China secondaries: Curious conversions

Private equity exits in China have declined steadily over the past five years, gradually piling up a significant but glacially inert secondaries opportunity. Now an overlapping trend in fundraising appears set to crack the ice. 

After reaching a high of 227 in 2014, the number of exits fell to 104 last year; 2019 is set to be the worst year since 2008 with only 52 IPOs, public market divestments, and sales to strategic or financial players realized to September. This might create a target-rich environment for fund restructurings, but secondary investors have been deterred by China's complex currency exchange barriers and patchy reputation for quality among local GPs. 

New possibilities are emerging, however, as managers who made their name in the renminbi space seek to raise US dollar-denominated funds. According to AVCJ Research, 53 US dollar China funds achieved incremental or final closes in 2018, up 74% on the previous year. A further 33 have achieved this to date in 2019. On the renminbi side, the total slid from 396 in 2017 to 210 in 2018, with 140 so far this year. Several regulatory and macro factors are at play in this reversal, some pointing to a wider theme of international crosspollination.

As renminbi managers embrace US dollar funds, secondary restructurings that involve the transfer of overripe local-currency portfolios into US dollar vehicles are becoming a realistic option for the first time. HarbourVest Partners, for example, is contemplating just such a deal. If it comes together, it would see the firm roll over renminbi assets from one of its existing China relationships into a US dollar structure.

"Traditional secondaries with renminbi funds are almost impossible, so a lot of these funds need to be recut," says Tim Flower, a managing director at HarbourVest. "They also have to be big enough to make it worth the time and trouble of figuring out the currency and structural issues. In markets like China, there might be one successful investment that counts for the vast majority of a fund's value, so we're looking for deals with more diversification."

Investor expectations around quality and scope will be significant controls on restructurings of this nature. But these hesitations will be challenged by a growing sense that there is a paradox to reconcile in the increasingly prospective yet still gridlocked China secondaries market. 

Setting a template

A clutch of renminbi-to-US dollar deals are said to have been cut under the radar in recent months, but to date, only one has received industry-wide attention: Last year, NewQuest Capital Partners led a $390 million fund restructure for Loyal Valley Capital. 

The transaction saw NewQuest anchor Loyal Valley's first US dollar fund in part by acquiring and transferring over several prized renminbi assets, including ride-hailing app Didi Chuxing, video-sharing service Bilibili, and drug developer Junshi Biosciences. NewQuest brought in some of its LPs as co-investors, such as TR Capital and GIC Private, taking out positions held by a varied field of high net worth individuals (HNWI) and family offices. 

"Since we did the Loyal Valley deal, a lot of renminbi managers are more aware of this type of transaction and are asking about doing something similar," says Daizong Wang, a partner at NewQuest. "We always tell them, it's not easy. It's a totally different game on the US dollar side. In order to replicate that, you need a team that fits in the US dollar world and top-quality assets. The assets are the most important consideration."

NewQuest is working on a few more potential deals in the same vein but, as with HarbourVest, the complexity of it all means there are no guarantees. Transitioning from solely renminbi investing to a multicurrency mix is a challenge that many GPs fail to meet. Still, most of the industry participants that spoke to AVCJ pointed to renminbi fund restructures as a meaningful sign of things to come in the secondaries space, if not a runaway trend. 

"It's very replicable," says Carol Liu, a partner at Kirkland & Ellis. "I'm not only seeing a lot of deals from renminbi funds to US dollar funds for US dollar secondary buyers to buy offshore, I'm also seeing offshore secondary investors buying directly onshore. In addition, there are more GP-led transactions where a US dollar fund is restructured to another US dollar continuation fund. I'm working on five deals in this space right now, but the fundamental issue is that the assets have to be very attractive to the secondary buyers."

Meanwhile, the forces hampering secondaries on the renminbi front will continue to push deal flow toward new US dollar launches. Notably, in April of last year, the government issued regulations that imposed restrictions on which financial institutions could participate in PE and how they can raise capital for deployment in funds. This curbed renminbi fundraising – consequently prompting US dollar strategies – but also directly inhibited secondaries activity: financial institutions were barred from acquiring secondary interests.

As a result, local currency funds remain dependent on HNWIs as LPs, and these investors have proven skittish in the face of rising macro risks related to the trade war with the US. This has supported the US dollar restructuring outlook by further crippling renminbi fundraising prospects and weakening local IPO markets. 

When pitching a new fund to LPs on the US dollar side, the presence of several assets that have been transferred from an onshore portfolio can help because it removes some of the blind pool risk. This has prompted Eaton Partners, among others, to focus on seeded portfolios. While Chris Lerner, a partner with the placement agent, expects this to drive more renminbi-to-US dollar secondaries, he is cautious. "Each one has different constraints, and in some cases, they are nearly impossible to get done," he explains. 

Problem solving

Addressing case-by-case constraints in renminbi-to-US dollar restructuring plays will mostly revolve around quality, both in the underlying assets and the GP. At the portfolio level, potential roadblocks include the fact that secondary investors in China will mostly be approaching minority stakes, which are difficult to roll over from fund to fund without extensive, multi-party negotiations. 

