Renminbi fundraising: Winter has come

“It’s quite a severe slowdown,” says Piau-Voon Wang, a senior advisor to the fund-of-funds division at CDB Capital, the investment arm of China Development Bank. “Capital has been raised at a ferocious pace in the renminbi space over the last three years. By the end of 2017 it was clear that this pace was not sustainable. You have to remember that the market is still driven by high net worth money, so the boom and bust cycle is dramatic.”

Dramatic is an appropriate adjective. Investors committed a record $88.3 billion to local currency vehicles in China during 2016, more than three times the amount that went into US dollar-denominated funds and nearly twice the renminbi total for the previous two years combined. In 2017, renminbi fundraising activity came to $80.4 billion, but the number of vehicles achieving a partial or final close went from 160 to more than 360. 

If 2016 was dominated by the emergence of huge government guidance funds – signaling an endorsement in Beijing of how the asset class can help the country’s transition from old economy to new – then 2017 was when everyone else piled in. 

It is now abundantly clear that they’ve piled out again. Approximately $27 billion was raised in the first six months of 2018, while less than $1 billion has come in since July, according to AVCJ Research’s provisional data. Eighteen months ago, managers with reputations established in the US dollar space were busy adding renminbi funds so they could tap the liquidity boom. The latest trend is for GPs with track records in the renminbi space to raise offshore vehicles. 

“Over the next few years I think renminbi managers will find it a very challenging environment to operate in, that’s for sure,” says James Wang, an investment funds partner at Han Kun Law Offices. “The US dollar fundraising market has been very active for Chinese managers recently and that will continue for a while.”

Falling back

There are various reasons why high net worth individuals (HNWIs) might be backing away from private equity. These include concerns about the meltdown in the peer-to-peer (P2P) lending space – several wealth managers that raise PE vehicles are also known for offering P2P products – and a general weakening in market sentiment driven by global trade tensions or the slowing economy.

But renminbi fundraising is being battered by a perfect storm in that every major LP constituency appears to be beating a retreat. HNWIs have lost confidence in wealth management platforms; listed companies are preoccupied with the deteriorating public markets; financial institutions are subject to restrictions that limit their participation in the asset class; and government guidance funds, while still active, usually don’t want to account for the entire corpus of a private equity vehicle. 

Not all private equity firms will be affected equally. Dayi Sun, a managing director at Jade Invest, divides the GP community into three segments. Most managers belong in the bottom tier of the market, raising capital through personal networks or local government relationships in tier-three and four cities. Then there is a comparatively small elite – comprising brand name GPs that are supported by China’s relatively shallow institutional investor base – and everyone else falls in the middle.

“The top tier is hardly affected, and the bottom tier has problems but it will always be there. The middle tier managers are the ones suffering. That is where most of the GPs will disappear,” Sun says. He recalls hearing from a manager as recently as last week who had to dissolve his fund because the largest LP, an insurance company, changed strategy and would no longer back the vehicle.

Even the elite aren’t immune to the prevailing market dynamics if they try to raise very large funds. For anything above RMB10 billion ($1.45 billion), the likes of the National Council for Social Security Fund (NSSF) and leading insurers are likely to feature in the LP base, and they take time to run due diligence. Only GPs with sizeable IR resources can handle these processes.

“You can still raise capital quickly if you are a good manager, but GPs are becoming very realistic about how much they can raise and who they can talk to. They are restricting fund sizes, targeting shorter fundraising periods, and focusing on investments,” says Frankie Fang, the former China head at LGT Capital Partners who recently founded renminbi fund-of-funds Starquest Capital. 

Several China VC firms, with US dollar fund track records, have achieved final closes on renminbi vehicles this year. The sums are of appropriate size for early-stage strategies. Qiming Venture Partners led the way, closing its fifth local currency fund at RMB2.1 billion. Meanwhile, Vision Plus Capital raised RMB1.7 billion for its second vehicle and GGV Capital and Redpoint China Ventures got RMB1.5 billion and RMB700 million for their debut renminbi funds.

The other key point is the timing. Vision Plus was the last to announce its final close towards the end of May. Yiran Liu, a partner with the firm, has since seen a slowdown in activity from all LPs, from fund-of-funds to listed companies. “Some of the fund-of-funds are big, in the RMB10 billion range. They were investing everywhere but now they are pulling back,” he says. “A lot of their funding comes from banks and insurance companies.”

