Ownership issues trouble state-backed PE firms

To most investors, the prospect of handing the government shares in a portfolio company for free as it prepares to go public and realize a cash windfall is inconceivable, let alone unappetizing. But this is the reality facing state-backed Chinese private equity firms as a result of a policy decision taken three years ago to enrich the National Social Security Fund (NSSF).

In June 2009, the government decreed that any company with an element of state ownership must transfer to the national pension fund shares equivalent to 10% of those being sold through an IPO on the domestic bourses. Aside from adding to the NSSF's coffers, the mechanism is seen as having a stabilizing effect on the capital markets because the pension fund is seen as a long-term investor.

For state-owned private equity firms that invest in such companies, the mandatory share transfer inevitably eats into returns. Qingdao Laoshan Venture Capital found out the hard way several months after the rule was introduced.

The VC firm bought 3.3 million shares in Qingdao-based power equipment manufacturer TGood. It paid RMB5.30 per share for a total outlay of RMB17.6 million and owned 4.62% of the company. Four months later, in October 2011, TGood announced that it would go public through the sale of 35 million shares. As the only state-linked entity on the investor roster, Qingdao Laoshan reportedly had to hand over its entire stake to the NSSF, receiving nothing in return. The Shenzhen-listed stock is now trading at around RMB14 per share.

"State-owned PE and VC funds are suffering," says James Wang, a partner at Han Kun Law Offices. "They have been saying the law is not fair and needs to be changed."

Collateral damage
The law doesn't target the private equity industry specifically, but is designed to ensure that the state can participate in windfalls from the sale of state-owned assets. While Qingdao Laoshan's interest might not be significant to a pension fund worth around RMB1 trillion, similar regulations governing state-owned enterprise (SOE) IPOs have allowed it to take a sizeable chunk of Agricultural Bank of China's $22 billion offering, among others.

Nevertheless, the interpretation of the rule as it regards private equity, specifically determining the state-owned shareholder status in limited partnerships, remains unclear. "If I were an SOE, it would be a lot easier because I would understand that I had to hand in a certain number of shares to the NSSF from my investment," says Frank Han, executive director of Bohai Industrial Investment Fund Management. "For funds, it becomes much more complicated."

Wang, who heads up Han Kun's fund formation group, agrees that the definition is less than clear. However, based on his understanding, a fund with more than 50% capital from state-owned investors is likely to be deemed a state-owned shareholder, and therefore subject to the mandatory transfer.

Further legislation, which has yet to be fully explained, outlines the transfer process. Funds considered to be state-owned shareholders are required to hand over shares to the NSSF on behalf of all LPs, while state-owned LPs within the funds should agree compensation with the remaining LPs through a transfer of shares.

The problem is whether such compensation should take place at the issue price or the market price. If the former, it could be unfair to non-state-owned LPs as they are supposed to capture returns at the market price, which is often higher, at time of IPO. Xiaohu Ma, a partner in Morrison & Foerster's Hong Kong office, says this arrangement could lead to conflict between LPs. He suggests that state-owned investors might instead come to financial agreements independently of the fund, perhaps by handing over a share of their profits from the fund to the National Treasury.

The regulation also raises concerns among GPS, some of whom are trying to keep their state-owned investor ratio below 50% to avoid being caught by the rule.

"A $100 million fund, with an investment period of 5-6 years, pays a 2% annual fee, or $2 million, to the GP. But after a share transfer to the NSSF, the base on which the management fee is charged shrinks," says Han Kun's Wang. "It is the same logic for carried interest, because you are not going to receive any carry from NSSF unless you have a proper compensation mechanism."

Reducing exposure
According to the National Development and Reform Commission, state-owned sources contributed 61.2% of total paid-in capital in the domestic venture capital industry in 2010. Although still dominant, the state-owned share has declined significantly in recent years, having stood at 68.5% in 2009 and 81.8% in 2006.

Notably, Shenzhen Capital Group (SCG), one of China's leading state-controlled venture capital firms, has sold stakes in its management unit to three private enterprises in recent years. Xinhe, a Chinese private-owned real estate agency, is now said to be SCG's second-largest shareholder with a 16.1% interest.

"It is logical and that some private equity firms turn away state-owned capital in order to keep their state-owned investor ratios below 50%," Bohai's Han points out. "But it is not a very big concern so far, because funds can still learn a lot of money via IPO deals with over 10x return."

While admitting that the 50% threshold is an issue, Vincent Huang, a partner at Pantheon, stresses that quality of capital is still the primary consideration. Few GPs would turn away a blue chip investor like the NSSF.

He adds that private money, particularly from high net worth individuals, has been drying up as exit multiples dwindle in Shenzhen and the pre-IPO bubble deflates. Several sources tell AVCJ that renminbi funds have seen a spate of defaults as non-institutional investors realize they no longer have a surfeit of capital and want out of their long-term commitments.

In this environment, it is critical that local governments continue to invest in funds. Huang says that some players remain very active and he expects this appetite to stay in place for the foreseeable future.

Stick or twist?
The GP response to these risks is mixed. John Zhao, CEO of Hony Capital, tells AVCJ that the regulation has little impact on private equity firms, while others have taken steps to remain within the 50% comfort zone.

According to anecdotal evidence, some state-owned PE firms have tried to bypass the rule by setting up vehicles similar to fund-of-funds. By creating subsidiary funds and investing state-owned capital into that vehicle, which then pursues pre-IPO deals, the PE firms hope their other operations go overlooked by the regulators.

"A company that gets 60% of its capital from the state can manipulate the numbers by creating two funds - one fund below the 50% threshold and the other above it," a person familiar with the matter tells AVCJ. "I don't know if it's happening but I know some funds are talking about strategies like that."

At the same time, the Chinese government hasn't simply turned a blind eye to the discontent emanating from the private equity community. In October 2010, it has exempted mandatory transfers for investments in small- and medium-sized venture capital enterprises with fewer than 500 employees and annual turnover and total assets of no more than RMB200 million.

"They have acted correctly by exempting venture capital because investing in small- and medium-sized companies is exactly what the country wants to do," says Bohai's Han. "They didn't exempt the PE firms because some of them are guys who only know how to speculate through IPOs."

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• Topics
• Greater China
• Investments
• China
• regulation
• Shenzhen Capital Group