The currency-changing aspect of these deals will also be varyingly problematic depending on the GP. Even those with significant experience in renminbi markets may be considered insufficiently sophisticated to manage longer-life funds under the stricter US dollar governance regime, especially if they were forced into the strategy by an eroding local LP base. But when the shift to US dollar in more premeditated, things get interesting.     

"It's true that renminbi fundraising has become more difficult, but we're less exposed to that because we have one of the largest evergreen funds in China denominated in renminbi," explains Linda Cai, a partner at Loyal Valley. "We wanted to raise a US dollar fund to diversify the LP base but also because Chinese companies considering listing on NASDAQ or Hong Kong were increasingly asking us for US dollars. If the best companies are being driven to US dollars, it becomes a disadvantage to only have renminbi."

The success of the Loyal Valley deal was also contingent on the positioning of the portfolio companies. Part of the US dollar plan was to facilitate an offshore IPO for a number of heavyweight investments. Bilibili and Junshi both went public last year, in the US and Hong Kong, respectively, while a listing by Didi – which has achieved a private valuation in excess of $50 billion – is much anticipated.

"Getting US dollar LPs to invest into a new fund in China is always about people, strategy and differentiation," Cai says. "You have to show your ability to invest companies that have 20 GPs knocking on their door as soon as the word is out that they're raising a round. You have to have access where very few investors have access."

The idea of chasing secondaries opportunities in buzzy companies could exacerbate familiar headaches around pricing, however. Investors in renminbi-to-US dollar restructurings will need to seek meaningful discounts to the prevailing valuations of hot companies, which may be tough to agree. These negotiations will be all the more difficult if the selling LP base features unwavering state-owned enterprises, which is likely.  

At the same time, there is the perennial secondaries tension of the related party transactions, where the same sponsor manages both the selling and acquiring vehicles. Friction on this point is not necessarily more difficult to manage in renminbi-to-US dollar deals, but there is a China factor. "Some renminbi fund documents may have never contemplated a conflict-of-interest transaction, so the sponsor may not have a proper channel or mechanism to deal with them," Kirkland's Liu explains. 

Managers that start out in the renminbi space and are known for game plans based on quick turnarounds and pre-IPO opportunism will also have to demonstrate competence in sustainable, long-term strategies when launching US dollar funds. But the internationalization implied by this approach must not distract too much from the domestic agenda, which is, in the end, the main draw from the perspective of foreign LPs. 

"If China-based managers want to roll over existing portfolios into new offshore funds, it will be all about valuation and investment thesis," says Alice Huang, a funds partner at Morgan Lewis. "The selling point to investing in US dollar funds raised by China-based managers is always going to be having a China angle because that's what those fund managers do best."

There is also the nagging question of the market's overall maturity. Industry participants with a global perspective typically estimate that there are only 15-20 renminbi GPs of investible quality, and that most of those already manage US dollar funds. For those entering the US dollar space with a view to rolling over existing portfolios, the concern is that the positions for sale are either too small or the manager is too passive. Early-movers in China secondaries are thought to have performed poorly due to a lack of focus on value-add. 

"If you look at the pitchbooks for these first-time US dollar funds in China, there are some half-baked strategies. A lot of them just want to have a new fund to continue their business, and they'll basically say anything about why they need a US dollar fund," says Dayi Sun, a managing partner at Jade Invest. "I believe many of the ones that are new and less institutionalized will be in big trouble when their US dollar fund terms approach the end. There will definitely be more supply of secondary opportunities when that happens."

A maturing market

Of course, there are other tools that will help build up outside participation in renminbi secondaries, ranging from straightforward red chip offshore listing structures to complex qualified foreign limited partner, or QFLP, programs. But Loyal Valley-style deals may yet prove one of the more feasible entries, even when dealing with GPs that are first-timers in the US dollar space. 

Shenzhen-based Maison Capital represents a valuable reminder on this point. The firm closed its first US dollar fund at $200 million last year with a view to investing growth-stage consumer companies across various lifestyle, technology, and services categories. And a number of existing portfolio companies could have hit the sweet spot for secondary buyers, including a rare global Chinese consumer play in the form of drone maker DJI. 

Maison did not raise its US dollar debut by rolling over this or any other assets, but its story does showcase the sometimes hidden potential for such a maneuver. The firm has quietly stepped in front of most of its peers in terms of long-horizon strategy and best-practice standards in areas such as environmental, safety and governance (ESG) compliance thanks to a leadership that has already worked with US dollar funds at separate organizations. 

Subtle but deep backgrounds of this nature suggest not only that many GPs have surprisingly sophisticated in-house capacities, but also that they could have more purposive motives for joining the US dollar market. They likewise imply that foreign secondary buyers looking to leverage the US dollar fundraising trend in China may, with a little digging, discover a more interesting shopping list of GPs to target.     

"Renminbi fund managers are aspiring to be more international players and grow in terms of their capabilities, and so is the case of us," says Roger Wu, a partner at Maison. "We want to manage larger pools of capital in both currencies to look at opportunities in nearby countries where Chinese companies are expanding to those markets. Our underlying focus on consumer industries will be very much the same."    

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• Topics
• Greater China
• Fundraising
• Exits
• Secondaries
• LPs
• GPs
• China
• RMB fund
• Renminbi
• HarbourVest Partners
• NewQuest Capital Partners
• Loyal Valley Capital
• Maison Capital