Bank trouble

It is no coincidence that new asset management regulations came into force in the second quarter of the year. The move is seen as part of broader government efforts to deleverage the economy, and wealth management products issued by banks – which have been used to raise capital for all manner of purposes – were a primary target.

First, material mismatches are now banned. If a bank wants to raise capital for a private equity fund by issuing a wealth management product, the duration of the product must be the same as the lifespan of the fund. Second, the multi-layer structures through which banks moved money into private funds have been simplified. 

This is supposed to bring greater transparency to a process that often resulted in capital raised from third parties being mixed together with principal capital and deployed in an opportunistic manner. As one industry participant observes, it becomes difficult to attribute a cost of capital to each investor, while promises of a guaranteed return made to participants in wealth management products tended to have little credibility.

The rule change has left banks hamstrung. “Banks cannot directly act as shareholders in non-bank enterprises, so a bank used to establish a wealth management product and go through a channel entity such as a trust or an asset management product operated by a securities company, a fund management company, or an insurance asset manager, which acted as the LP,” explains Candy Tang, a partner at Fangda Partners. “The three-layer approach has been reduced to two, which makes it very difficult for banks to use funds of wealth management products to invest in private funds.”

In addition, regulators are placing greater emphasis on transparency through know-your-customer (KYC) protocols and custodian responsibilities. A GP raising capital through a private placement must look through any holding entities and ensure that the ultimate investors meet China’s qualification criteria. Lanquan Ruan, a partner at Beijing Heng Du Law Firm, suggests this could reduce the target LP market considerably as few investors have the required RMB5 million in financial assets.

On custodian arrangements, the Asset Management Association of China (AMAC), an industry supervisory body under the securities regulator, started asking custodian banks to issue letters confirming they had run compliance checks on a funds. “When the rules were clarified, some banks pulled out of the market,” says one local LP. “Funds couldn’t be raised because no one would provide assurance. Others couldn’t meet capital calls, so they defaulted.”

AMAC registration – a precursor to raising capital – is also contingent on receiving a business license from the local Administration for Industry & Commerce (AIC). These have become more difficult to obtain as well. Fangda’s Tang notes that Shanghai and Shenzhen tightened up their due diligence processes at AIC level more than a year ago, and the likes of Ningbo and Jiaxing in Zhejiang province are following suit. This tallies with accounts from other industry participants who claim it is difficult to get a license without a state-owned enterprise as a sponsor or significant investor.

Private equity firms can always target government guidance funds as anchor LPs – and in the absence of other capital sources, government money is arguably more significant than ever before – but it isn’t to everyone’s taste. A guidance fund might agree to put up 20% of the corpus but insist that a similar or larger portion of the overall capital be deployed in its home province or sector. They have also been known to ask for stakes in the GP or investment committee participation. 

Even if such terms are palatable to the manager, the remaining 80% must be raised from commercially-driven LPs. Those investors might be resistant to the prospect of participating alongside a guidance fund with strategic interests that be at odds to their own. 

Exile from the asset class will not be permanent for China’s banks. It is suggested that they establish asset management units and make the entities independent to get around direct ownership restrictions. These units could issue wealth management products that make private investments directly or commit to funds raised by accredited investment firms. 

Another option is to strip out one of the layers from the now redundant three-layer structure. The trust would deploy the proceeds of the wealth management product directly into underlying assets rather than across an opaque selection of secondary products that make their own investments. 

Accentuate the positive

In the meantime, a case can be made for a slowdown in renminbi fundraising ultimately being to the industry’s benefit. Fewer funds means less competition for deals, and some managers claim they are already seeing an impact. “There is less money available and sellers are more motivated – entrepreneurs are willing to raise money at any cost,” says Vincent Huang, founder of local PE firm Juntong Capital. 

The caveat is that not all sectors will see downward pressure on valuations. For example, a lot of project funds were raised to pursue single investments in late-stage technology companies. A drop-off in demand for lower quality assets is reasonable, but there is still a lot of US dollar capital available for the leading players, most of which are still structured offshore.

