China winning out?

Yet whether positive or negative tendencies ultimately gain the upper hand, the fact remains that China is perhaps the key driver of worldwide recovery from the GFC, transmitting its stimulus to other countries across the region and beyond.

Macro momentum

China's full-year GDP growth for 2010 is likely to be 10.5% according to the International Monetary Fund, falling to 9.9% in 2011. It is worth remembering that, even as it moderates, China's GDP growth is still more than three times that of the US, which saw 2.5% this year. Carlyle Group co-founder and MD David Rubenstein recently said publicly that, if he was 25 years old, he would study Mandarin and move to China. Carlyle, Blackstone and TPG – the world's largest and most iconic PE firms – have all queued up, with regional offices in China and dedicated investment vehicles in both US dollars and Renminbi. But does the formation of RMB-denominated funds, in cooperation with central and local government, mean that foreign private equity players are welcome in China?

China certainly needs foreign PE players who have state-of-the-art systems, industry best practice and other domain knowledge that they can apply to their activities in China. But China also simply needs their capital to help boost the size of the PE sector, with penetration still low compared to the overall size of the economy.

The central government has indeed welcomed some foreign PE players, but on a clear understanding that they will be steered towards the country's growing enterprises most in need of support and development. They will also be carefully watched and monitored. Nearly every PE player says that they are looking at the China market, but some domestic GPs say that China does not need more offshore money, because domestically there is already plenty of cash in hand. And China has foreign capital to spare – with foreign reserves of over $2 trillion.

Ugly Americans

A significant group of GPs, both local and international, do maintain that China needs to continue importing more foreign capital to boost future economic growth, despite its present surplus.

Derek Sulger, Partner at Lunar Capital Management, notes, "China's PE market is still very small compared to the size of its GDP. China needs more capital, both domestic and international, to fuel its current rate of economic growth."

While some GPs have noted that LPs are worried about the ballooning size of China funds, Sulger says that in aggregate, private equity penetration remains low enough to warrant larger funds and a larger private equity community overall in the future. "Any country with a closed currency system needs continued FDI to offset its fixed currency regime. Part of the reason the Chinese government has encouraged PE in China has been to develop a better understanding of what is the right price for getting a return from an investment."

Many market observers concur that there is no ultimate benchmark for valuations in China, especially in the private sector.

Land of the rising RMB

With the US and other countries putting pressure on China to let the RMB appreciate, the People's Bank of China earlier said publicly that China would gradually increase the flexibility of its exchange rate range – this after months of rhetoric in which top leaders had stressed that a stable yuan was essential to the country's economic health, and that China would not be bullied into ending a nearly two-year-old peg to the dollar.

For investors, RMB appreciation will strongly affect their investment activities in China, particularly for offshore funds. So how are these currency-related tensions likely to play out in 2011?

Thomas Chou,  partner and co-chair of Morrison & Foerster's Asia private equity group, remarks, "For most  private equity and venture capital investors in China, RMB appreciation is not a material driver of investment decisions, but the gradual appreciation and convertibility of the RMB against the USD appears to be implied for many GPs considering potential IRR on their investments. On the other hand, for USD-denominated funds with reserves of committed capital, the appreciation of the RMB will dilute the eventual investment power of their USD commitments, while valuations and working capital needs of their portfolio companies remain expressed in RMB."

As a GP already investing in China, Sulger agrees that continued RMB appreciation will bring challenges, and may boost returns. "People are looking at the positive side, but RMB appreciation will also increase the cost of capital in the future." He also warns that costs of PRC exports may rise in global markets, and that foreign capital may be able to do less in Chinese enterprises, especially given these businesses are already seen as expensive.

LPs' growing appetites

One striking and often-observed phenomenon is the plethora of new local LPs, cashed up with RMB, investing into local private equity firms that are emerging every week. Government policies with regards to foreign investment are also helping the Chinese PE market to grow. Initiatives such as the foreign investment partnership regulations introduced in December 2009, tax incentives, and the possibility of securing domestic LP investment, have all helped to continue to attract interest from international PE houses.

Some at least of the new-generation PRC LPs appear to be of reasonable quality. Mark Qiu, CEO and MD of China Renaissance Capital Investment, points out, "we see many sophisticated new LPs emerging, the latest being insurance companies."

David Xu, Head of Private Equity with the Transaction Services department of KPMG China, confirms that, "recent legislation has been passed in China to allow for more sophisticated LPs to emerge. The most significant is that insurance companies are permitted to invest up to 5% of their assets in PE. According to the estimated insurance fund size of RMB4.52 trillion [$676 billion] at the end of June 2010, as much as RMB226 billion [$33.8 billion] in funds will be allowed to enter China's PE market – a massive amount of capital."

Douglas Ferguson, Partner, Transaction Services, KPMG China, says, "The growth of the domestic fund sector has been the hot topic in recent years and shows no sign of abating. For various reasons including speed of regulatory approval and therefore deal execution, RMB funds are attractive."

Also on the rise are RMB-denominated funds being formed by regional governments (sometimes allied with local enterprises), often one after another. However, neither GPs nor their supporting LPs appear to have much experience in private equity at all, but appear to be aiming to promote local businesses through PE strategies. Johannes Schoeter, Founding Partner at China New Enterprise Investment remarks, "Many RMB funds do not understand risks and are undisciplined in due diligence, often paying high prices for targets."

He adds of his own experience, "We have never received money from regional funds, despite numerous offers from them." There are both advantages and disadvantages to working with local government, in his view. "Local governments do not understand PE well; nor do they know what PE investors are looking for. But they will have certain rights through their position in co-investing or co-managing the fund, if we work together."

