as its launching pad - it has 200 offices and 3,200 wealth advisors - the latter rose to prominence as a placement agent. It helped the likes of Shenzhen Fortune Capital and SAIF Partners to raise renminbi-denominated funds, tapping into a sizeable local distribution network.

Gopher Asset Management followed, offering domestic fund-of-funds and secondary funds to these same investors. The company then sought to replicate this suite of products offshore, establishing an international private equity arm in 2012 as well as an office in Hong Kong. Gopher International now also covers co-investment and has a presence in Silicon Valley.

Traditional GPs that want to raise money from Chinese HNWIs directly, I wish them good luck – it is a tough process and education alone requires substantial resources – PV Wang

"What we have seen over the last 2-3 years is Chinese HNWIs starting to make global allocations to private equity. The peak was last year, and that's clearly the trend," says Piau-Voon Wang, co-CIO at Noah, who joined the firm earlier this year from Adams Street Partners.

By virtue of their distribution networks, CreditEase and Noah has managed to place themselves at the forefront of this Chinese charge into everything from real estate to private equity - and a slowing domestic economic and a weakening renminbi have only served to whet this appetite. The two firm's fund-of-funds products have already made commitments to global brand names such as KKR, The Carlyle Group and The Blackstone Group.

While HNWIs cannot expect to make the same impact on the market as institutional players by size of allocation, they represent a new and attractive target for offshore private equity. This is especially welcome given that insurance companies - perceived by many as Asia's next big LP base - have yet to realize their potential.

"There is a huge amount of capital from Chinese insurance companies and pension funds seeking to invest in private equity globally, but foreign exchange controls are the most crucial hurdle right now," says Sally Shan, managing director at HarbourVest Partners. "Remove it, and there would be an aggressive shift into overseas private equity through fund commitments or direct equity investments. However, as it stands, everything is sort of slowing down."

Institutional tortoises

The largest and longest-standing players in the country's institutional landscape are sovereign wealth fund China Investment Corporation (CIC) and SAFE Investment, a unit of the State Administration of Foreign Exchange. There were among the first batch of Chinese LPs to enter the overseas PE market.

CIC, which has more than $800 billion in assets, established CIC International in 2010 to handle private equity fund commitments and co-investments, as well as other asset classes. Last year it launched CIC Capital to drive overseas direct investment. The unit could have more than $40 billion put at its disposal.

While CIC and SAFE are obvious targets for international GPs on the fundraising trail, their investment activity has lessened in recent years. CIC is said to be holding back because its private equity program is maturing and there is less capital available for new relationships. It is also committing more to direct investments. As for SAFE, checks are still being written but they are smaller in size and number - a reflection of the foreign exchange controls imposed by its parent.

Regulation is also an impediment for Chinese insurers. They received clearance to invest in offshore private equity and real estate funds in October 2012, but take-up has been modest. As of last year, about 2% of the Chinese insurance industry's RMB12.36 trillion ($1.8 trillion) in total assets had been invested internationally. This is despite the overseas asset allocation allowance, which includes fixed income and private equity, rising from 5% to 15% three years ago.

Initial signs were positive, with China Reinsurance (China Re) becoming the first domestic insurer to back an international PE fund in 2013. Since then, China Life and Ping An Insurance have gradually increased their allocations to the asset class, followed by privately-held players like Taikang Life and Anbang Insurance. Their preference is for established brand names and strong track records; minimum check size restrictions push them towards fund-of-funds and global funds.

Ping An Insurance and Anbang are seen as the most aggressive players across fund investments and direct deals. According to one industry participant, Ping An mobilized three of its sister divisions to commit a total of $950 million to a $3.5-4 billion fund-of-funds raised by Neuberger Berman. The decision to invest came after just half an hour of discussion.

In recent months, second-tier insurers such as China Pacific Insurance and Qianhai Insurance, have started building overseas investment teams for PE, responding to the weakening local currency and stock market volatility. But they came up against a government intent on preserving stability, and foreign exchange controls are one of its tools. Since the start of the year, local banks have been ordered to limit the use of US dollars and strengthen checks on foreign exchange deal limits. New attribution quotas for the Qualified Domestic Institutional Investor (QDII) program have also put on hold.

Insurance companies with Hong Kong-listed subsidiaries - China Life, Ping An, Taiping Life, China Pacific and PICC - don't necessarily have to go through the same currency conversion approvals process, because they can use non-renminbi assets to make offshore commitments. Once they limited reserves run out, however, currency converting renminbi to US dollars would require approval.

"If you asked me last year whether Chinese institutional LPs would become a significant source of capital in offshore private equity, I would have definitely said ‘yes.' That's why we advised clients at the time to build good relationships with Chinese insurers, because one day they will start investing in mid-market funds [as well as global funds]," says Guo Sun Lee, a partner King & Wood Mallesons. "Now, though, I am not sure anymore, as there are more regulations on capital control."

Willing participants

Regardless of these restrictions, insurance companies' desire for private equity exposure - onshore and offshore - is undimmed. This is only logical given their huge asset bases and long-dated liabilities. However, the level of sophistication of investment programs varies across the industry.

