Niche funds: Finding an angle

Three years ago, Yunnan Hongfu Venture Capital, the first independent VC firm in southwest China's Yunnan province, launched its debut fund. The target: funeral services. 

Expecting to see a wealth of investment opportunities following a local government pledge to improve funeral services quality, Yunnan Hongfu hope to reach a RMB$200 ($32.7 million) first close within 182 days. It would then invest in 40 small to medium-size funeral parlors and graveyards over the next three years.

After 160 days in the market, the VC firm scrapped its fundraising plan for lack of interested LPs.

Yunnan Hongfu's aborted vehicle would qualify as a niche fund, albeit an extreme example of one in the context of Chinese private equity. These funds usually focus on particular sub-segments of the healthcare, consumer and financial service sectors. Technology also comes into it. While IDG Capital Partners' broad China tech vehicles couldn't be described as niche, the mobile internet-focused "mFund" it set up with Hong Kong-listed gaming developer NetDragon Websoft probably could.

There has been a proliferation of specialist funds in China over the last 2-3 years, certainly compared to other parts of Asia, according to industry participants. This is essentially a function of the difficult fundraising environment.

Only $4.8 billion in capital entered renminbi-denominated funds in the first half of 2013, down from $15 billion in the same period one year ago. The situation has also been fraught on the US dollar side, with $1.8 billion committed between January and June of 2013, extending a general downward trend that dates back to 2011.

While many GPs are also struggling in other parts of Asia, China's problems are exacerbated by IPO uncertainty. Once the source of almost guaranteed stellar returns, the public markets are currently closed to new issues and even when they re-open the queue will be long and exit valuations are likely to be a shadow of their former selves. Fund managers must therefore offer more to investors than just a multiples arbitrage strategy.

A niche approach could help a manager stand out from the crowd.

"Niche players are trying to differentiate themselves from generalist funds," says Frank Han, executive director at Bohai Industrial Investment Fund Management. "Smaller size fund houses lack the resources to source deals in every single industry. It is easier for them to market funds designated to a specific investment area. How these niche strategies perform and whether they appeal to investors remains to be seen."

Emphasis on expertise

Needless to say, a niche strategy is pointless if not backed up by genuine operational experience and deal access in a particular segment that convinces investors of a competitive advantage.

Real estate makes for an interesting example. Specialization takes many forms: residential property in a specific geography, a focus on hospitality, and even strategies devoted entirely to car parks. China Resources Capital (CR Capital), the financial services arm of state-owned China Resources Group, has established itself as an early market leader in the latter segment. Hong Kong-based Limetree Capital has since followed suit, launching its own fund aimed at addressing the country's lack of parking spaces.

CR Capital started principal investment in 2008 with capital from its parent company. It formed a specialist team responsible for deal sourcing, as well as developing and managing car parking space in several Chinese cities, including Chengdu, Chongqing, Tianjin, Shenyang, and Nanjing.

"Originally we didn't have the opportunity to acquire these kinds of businesses, given it is quite new in China - there were little or no investors or developers just a few years ago. So we sourced deals mainly from local governments, and then we constructed the car park buildings, which were managed and operated by our team," says Derek Cheng, managing director at CR Capital.

Earlier this year, CR Capital partnered with Dutch pension fund asset manager APG to establish a $265 million car parking vehicle, known as the China Resources Urban Car Park Investment Partnership. Other strategic investors include Macquarie Capital and Asia Pacific's leading car park manager and operator Wilson Parking Hong Kong.

Certain seed assets, including a few thousands car parking berths developed by CR Capital, will be injected in the vehicle. After that it will source additional deals from the market. Returns will come in the form of parking fees and land appreciation.

For their part, industry specialist Wilson Parking and APG - which has previous exposure to car parking assets in Europe and the US - will be expected to contribute knowledge and expertise that supports the management of these assets in China.

Cheng hints the firm will continue exploring niche strategies in this sector, with senior housing and student accommodation among the potential targets. "There are companies investing in senior housing now, but their business model hasn't been well-developed. Investors need time to explore how to make a profit out of this kind of investment in China. There is high demand for emerging quasi real estate assets," he says.

The consumer sector has also emerged as a popular specialist play. L Capital Asia is arguably the poster child in this space, having reached a first close earlier this month on its second regional fund at the institutional hard cap of $950 million. The invest in the same areas as its predecessor: consumer products, including fashion, leather goods and jewelry; beauty and wellness; lifestyle and food and beverage; and select retail and distribution assets.

If L Capital is best described as a sector-focused GP, China Telescope Investments certainly has a niche feel. The Telescope Consumer Growth Fund I, which is co-managed by SAIF Partners, targets retail and chain stores.

This strategy - investing in a single business model across the consumer sector - is rooted in the founder's experience, with Yucun Du's family having previously run Chinese hypermarket chain Home World Group. Strategic investors in the fund include other chain store entrepreneurs who can advise portfolio companies.

Local government agendas

In the US dollar-denominated fund universe, vehicles are specialist rather than niche, often with a focus on healthcare, cleantech, biotech and energy. Most truly niche offerings exist in the renminbi space and many are formed for reasons that go beyond providing LPs with a differentiation story.

There are two primary factors. First, opportunities created by larger enterprises wanting to spin-out business units under independent funds, classified as market-oriented vehicles driven by investment returns. Second, piggybacking on local government policies and winning state backing for funds managed by professionals who claim to have operational experience in niche areas.