The other positive to take out of the carnage is that, out of the 24,191 registered PE managers in China at the end of August and 70,000 fund products, only the better-quality GPs should prevail. “There was an overflow of GPs and of hot capital chasing opportunities,” says Starquest’s Fang. “The fundraising environment is now tougher, but whoever survives will have proved their longevity and institutional credentials.”

This is not the first time a vertiginous peak has become a confused trough in China’s renminbi fundraising space. A pre-IPO investment boom saw fund commitments rise from $7 billion in 2009 to $22.1 billion the following year and $37.1 billion the year after that. It ended when the government banned new share listings while efforts were made to clean up the system. The current correction, while not motivated by a liquidity crunch, could be seen in a similar context of market improvement. 

If China is to evolve in a similar way to more developed economies, fundraising will stabilize once large institutions with dedicated alternatives programs become more prevalent. Some industry participants claim to see early evidence of this as the existing pools of government and insurance money are joined by fund-of-funds – managing state capital but in a commercial manner – family offices, and endowments. 

It will take years for these changes to bed in, which means that HNWIs are likely to remain a disproportionally large part of the Chinese LP community compared to other markets, in part because currency controls mean these investors are restricted to the limited choice of financial products available on the domestic menu. But CDB Capital’s Wang notes that institutionalization could also be reflected by a change in attitude. 

“Until you have an investor base that is more rational, more professional and knowledgeable, we will see sharp peaks and troughs because retail investors tend to get sucked in through the cycle,” he says. “At the same time, these LPs are dealing with funds distribution middlemen that are not incentivized as long-term investors, which is why it’s a bit of a rollercoaster ride.”   

 

SIDEBAR: There and back again 

BabyTree, a Chinese parent-focused social networking and e-commerce platform, filed for a Hong Kong IPO in June – less than 12 months after engaging in a corporate restructuring intended to prepare the company for a future onshore rather than offshore. 

Between 2007 and 2014, BabyTree raised $40 million in venture funding from offshore investors like Matrix Partners China and SIG Asia. Following a decision to “pursue other financing opportunities in the PRC,” the company’s variable interest entity (VIE) structure, through which foreign investors get exposure to restricted industries, was removed, and the VC investors were bought out. In the meantime, several domestic players committed renminbi funding to BabyTree.

In February 2018, however, the company switched back to an offshore structure, signaling its intent to pursue an IPO overseas. A new VIE structure was put in place and existing investors in BabyTree’s onshore entities subscribed to shares offshore in a transaction worth RMB2.72 billion ($397 million) in May. Alibaba then paid RMB214 million for a 9.9% stake in the business.

BabyTree is not an isolated case. Dozens of Chinese start-ups restructured onshore with a view to tapping abundant pools of renminbi capital and pursuing local listings. There was also the hope that China would follow Hong Kong’s lead and allow pre-profit companies to list. This plan was nixed by the government. Having found liquidity lacking, start-ups are now moving offshore again. 

“Companies are flexible for subsequent rounds of funding – if renminbi isn’t available they switch the structure and take US dollars,” says Yiren Liu, a partner at Vision Plus Capital. “Some of our portfolio companies are opening up for US dollar investment.”

Even profitable businesses can’t be certain of market access due to increased scrutiny of listing candidates. Nine out of every 10 applicants for A-share listings won approval in the first quarter of 2017; the rate was down to just over four in 10 by the first quarter of 2018. There were 243 IPOs by private equity-backed companies on mainland bourses during the 12 months ended July 2017. For the subsequent 14 months, the total fell to 152, including just 42 since the start of the year. 

Over the same two periods, Chinese offerings in the US rose from three to 23, while Hong Kong has become more active as well – based on IPO filings, if not completed offerings. The clampdown in Shanghai and Shenzhen has also coincided with a downturn in the public markets as investor sentiment weakens. The Shanghai Composite Index is at its lowest level since late 2014.

“Founders want speed and certainty in fundraising and you get this in the renminbi market. When the market is competitive, founders will go for renminbi. If the renminbi dries up, they have the option of going back to US dollar funding,” adds Liu. “As the A-share market and the US market switch in terms of valuation, the funds will follow.”

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• Topics
• Greater China
• Renminbi fund
• Fundraising
• Regulation
• IPO
• China
• Renminbi
• China Development Bank
• LGT Capital Partners
• Vision Plus Capital