Foreign RMB funds at a crossroads

It was the missive that international private equity firms dreaded, but always half-expected. Despite years in the making, the rules governing foreign participation in local currency funds in China are still disturbingly gray, a shortfall generally blamed on poor regulatory coordination. Towards the end of April, the National Development and Reform Commission (NDRC) seized the initiative: In decreeing that one foreign-invested renminbi fund shouldn't qualify for local treatment, it appears to have damned them all.

Responding to a request from The Blackstone Group for clarification as to whether its local currency vehicle would be considered local for investment purposes, the NDRC answered in the negative. Crucially, the regulator's statement - not an official policy directive - cited Blackstone "and this type of situation where the GP is foreign-invested."

When the likes of Blackstone, The Carlyle Group and TPG Capital won the right to launch renminbi funds in 2009 they hoped it would present a means of circuiting the obstacles to foreign currency vehicles: regulatory bureaucracy that slows down transaction approvals and restrictions on target investment areas. These obstacles remain.

"A big part of the story when marketing these funds was that it makes you local, but it doesn't work anymore," says Maurice Hoo, a Hong Kong-based partner at Orrick. "A good number of market participants have always believed that it would be like this. When you have a gray area there are people who are more aggressive, while others are more conservative."

These sentiments are echoed by several other industry participants, whose assessments range from the cynical ("maybe it was just marketing talk anyway") to the sympathetic ("foreign GPs have this overly romanticized view of renminbi funds").

To ask or not to ask?

Opinion is divided, however, as to Blackstone's culpability in the matter. Following the introduction of the Qualified Foreign Limited Partnership (QFLP) program, which allows foreign capital to be channeled into renminbi vehicles, Shanghai added a twist of its own. These funds would be able to operate on an equal footing with local players if less than 5% of the total corpus came from overseas.

One view is that Blackstone was pushing Shanghai to get the pilot program approved nationwide, but pushed too far. The other is that prospective LPs said they would only invest if the private equity firm could guarantee its domestic treatment would extend beyond Shanghai. Blackstone had little choice but to seek clarification.
"They knew Shanghai would have to pass up the inquiry to national level but if you want to do that, you should have already approached senior government officials," one China-focused GP tells AVCJ. "Once something is on paper it becomes very difficult to overturn."

The China Private Equity and Venture Capital Association (CVCA) has initiated lobbying efforts with the NDRC and the Ministry of Commerce (MofCom), but it is uncertain how much impact this will have. According to Vincent Huang, a partner at Pantheon who helped set up the Limited Partners Association of China (LPACN), regulators at central level have never said that treating foreign-invested funds as local entities was feasible.

A key issue is the fact that the capital, no matter where it comes from, is ultimately controlled by managers who carry foreign passports and therefore dont have legitimate local income to make GP contributions in renminbi. It has been suggested that PE firms should appoint senior executives to run these funds who hold Chinese passports but there are very few of them.

The likes of IDG Ventures and Sequoia Capital have created renminbi vehicles by eschewing the joint venture approach and setting up onshore Chinese companies, owned by local partners, to act as the GP. It is unclear exactly how this approach passes muster with the regulators, but it is unlikely to be replicated by the big foreign players. "They might not be comfortable setting up special companies because, although there are contractual agreements, there is less protection," says York Chen, founding partner at ID Techventures. "That is the compromise you have to make in China."

Pantheon's Huang adds the LPACN is lobbying for an alternative solution - loosely described as the QFLP program expanded nationwide - that would potentially allow foreign LPs invest directly in local funds without changing the nature of these funds. It will not happen unless there is high-level political support.

In the meantime, Orrick's Hoo argues that the NDRC's clarification will impact fundraising for renminbi vehicles launched by foreign PE firms as joint ventures with local governments.

Blackstone reached a first close on its Shanghai-based RMB5 billion ($790 million) renminbi fund last April while Carlyle neared the halfway mark on its own similar-sized vehicle one year earlier, with both funds securing the bulk of their commitments from local government-related entities. This February, TPG announced it had received RMB4 billion across two renminbi funds, each worth RMB5 billion. Fundraising has been much slower than the foreign private equity firms would have liked - a result of intense competition from local players that are perceived to have better deal access and a shallow domestic LP pool.

"There is a serious question as to whether some of these funds that have been launched or announced will ever close," says Hoo. "The funds with a major brand are likely to be better positioned and so what we might see is the emergence of tiers among the foreign funds."

At the heart of this theory is the idea that, while damaged, the investment story hasn't been destroyed. Even though foreign-backed funds may not be able to commit capital with the pace and certainty they might have liked, they retain some selling points. Certain sectors remain off limits, but assets in areas such as natural resources and broadcast media are barely realistic targets for fully domestic funds, let alone foreign-invested entities. Similarly, large-scale control transactions, in the rare event that they might be available in China, would face regulatory hurdles even under the Shanghai model.

From the perspective of a potential portfolio company, the benefits of getting immediate access to capital - often at massive valuations - must be balanced against those of taking investment from a high-quality player that may also have strong local government backing. The brand value of a Blackstone or a Morgan Stanley, which suggests access to global expertise and connections, isn't necessarily diminished by the NDRC's clarification.

These funds still have the edge over US dollar-denominated in vehicles, which must go through foreign exchange controls when investing in China.
In this respect, there is much to be said for foreign private equity firms establishing a presence in the renminbi space with a view to developing local knowledge that complements global practices. While initial forays into the market were in part driven by competitive pressure, a few years from now it might look like more than a marketing exercise.

"Without a renminbi fund, you don't have an onshore track record, and this makes it harder to convince people you have the capability to operate here," says Pantheon's Huang.

Mixed blessings

In the short term, though, renminbi funds of all stripes threaten to flatter to deceive. In 2011, local currency funds attracted more than $24 billion, twice the figure achieved by US dollar funds, while total renminbi-denominated investment topped US dollar figure for the first time. It has created a market in which valuations are propelled upwards and returns downward and there have already been defaults in the local LP base as investors become disillusioned. Ultimately, there won't be enough capital to support the several thousand local currency funds that have sprung up in recent years.

A number of successful renminbi managers are now looking to raise US dollar vehicles in order to tap the more reliable global LP community. Sources with links to MofCom tell AVCJ that a string of new incentives is being lined up for US dollar funds.

At the same time, there are reports of regulatory conflict. Power grabs are inevitable once an industry reaches a certain size and significance and, in this case, the NDRC is seeking to consolidate its position of command in the face of arguments that China should follow global practice and appoint the securities regulator as private equity's watchdog. No one expects these issues to be resolved until well after China's fifth-generation leadership is fully installed in early 2013.

Until then, the industry is likely to remain a work in progress, with a few more clarifications and no official policies. Foreign-invested funds are now in a slightly less gray area than before, but PE in China still lacks clear guidelines and the basic legal and practical infrastructure required to facilitate long-term development.

"We have raised about 20 funds and I've never had to get into as much detail as I did with the renminbi fund," says Yichen Zhang, CEO of CITIC Capital. "We had to register with the NDRC and with the Tianjin authorities for taxation and licensing, and then we had to arrange custodian banks. We did a capital call and the manager of CITIC Bank in Tianjin had to phone me up and confirm it."

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• Topics
• Renminbi fund
• Greater China
• Investments
• Fund formation
• Renminbi
• China