RMB fund-of-funds: Patience is a virtue
As some global fund-of-funds struggle to raise funds, their renminbi counterparts are struggling to find a purpose – government-backed vehicles excepted. A more mature LP base should bring more demand
The fund-of-funds industry globally is in a state of flux. In the first six months of the year, $162 billion was raised by private equity funds reaching a final close; of that, only $6.4 billion went to fund-of-funds vehicles, according to data provider Preqin.
It continues a trend that has seen their share of total capital fall from 11% in 2009 to 7% in 2011, and now 4% for 2013 to date.
China, however, appears to be bucking this trend. Guochuang Kaiyuan Private Equity Fund became the largest fund-of-funds to close worldwide in the first half when it announced a bumper RMB15 billion ($2.4 billion) fundraise in February. This was more than double the size of the second-placed vehicle - Porfolio Advisors' $1.09 billion Private Equity Fund VII.
There is a caveat: Guochuang Kaiyuan is a government-backed fund with a policy-driven mandate.
This begs two questions. First, assuming China is not immune to the difficulties encountered by global fund-of-funds, what does the fallout mean for local managers? Second, does the proliferation of vehicles of Guochuang Kaiyuan's nature mean the independent model is unsustainable in China?
"US dollar-denominated fund-of-funds consolidation won't impact China much, as most of global funds don't consider China as a main part of their asset allocations. They invest when the market is peaking and then shift their geographic focus when there is a down trend," says Dayi Sun, management director at China-focused Jade Invest, which runs US dollar fund-of-funds.
Renminbi fund-of-funds, meanwhile, have yet to emerge as a visible investment segment. There are only about 20 in existence and they are struggling to find backers. Commitments to standard funds fell from $15 billion in the first half of 2012 to $4.8 billion in the first half of 2013. If there is little appetite for the asset class in general, there will be scarce demand for fund-of-funds products.
Immature demand
Global fund-of-funds are usually driven by two kinds of demand. First, large institutional investors hire them to cover small-cap or specialized managers for areas in which they don't have in-house expertise. Second, individual investors, who either lack the professional knowledge to invest or can't meet GPs' minimum capital requirement, rely on fund-of-funds to help them get access to top-tier managers.
In China, large institutional investors, such as insurers and corporates, are either unable or unwilling to invest in fund-of-funds. Insurers tend to be among the unwilling. They won approval to invest in domestic private equity three years ago and are proceeding slowly - in part due to strict regulation - and by themselves.
"As we understand it, many Chinese insurers want to build their own fund management teams instead of outsourcing investment activity," says Zhang Xuan, counsel at O'Melveny & Myers. "They are not really interested in investing in fund-of-funds given the extra layer of fees compared to investing directly into funds."
Some have deigned to participate in the Guochuang Kaiyuan fund-of-funds, but that is largely due to the vehicle's government credentials. It is part of the joint venture between China Development Bank (CDB) and Suzhou-based Oriza Holdings, with CDB Capital acting as the GP. The National Council for Social Security Fund (NSSF), China Life and China Reinsurance are among the LPs.
According to industry sources, most of Guochuang Kaiyuan's capital comes from CDB's borrowers.
"The Suzhou government also requested local enterprises to invest in the vehicle as part of efforts to support local economic development," one fund-of-funds manager says. "Therefore, we don't see Guochuang Kaiyuan's sizeable capital commitments are evidence of particular demand for a fund-of-funds strategy to mitigate their investment risk."
AVCJ Research has records of 74 renminbi fund-of-funds being raised in China in the last 14 years, over half of them between 2009 and 2011. Of the top 10 vehicles by value, nine are government-backed. The sole independent - Noah Holdings' Jingzhao Fund - was raised from high net worth individuals (HNWIs).
"Local governments would like to inject capital to set up fund-of-funds in order to support growth in their regions, as they lack of capability - in terms of investment experiences and expertise - to make direct investments in local projects on their own," says Frank Han, executive director of Bohai Industrial Investment Fund Management.
Given these government guidance funds tend to be driven by incentives encouraging private equity firms to bring their capital and expertise to a particular geography, it is no surprise to learn that they don't prioritize financial returns. In some cases, these vehicles fade away because their government backers have run out of money.
For government-linked fund-of-funds to achieve long-term sustainability, they should be market-oriented and independently run, says Chun Zeng, a partner at Gopher Asset Management, the private equity arm of New York-listed Noah Holdings.
Gopher Asset Management started a fund-of-funds business three years ago, leveraging parent company Noah's HNWI network. This network was cultivated through the firm's placement agent business, which distributes fixed income products and private equity funds. It has assisted the likes of CDH Investments, Sequoia Capital and SAIF Partners in their fundraising efforts.
With domestic private equity firms facing a period of painful consolidation due to the challenging fundraising environment, Gopher sees opportunities arising in the secondaries market. PE players that want to tap investors for new funds must return capital - a bridge too far for managers that invested with a view to an IPO exit but now find the public markets closed.
In May, Gopher reached a first close of RMB500 million on its debut secondaries fund.
The firm also plans to enter the US dollar fund space, following managers that made their names with renminbi vehicles and now want to target more sophisticated offshore investors. Several years down the line, these managers are also likely to start pursuing cross-border transactions.
"Later when local GPs are familiar with overseas markets, we will allocate assets to invest in managers operating overseas," Zeng adds. "We foresee enormous change for China's PE industry, including fund managers focusing more on early-stage investments rather than pre-IPO deals, different exit routes and increased specialization. We want to have the flexibility to launch new products in line with these changes."
Two's company
Partnering with foreign fund-of-funds is another way for renminbi managers to get more exposure to global markets. In April, Swiss-based Capital Dynamics joined forces with China-focused Diligence Capital, agreeing to adopt its partner's name when conducting activities relating to China, while Diligence Capital operates under the English brand name Capital Dynamics China.
"We have established a very tight cooperative arrangement and we definitely plan to offer our clients - whether Chinese or international - a fully integrated investment solution. It should be to the degree that people know there are two separate corporate entities, but with one product in the future," Thomas Kubr, Capital Dynamics' executive chairman, told AVCJ earlier this year.
Other industry players are concerned that such strategic partnerships won't last long, citing a misalignment of interests. While Capital Dynamics chose a local partner to access the Chinese market, Diligence Capital's objective is to raise US dollar funds. What happens to this dual currency cooperation as the renminbi moves towards convertibility remains to be seen.
"In 2-3 years, the current model of US dollar funds will disappear. The renminbi will become an international currency - more transferrable, exchangeable and liquid - so there will be no need to have renminbi and US dollar vehicles running in a parallel," says Bruno Raschle, executive chairman of Adveq Group.
This evolution is expected to coincide with a maturing of China's LP base, which may ultimately provide succor to the renminbi fund-of-funds. For now, those that are able to outsource their investments don't want to, but the institutional participants in PE should be very different in several years compared to today.
Some LPs might adopt a passive approach because they don't have the resources to engage with managers directly; others may simply appreciate the diversification fund-of-funds bring to their investment exposure.
"For example, we expect Chinese insurers' appetite for fund-of-funds to increase as they realize the advantages it brings in risk mitigation, and after they have tried to make investments themselves," Jade Invest's Sun says.
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