China Life is a case in point. The insurer, which has more than RMB1 trillion in total assets, set up China Life Investment in 2007, a dedicated alternative assets unit that pursues infrastructure and private equity deals as well as making pre-IPO commitments to late-stage technology businesses and state-owned enterprises. As of last year, it has RMB126 billion in assets. The unit has backed offshore funds raised by TPG Capital and others, writing checks of at least $50 million. Investing in global brand names means it is easier to do reference checks on GPs with counterparts like CIC and GIC Private.

"They are under pressure to deploy a large amount of capital every year, but the team is not very large. It is very difficult to manage many relationships with offshore mid-market GPs, particularly when they don't have offices in China," says a source familiar with China Life Investment's strategy. "They understand that they might not get equal treatments, such as first-referral on co-investment rights, from large GPs as these typically will go to longer-standing LPs."

Taking a more aggressive approach to the asset class - for example, co-investing alongside a GP with a view to backing its next fund - is challenging due to complex internal reporting and approval systems. A China Re representative alluded to this problem at the 2014 AVCJ China Forum, noting that that some executives from state-owned insurance companies do not fully grasp the risks and rewards of a priate equity program and instead focus only on investments with a short-term horizon.

Privately-held and market-oriented insurers differ in this respect from state-owned China Life because they do have more strategic flexibility: this is evident from the greater interest in long-term assets at joint-stock insurers such as Ping An Insurance and Taikang Life. Younger players, whether joint stock or state-owned, may also have greater freedom because they are not weighed down by years of bureaucracy.

China Post Life Insurance, a subsidiary of state-backed China Post Group, was established in 2009 and launched its PE program in 2014. Commitments have been made to five funds, onshore and offshore, including a cross-border VC fund raised by China Everbright and Israel's Catalyst Investments and a Canadian energy-focused fund. It helps that the insurer managed to assemble a reasonably large PE team with experience in overseas institutions; familiarity means there is greater comfort in backing smaller overseas managers with niche strategies.

However, teams like this are not yet the norm. Most Chinese insurance companies are still in the process of developing investment strategies and recruiting people to execute them, so their comfort zone remains the global brand names. "Almost all foreign GPs tell us they want to raise money from Chinese sovereign funds and insurances, but in reality, the chance of these Chinese groups investing the mid-market space is quite low," a placement agent says. "On the other hand, the chance of raising money from wealth management groups is probably higher and it's good to know them."

CreditEase and Noah started backing established global names but moved quickly into the middle market, and from there into co-investment. For Gopher International's latest fund-of-funds, which is seeking to raise $300-400 million from Chinese HNWIs who have US dollars offshore, 40% of the corpus will go into fund commitments and 60% into co-investments. The co-investment part will be co-managed by Gopher and Sequoia Capital China.

The customers

These firms have also sought to offer assurances to GPs looking to tap Chinese HNWIs that they, as intermediaries, represent a consistent and professional source of capital. CreditEase generated $4.5 billion in wealth management sales last year, with individual investments in its US dollar and renminbi products starting from $150,000. Each client is assessed to verify the origin of the funds, the idea being that foreign GPs only need conduct due diligence on CreditEase, not the underlying investor.

Investments are also taken upfront, which means the firm can respond to capital calls in a timely manner, rather than waiting for contributions from clients. "We thought that receiving capital commitments from retail clients would be an expensive, logistically challenging and a risky way of dealing with capital calls from our fund investments, and would complicate financial and cash management for our clients" says Richard Williamson, CreditEase's co-head of wealth management product.

The situation is far removed from 2011-2012 when HNWIs rushed into domestic private equity in expectation of swift returns on pre-IPO deals, sending fundraising to record highs. When the market slowed, investors became disillusioned with the asset class, ignoring capital calls or simply writing off their interests in illiquid fund positions. While the fundraising structures have changed, understanding of private equity has not necessarily improved, and so Noah also emphasizes education.

"Domestic investors do not have clear views on every product and some are misled by market information," says Noah's Wang. "We have over 1,000 professionals and 3,000 staff who educate investors on long term and illiquid assets, and return expectations for offshore PE products. It is a critical part of our service. Traditional GPs that want to raise money from Chinese HNWIs directly, I wish them good luck - it is a tough process and education alone requires substantial resources."

Establishing an institutional mechanism for tapping into the wealth of China's retail investors could deliver a potential windfall to international private equity firms, and also to the parties that operate the system. According to the latest installment of Capgemini's World Wealth Report, China's HNWI population - defined as those with an investible assets of at least $1 million - reached 1.03 million last year. The 16.2% year-on-year gain was the largest of any country globally.

By 2025, the number of HNWIs in Asia - driven by emerging markets such as China and India - is expected to be more than double the 11.7 million recorded last year, with aggregate wealth reaching $42.2 trillion at that time, far outstripping the projected US total of $25.7 trillion.

