China’s fund-of-funds experiment

Magic Stone Alternative Investment is one of the first investment firms in China to experiment in the renminbi fund-of-funds market. However, getting things right in China's nascent private equity market is never an easy task.

Given its management profile, Magic Stone - led by a team of Chinese PE veterans including former founding partner of Jade Invest Jenny Zeng and ex-president of China Venture Capital and Private Equity Association Frances Huang - has tried to approach the local fund-of-funds space with institutional practices, unlike many of its local counterparts. It has established a database that houses information from more than 1,000 GPs, it follows precise due diligence and investment processes, and organizes tailor-made roundtables to bring together institutional investors and high net worth individuals (HNWIs) and entrepreneurs, to talk about the changing dynamics in the industry.

Its international approach, however, has not borne fruit just yet. The private equity player launched its maiden renminbi-denominated fund-of-funds in January 2009 with a target of RMB1 billion ($158 million). The vehicle - which is yet to count institutional investors as its LPs - is still on the fundraising trail after more than three years, according to a source close with the situation.

It goes without saying that Magic Stone - which also manages US dollar fund-of-funds - is not the only recent player to attempt the renminbi market. According to AVCJ Research, among the 80 disclosed renminbi fund-of-funds in China, over half of them were raised between 2009 and 2011. However, out of the top 10 vehicles by value, nine of them are government-backed, with the remaining one - Noah's Jingzhao Fund - entirely raised private placements by HNWIs.

There is no doubt that a maturing renminbi fund-of-funds market will play a positive role in introducing Chinese investors to a more institutionalized investment approach, but a number of private equity players question whether this is a realistic goal in short term, given that fund-of-funds in China are still largely constrained by institutional and individual investors too immature to appreciate the long-term investment philosophy of such products.

"Raising renminbi has been a challenge so far in China, but we do see the need to develop our industry with other players," Jenny Zeng, managing partner of Magic Stone, tells AVCJ. "Building up a fund-of-funds takes you years of experience and any new players which come without preparation and patience are not going to be very successful."

Nascent market

The renminbi fund-of-funds market first started to emerge to any great extent in late 2009, when China witnessed ample liquidity and investors were impressed by the high returns generated from private equity investments. At that time, a large number of intermediaries - some of which called themselves fund-of-funds - were set up with the primary motive of pairing up rich individuals with the large number of GPs that were flocking into the market.

Noah Holdings has been a classical example. Founded in 2005, the New York-listed company distributes fixed income products and private equity funds that are originated in China. Its financial services also involve fundraising for GPs, including the likes of CDH Investments, Sequoia Capital and SAIF Partners. When these funds were oversubscribed, Noah was said to channel the extra capital into starting a fund-of-funds business. In February, Jingbo Wang, founder of Noah, told AVCJ that the company's renminbi-denominated fund-of-funds had reached a total value of RMB3.3billion.

According to market sources, the US-listed company first began its private equity business by setting up centers in each city to cold-call individuals with bank balances above a certain level, in a move to match prospective investors with GPs. The business model has proved itself as very profitable in the last few years, with another 6,000-8,000 copy-cat operations having been set up in Shanghai and Beijing.

"People were invited to events where GPs could introduce their funds. After that you had to sign a document," a pan-Asian LP who joined one of these matching events recalls. "Because of the lack of channels to LPs, these intermediaries - who have developed a large network of HNWIs - have the bargaining power to charge up to 3% up front and half of the carried interest from GPs. No one has ever done that."

While local structures doe serve as a bridge between retail investors and GPs that are thirsty for capital, most of them focus on screening the most popular funds without an institutionalized due diligence system. Although some of these so-called fund-of-funds have generated good returns from China's previous private equity frenzy, it is questionable whether they will be sustainable when clients become more sophisticated.

In addition, given that IPO exit multiples have fallen sharply in domestic bourses in recent months, the more challenging fundraising environment may be an indication that investors wanting speedy returns have now lost their appetite for the asset class. "There is no more money from these LPs compared to a year ago and they don't want to maintain their commitments," says Ludvig Nilsson, managing director of Jade Invest. "So a lot of renminbi LPs are selling their stakes and there is currently a big mess."

Immature LP Base

As HNWIs fail to guarantee long-term capital sources for local currency funds, PE players eyes on the few institutional investors that may have the potential to deploy a large amount of renminbi capital in the private equity sector.

In one corner, the National Social Security Fund (NSSF) is allowed to deploy as much as RMB90 billion to the asset class; in the other, the top 10 insurance companies - under the current regulatory system - also have a potential private equity allocation of more than RMB250 billion, JamesZheng, managing director of Fosun Capital Group, claims, citing official figures.

"If we apply the global average - which is that fund-of-funds account for roughly 10% of total private equity commitments - an existing RMB34 billion can be channeled from the NSSF and local insurers, not to mention large conglomerates and HNWIs," Zheng adds. "Yet, most of the Chinese investors want to do private equity investments by themselves as they believe they can make money faster than hiring a manager."

For example, the NSSF is already large and sophisticated enough to invest into private equity and venture capital funds through its in-house fund management professionals. Insurance companies such as Ping An Insurance, China Life and China Insurance are all said to have hired consultants to provide private equity advice instead of outsourcing their investment activity. Small insurance companies - which have not been able to develop their own fund management teams - will be potential investors for local fund-of-funds, but none of them have put their thoughts into action so far.

In addition, given the fact that most private equity and venture capital funds in China are not specialized funds, fund-of-funds do not necessarily serve a diversification purpose, considering there is an extra layer of management fees compared to directly investing into GPs. According to a source close to the China Insurance Regulatory Commission (CIRC), while insurers do not see local fund-of-funds being too different from what they have internally, none of them has even remotely considered investing in such vehicles.

