Bridging the gap: China fund T&Cs

The cult of personality which surrounds many of China's private equity funds rarely extends into more mature markets. Other than Terra Firma's Guy Hands and Coller Capital's Jeremy Coller, few US or Europe-based GPs have built their organizations around one particular luminary. In China, however, while far from being one-man bands, a disproportionate number of entities ride on the backs of a single high-profile individual. John Zhao, CEO of Hony Capital; Fred Hu, founder of Primavera Capital and ex-Greater China chairman at Goldman Sachs; and Boyu Capital's Mary Ma are notable examples of this.

This specific divergence has resulted in more focus being placed on key man clauses in China funds than in other parts of the globe. According to Squadron Capital, which surveyed 104 Asian GPs, 33 of which were focused on China, 90% had a key man clause in place, which compares favorably against similar polls conducted on US funds.

"Key person provisions are probably more important in Asia than in many other markets, given the fact that many GPs at the earlier stager of their evolution - and even some at the later stages - are single-person dominated," says Wen Tan, managing director at Squadron, who led the research. Another reason cited by industry participants for the increased focus on this clause in China is team volatility, which has led to multiple spin-outs in recent years.

There are several areas in which the distinctive characteristics of the China market have had a knock-on effect on terms and conditions. While certain terms were automatically adopted from the US by Chinese firms upon their establishment - such as no-fault divorce clauses - preferential carry, fee offsets and GP contributions have all seen a deviation from Western market norms.

Carry in investing

Premium carry is a fund facet tracked by private equity-focused law firm Cooley. Following its survey of 20 China-based funds, and a comparable poll of 30 US funds, Cooley found that 20% of China vehicles were offering premium carry, more than in the US, albeit on a minority of deals. One reason for this, according to Jordan Silber, a partner with the law firm, is the greater prevalence in China of both captive funds and joint ventures where GPs have teamed up with local corporations.

"For those kinds of funds, there's more tolerance among LPs for putting up with a higher rate of carry than in non-sponsored funds," he says. "They know that it's being shared with a larger team, so they want to ensure the team in China gets 20%, believing that 5% is going to the team outside of China. Several leading LPs have told me that's the way they think about it."

The overwhelming demand among investors to pocket a piece of China's growth story is another factor which leads to LPs conceding extra financial rewards to GPs. Whereas it would be atypical for private equity funds launched in the US today to command a premium carry from the outset, China-focused firms are frequently doing this. Managers with a strong reputation locally are being excused from the need to prove themselves through track record - and thereafter earn a higher rate of carry - by the almost feverish desire for their product.

It is this basic model of supply and demand that has kept China funds' use of preferential carry terms at relatively low levels. Despite Squadron reporting a 9% year-on-year increase in the number of Asian GPs granting differential carry terms to a subset of investors, US funds are much more likely to offer these concessions. This is because the easier fundraising environment means far fewer fund managers in China are backed into the position of offering such deals to attract capital.
"Out of the 25 or so China funds that I have worked with, maybe 10% have offered premium terms," reveals Cooley's Silber.

RMB vs. USD

Of course, while the difference in nature between China and US-based funds is interesting to note, other issues provoke greater concern among LPs. The conflict of interest that can occur when China-focused GPs' parallel renminbi and US dollar funds have different terms and conditions is a prime example.

The main areas of potential conflict, according to James Ford, private equity partner at O'Melveny & Myers in Hong Kong, are in the allocation of investment opportunities and the time commitment of the team. Investors commonly worry that the challenges involved with doing foreign direct investment from the US dollar fund will lead the GP to focus its efforts on the more easily deployed renminbi vehicle.

Squadron's findings suggest this could be a very real fear, as of the GPs it surveyed that had agreed to allocate their investments on a pro-rata basis between the two funds, 35% were actually doing this on less than half of their deals. That means 65% of transactions were being allocated to a particular fund purely at the discretion of the GP.

Another point of contention among LPs is the existence of unequal investment periods and fund lives between renminbi and US dollar vehicles. Squadron discovered that more than half of parallel funds were not coterminous; in all of these cases, the renminbi funds were of shorter duration. This could end up forcing GPs to invest their renminbi vehicles at a quicker pace and also to exit before the investment is fully mature.

"We worry about this for our clients - we like to see them having cycles that match because there are so many factors that make it so much easier to be fundraising for both funds at the same time," cautions Silber. "There is a big chance for conflict as you get off-cycle. It isn't an issue that has come to the forefront yet because we're in the infancy of managers having both funds, I think it will become significant in 3-4 years."

Some LPs have resorted to lobbying for clauses to be written into their contracts to help level the playing field as much as possible between parallel funds. One such clause gives investors the option to end the fund if the renminbi vehicle is drawn down by a specified percentage more than its US dollar counterpart. Another option is for the management fee on the US dollar fund to step down once the renminbi fund is fully invested. This encourages GPs to keep up the pace of investment on both corpuses.

O'Melveny and Myers' Ford suggests that the most important aspect is to ensure that LPs are satisfied with the overall alignment of more straightforward elements, such as investment allocation, investment period and fund life, from the outset. No investor wants to terminate an agreement after paying fees for three years, after all.

"We've seen a lot of time spent on complex conflict mechanics, but they tend to create as many problems as they resolve. Ultimately, we see LPs focussing on overall alignment as the key, and often the asymmetry of capital [USD funds are frequently much bigger] tends to provide a lot of comfort."

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• Topics
• Greater China
• Fundraising
• Renminbi fund
• China
• Fund formation
• Squadron Capital Advisors
• Primavera
• Boyu Capital
• Hony Capital