"If you add these four things together - the growth of the domestic Chinese HNWI pool, the diversification of Chinese HNWIs' wealth away from their proprietary businesses, the increasing interest in offshore assets, and growing appetite for private equity - relative to HNWIs in other markets - you have a very strong long term structural trend driving Chinese HNWI capital into offshore private equity, and we foresee that this trend will continue to grow," says Williamson.

Benjamin Wiley, a partner at placement agent Sixpoint Partners, which specializes mid-market funds, echoes this view. He also observes that more family offices are emerging out of China as the second generation takes over investment decision-making and professionalizes operations, bringing in third-party managers to construct and manage portfolios. This will likely heighten the appeal of HNWIs to international private equity firms.

"Private wealth has not been our main focus historically; we're focused more on institutional investors. In China, we're still assessing whether HNWIs could be a significant source of capital for our funds in the future. We are conservative at this stage, and would only consider taking capital from wealth managers' fund-of-funds that have already secured cash," says HarbourVest's Shan. "However, there is a long-term trend in the industry whereby more individual investors will get access to private equity assets."

Whatever the long-term projections, the more immediate obstacle facing HNWIs is the same as that for institutional players: foreign exchange controls. The government is specially targeting outflows of hot money - driven by Chinese HNWIs - that is used to speculate on offshore assets, but those with clear investment purposes and detailed information disclosure, should still be able to get regulatory approval. It may just take longer than before.

This is perhaps in keeping with the broader message that the entry of Chinese capital into international private equity, from institutional and retail sources, will be a gradual process - although GPs keen to facilitate development should think about building relationships early.

"The Chinese LPs market is new and evolving quickly. You need professional staff in and of the market, the linguistic and cultural skills as well as a longevity in the market and an understanding of what's really going on," says Sixpoint's Wiley. "You need to cultivate LPs relationships, and keep up with changes in LPs' staff and strategies."

SIDEBAR: Institutions - A local story

The National Social Security Fund (NSSF) is generally acknowledged as the first and most sophisticated institutional investor in the mainland. With RMB1.9 trillion ($280 million) in assets under management (AUM) as of year-end 2015, it also remains the largest.

Established in 2000, the pension fund made its first commitment to a domestic private equity fund in 2004. Four years later, it won regulatory approval to deploy up to 10% of its total assets in the asset class. "When the government tried to promote private equity 10 years ago, the NSSF was the only institutional investor domestically. It really is the guiding force for the entire industry, enabling many renminbi fund managers to raise capital. Without the NSSF, they could only talk to individual investors," says Frankie Fang, who heads the Beijing office of LGT Capital Partners.

Relying on a dedicated in-house team, the pension fund constructs its own fund portfolio and has backed funds raised by the likes of CDH Investments, Hony Capital and IDG Capital Partners. The team is also hands-on, sometimes conducting due diligence on specific deals, Hugo Shong, founding general partner at IDG, recalls. Last year, the NSSF started making direct investments, taking a 5% stake in Alibaba's internet finance affiliate Ant Financial Services.

Chinese insurers were not allowed to invest in domestic PE until 2010. The following year the cap on exposure to private funds and companies was raised to 10% from 5%, and then in 2012 investment in offshore PE funds was permitted. Two years later, the regulators decreed that investments in public and private equities combined could account for 30% of the total assets. The system continues to liberalize. In early 2015, insurers were allowed to get exposure to domestic venture capital funds, with an extra RMB200 billion released into the venture space.

In addition, they can now operate as GPs, setting up their own funds and raising capital from third parties. China Life Investment Holdings - the alternative investment platform of China Life Insurance Group - duly launched what it claims to be the largest-ever domestic healthcare fund; Taikang Life Insurance soon followed suit, forming a RMB5 billion healthcare vehicle in partnership with industry player Tasly Holdings.

While domestic alternatives have become mainstream for insurance companies, with increasing amounts of capital deployed in the asset class, Chinese endowments are still small compared to their overseas peers, although LPs are also emerging in this category.

Tsinghua University Education Foundation (TUEF), a non-profit university organization with RMB4 billion in AUM, was the first mover in private equity, making its debut commitment in 2008. It has built a diversified investment portfolio with significant PE allocation - both funds and direct deals - that accounts for a double-digit share of total assets. TUEF started investing in Tsinghua's family funds such as TusPark Ventures, and had since expanded into independent GPs such as CDH and CITIC Capital, as well as cross-border specialists Yao Capital and Cathay Private Equity.

"We had difficulty with long-term investment products in the early days. When we invested in a seven-year PE fund, we became very nervous and worried if portfolio companies could go for IPOs or achieve exits with good profits," says Huang Ying, investment manager at TUEF Asset Management. "Now, with more experience, we feel comfortable in traditional US dollar fund with lifespans of 10 years. We are also diversifying into smaller players with niche strategies. It's a learning process for us."

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• Topics
• Greater China
• LPs
• Fundraising
• Fund-of-funds
• Noah Holdings
• CreditEase
• China
• CIC
• SAFE
• China Life
• Ping An
• China Re