"The key problem is that no one in the market is willing to pay for manager selection. Understandably, it is difficult to appreciate the value of manager selection until you have seen low or negative returns from brand name funds and deals," says Jade Invest's Nilsson. "Local institutions don't want to pay because they can set up their own teams, neither do HNWIs because they just appreciate the placement solutions, which provide them discounts to some famous GPs."

Government guidance funds

Given the limited LP base, a recent trend is that private equity players have entered into partnerships with local governments and state-owned entities to form guidance funds, which work similarly to fund-of-funds in that they invest in various private equity and venture capital vehicles.

Shanghai Venture Capital is a case in point. The venture capital management company - which was founded in 1999 - now manages RMB600 million for the Shanghai government. In 2006, Shanghai Pudong Science and Technology Investment (PDSTI), another state-backed manager, also closed its first fund-of-funds at RMB1 billion. The private equity manager subsequently closed two more similar funds in 2009 and 2012 for Anhui and Hubei, respectively.

Diction Ying, managing director of investment management at PDSTI, tells AVCJ that their funds were launched to serve two underlying objectives: first, fund-of-funds may achieve better financial efficiency when compared with direct investments done by the government; second, investing into GPs will enhance the overall development of private equity and venture capital within the region.

"Given that every single dollar of our fund is channeled through our balance sheet, we are not a real fund-of-funds from a fundraising angle," says Ying. "However, with the lack of clear regulations, participation from mature institutions - rather than individuals - is more appropriate for the development of the whole fund-of-funds industry."

While the rationale for the existence of these guidance funds is largely driven by government incentives to promote private equity and attract people to set up shops in their specific regions, it is not surprising that they often work with a different mandate, with less emphasis on financial returns. Jade Invest, for example, was approached but did not end up going to any of these partnerships as it doesn't see the alignment of interests.

A learning process

Although many of the guidance funds do not consider financial numbers as their primary objective, they also have to achieve reasonable returns in order to defend the feasibility of establishing a private equity industry in their regions. As a result, some guidance funds have started to hire talented individuals from the market, in a move to transform themselves into commercial-driven entities that can make meaningful investments.

Suzhou Ventures has been the most successful case so far. In 2006, it launched a RMB1 billion fund-of-funds, Suzhou Industrial Park Venture Capital Guidance Fund, alongside China Development Bank (CDB). Four years later, the pair launched another fund-of-funds targeting RMB20 billion to invest in venture capital funds with an investment range between RMB200 million and RMB1.5 billion. The fund is expected to close at the end of 2012.

"It's true that we started off being a guidance fund, but we have gone through restructuring processes to become a market-driven entity. Now we are open to various investment regions and stages," Jipeng Wang, partner of Suzhou Ventures Group, tells AVCJ, adding that the company's LP base will consist of institutional investors, financial investors and big private companies in the future.

While Suzhou Ventures has been the first case that has gradually taken a market-driven approach and attracted the continuous support of CDB, more similar cases are expected to emerge as time goes by. Given that guidance funds are currently the only local groups which have experience betting on a sizable number of funds, they would be in the best position to become the next wave of fund-of-funds in China.

Some overseas players also recognize the opportunity to test the water through an initial partnership with local governments. EMAlternatives, through its China affiliate YiMei Capital Management, launched a local currency separate account with the MinHang district of Shanghai Municipal Government to invest in venture capital and private equity funds across the country. The local government has so far invested RMB500 million.

"It's the right move to develop renminbi fund-of-funds in the long run because it is a market that you don't want to miss," says Judy Qing Ye, managing partner of Yi Mei Capital. "Unless you manage renminb, you can't understand the depth of the market. You can never evaluate the market by just taking a Western point of view."

Globally, mature fund-of-funds markets are often driven by two kinds of demand. First, small institutional and individual investors - who do not have the expertise in fund management - rely on fund managers who have the professional knowledge and skills to aggregate their capital and get access to top-tier GPs. Second, large institutional investors hire fund-of-funds to access small-cap or specialized funds in areas in which they don't have in-house expertise.

Similarly, once the LP base in China develops to a stage at which it can embrace different types of demand, it will be time for renminbi fund-of-funds to become a meaningful part of the private equity supply chain. It's possible that Intermediaries - which have developed a good client-base and start to adopt a more international approach - will emerge as another impetus for the fund-of-funds market, though not immediately.

"Some of the intermediaries have been able to bring their clients good quality renminbi GPs based on their own due diligence work" says Rebecca Xu, co-founder and managing director of Asia Alternatives. "I would not be surprised if any of these players became a real fund-of-funds, given that investors will eventually need professional fund management services when they are overwhelmed by the market complexity as time goes by."

Foreign players, which have institutional platforms and long-term experience, may also help educate the market. At the moment, there are plenty international fund-of-funds already working in the country, although they are using US dollars and investing in offshore funds. Based on the most recent definition from the National Development and Reform Commission (NDRC), any money managed by foreign GPs is still defined as foreign capital. As a result, GPs may have to rely on local fund-of-funds, if any, to enjoy domestic treatment.

"The race between fund-of-funds players will be determined by whether pure local fund-of-funds can develop institutionalized practices and a track record before the market opens up to allow groups like us to do renminbi fundraising," says Vincent Huang, partner at Pantheon Ventures. "The entry barrier is still very high for renminbi fund-of-funds targeting institutional LPs. For any group that meets the hurdle, there is very little competition and the market is huge."

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• Topics
• Greater China
• Fund-of-funds
• Renminbi fund
• Fund-of-funds
• Renminbi
• Pantheon
• Asia Alternatives Management
• China
• Jade Alternative Investment Advisors
• Magic Stone Alternative Investment
• Yi Mei Capital
• Suzhou Ventures Group