While there has been much progress in the regulatory landscape for RMB funds in 2010, there are still many issues that need to be resolved before the industry can truly flourish, emphasizes Chou. Structurally, these include having the so-called QFLP [Qualified Foreign Limited Partner] program in place to permit foreign LPs to convert USD into RMB, not least in light of the State Administration of Foreign Exchange (SAFE)'s desire to curb hot money inflows. Also needed is a consistent approval process for foreign managers in the establishment of RMB funds, and measures allowing foreign-invested RMB funds ‘national' treatment, to leave them free to make investments in industries traditionally kept off limits for FDI. Finally, China needs to see continuing evolution of its broader capital markets.

China as the world's biggest PE market?

Despite the many areas that still need to be tackled, China PE is still a story of great expectations. There is no question the industry will continue to grow substantially – the question is when. Generational change is one consideration. "I think that it may take somewhere between five to ten years for the PE market in China to materialize, says Schoeter. "China may not able to catch up fast, because there are so many young companies, and banks cannot satisfy the demand for loans to them. In China, companies are still relatively small, and until recently most of them were still owned by the state. Companies are generally still owned by the first generation, so the original founders do not want to sell a majority stake, and prefer to hold on to the business. But as in North America, when generations change, people will become willing to sell majority stakes."

Ferguson of KPMG China adds, "Whether China will become the biggest PE market in the world may be difficult to predict, but it will certainly be one of the biggest markets globally." He added that, after a dip in 2008, the Chinese PE market has been growing steadily from early 2009 and that his firm was aware of at least 10 new funds raised in the first half of this year. The amount raised so far in 2010 has significantly increased year-on-year and has already exceeded the total for the whole of 2009.

Asked when China may have a PE market to rival the US or Europe, Sulger hazards, "Maybe in 15-20 years, but certainly not now. The current PE market is too small. There are only a few PE players operating in China with funds larger than $1 billion."

All the same, Sulger asserts that the Chinese government has been proactive in promoting private equity as a tool to help capital markets in China evolve, and price investment risk appropriately. He believes that China looks positive in this regard, compared to the world's other currently fashionable high-growth markets like Brazil and Russia, which have tightly controlled PE activities.

M&A trends; PE forecasts

Chinese corporates have been involved in aggressive cross-border M&A transactions involving Japan companies under pressure to seek sales from their high-growth neighbor, where consumers favor Japanese products. This is one recent development that may impact private equity, particularly as Japanese businesses struggle with their static domestic market and shrinking population. Renown Inc., a leading Japanese fashion retailer and manufacturer, recently saw a 41% investment by Shandong Ruyi Science & Technology Group Co., a Chinese textile company, for JPY4 billion ($44.2 million) in May this year. Meanwhile, Royal Host, a Japanese family diner chain, has become one of the many Japanese restaurant operators to open up in the Mainland.

"In the past year, we have seen significant increased interest from Japanese strategic and financial investors in China across a wide range of industries – including consumer, e-commerce, and healthcare and technology.  With Japan's strong yen, its discrete but upscale domestic consumers, and the rapid rise of China's consumer and leisure class, there are tremendous opportunities for regional consolidation and investment among Japan - China companies. Japan is China's second-biggest trading partner after the US, with bilateral commerce in the first seven months of 2010 rising 25% from the same period in 2009 to $65.2 billion", notes Chou at Morrison & Foerster.

Fund quality, fund future

The China PE market remains to be at its early stage due to regulatory framework and relatively short history of PE investments in China, though, and  Olivia Lee, Partner and Head of the Greater China Practice at Troutman Sanders, sees some segmentation already emerging even at this stage. "There are just a handful of experienced and good PE fund managers in China, and investors are aware of this. They are no longer looking at brand names of funds, but instead looking at individual fund managers' track record, capabilities and how familiar they are with respect to handling PE investments in China." She adds, "There are local entrepreneurs who know how to run local companies and may have access to capital to form their own PE funds. However, they may not have adequate experience and know-how in managing PE funds. On the other hand, as for foreign PE funds, there are increasing number of foreign PE funds coming to the China markets as new players. While they have the know-how to manage private equity funds, they may not yet have the local market knowledge and experience to source, secure and manage good PE deals until going through the learning curve because China is a very challenging and unique market subject to various regulatory restrictions."

Control investments, though rare, are also gradually increasing. While very few LBO or MBO deals of any scale have emerged in China, several have been completed, indicating increasing acceptance among PRC businesses of the PE value-add, and their ability to bring sophisticated business strategies into the company, to help them expand further.

As the market increases and to remain competitive, foreign offshore players are looking to get more involved. "We have all seen Blackstone, Carlyle, CLSA and other make announcements and RMB fund formation remains a key strategic consideration and a topic that KPMG continues to advise many of our PE clients on. The perceived potential conflict between domestic and offshore funds remains an area that the all foreign PE funds that also manage an RMB fund will need to address and avoid." said Ferguson at KPMG.

Somewhere in the convergence of these two is the future of Chinese private equity. International LPs and GPs alike show no signs of backing off as they continue to pile into the market alongside their domestic peers to drive it forward. 

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• Topics
• Greater China
• Performance
• Funds
• Fundraising
• Renminbi fund
• The Carlyle Group
• David M. Rubenstein
• Derek Sulger
• Lunar Capital Management
• Mark Qiu
• China Renaissance Capital Investment
• Johannes Schoeter
• CNEI