"Some GPs set up specialized funds simply because a local government wants to promote a specific industry. We see this as a marketing strategy for raising capital," says Dayi Sun, managing director at fund-of-funds Jade Invest.

China is awash with specialist industrial funds targeting everything from financial services to culture and media.

In July, China Bright Stone Investment partnered with the Guizhou provincial government to launch the country's first tourism-focused fund, targeting up to RMB30 billion. The vehicle, Wuling Mountains travel industry investment fund, will mainly invest in Guizhou's Wuling Mountains tourism areas. Commitments are being sought from state-owned banks, the National Council for Social Security Fund, insurers and listed companies.

China Fortune Link Fund Management, meanwhile, has rolled out a RMB100 million ($16.3 million) venture capital fund to invest in Qinghai, a province located in China's far northwest. It wants to partner with the local government to launch VC funds that support potential start-ups in the region.

Industry participants are skeptical as to whether Fortune will keep its promises to invest in Qinghai, with some suggesting the fund is just an excuse to win subsidies from the local government but invest in more developed regions that are richer in opportunities. Questions are also asked of Bright Stone, and whether it will really help boost Guizhou tourism industries. Similar vehicles have been used by PE players to win approval for land acquisitions and real estate developments.

The Shanghai Financial Fund, managed by GP Capital, was the largest renminbi fund raised in 2011, reaching a $2.9 billion first close. However, market sources say only half of this capital was actually invested in the financial sector.

Sun says he examines specialist funds closely before commiting, noting that they haven't necessarily outperformed generalist vehicles.

"There are certain criteria to evaluate an industrial fund performance," he adds. "Firstly, do the investment managers have the relevant industry expertise and will they deploy capital in these particular areas? Secondly, are they able to raise capital from institutional investors rather than through local government subsidies? We are more convinced it is a sustainable business model if they are able to do this."

The demand side

Niche funds comer with a high concentration of risk, while a generalist fund offers investors more exposure to different regions and industries. Niche managers therefore tend to be selling a particular theme or story, and the chances of an LP buying into largely depend on that investor's origins and criteria. A North American LP with broad exposure to Asia, for example, might be unwilling to take the strategic risk.

"US endowments may only allocate to 1-2 funds in Asia each year. They will often opt for generalist funds to provide them with more diversification and gain broader exposure," says Vincent Ng, a partner at Atlantic-Pacific Capital. "However, it also depends on whether or not the investor has had a longer and more developed program in China and Asia as a whole. Niche fund strategies might be part of efforts to increase and deepen exposure in Asia."

The appeal of CR Capital's car parking vehicle to APG might have been the nature of its returns - these are real assets that generate stable cash yields. High net worth individuals and family offices, meanwhile, may be drawn to more alternative strategies like wine and art funds.

However, Ng's view is that most overseas institutional investors still view specialist blind pool equities funds as too niche for their liking. It is therefore hard to see some of these managers being able to scale to a very large size.

Enrique Cuan, managing partner at placement agent Mercury Capital Advisors, echoes these sentiments, noting that while an LP in the US or Europe may have the flexibility to invest in a financial services, healthcare, or energy fund in its home market, appetite for these sectors in Asia is still nascent.

Some niche strategies will prove sustainable - either as fully independent US dollar vehicles or renminbi funds that develop a following beyond local governments offering subsidies - and appetite for the asset class may pick up in other parts of Asia as exposure to the region grows. For now, though, the vast majority of LPs are still quite conservative.

"There is a lot of talk about frontier markets, sector funds, and new asset classes but the reality is that 80% of the capital invested in Asia is concentrated in about 20 funds," Cuan adds.

 

SIDEBAR: Niche exits, who's buying?

The basic premise of a niche fund is that a manager with experience and expertise in a particular segment can identify and cultivate a highly concentrated but lucrative set of investments. Does this mean the exit pipeline is similarly narrow?

The answer depends on the nature of the assets. Funds focusing areas such as art and wine have little option but to sell through an auction process. Where the investment targets are companies, however, the standard exit routes of public listings and trade sales apply.

For example, China Bright Stone Investment, which has partnered with the Guizhou provincial government to launch a tourism fund, is expected to invest in a basket of tourism-related companies. Exits might come through sales to entities tied to the niche fund's government backer.

In July, IDG Capital Partners exited travel agency Tongxiang Wuzhen Tourism Development to the investee's parent company, CYTS Tours Holding, for $67.5 million. The initial investment, in 2009, was encouraged by the local government as a means of promoting the tourism industry.

For real assets, exits could also be made to institutional investors looking for stable cash yields. China Resources Capital (CR Capital), which has established a $265 million car parking vehicle, known as China Resources Urban Car Park Investment Partnership, sees domestic insurers as potential buyers. According to Derek Cheng, managing director at CR Capital, several leading insurance companies in Shanghai have already expressed an interest.

"Traditional private equity real estate funds cannot fully digest their investment capital. They are facing investment pressure and to some extent they are prohibited from investing in the residential development market," he says. "So they are looking to real assets such as infrastructure. Car parking is also another type of asset class they can invest in."

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• Topics
• Consumer
• Greater China
• GPs
• Funds
• China
• Fundraising
• Exit
• Consumer