China secondaries: Fresh start or false start?

"The Chinese private equity market has been so messy that a lot of individual investors are now defaulting on their commitments to GPs," says Frank Han, executive director at Bohai Industrial Investment Fund Management. "But GPs dare not to sue them because this will hurt their reputations - all they can do is to let their investors go away."

Drawn in by the attractive returns generated by pre-IPO investments, Chinese high net worth individuals have crowded into private equity in the past couple of years. According to AVCJ Research, renminbi funds attracted more than $24 billion in 2011, twice the figure achieved by their US dollar counterparts.

However, IPO exit multiples on local bourses are a fraction of what they once were. As of June, average book return of PE exits from Shenzhen's SME and GEM boards were 3.8x and 2.9x respectively, compared to 4.9x and 6.5x a year ago. Individual investors have become disillusioned with the asset class and are looking for a way out of their fund positions.

Work has been underway for over a year to create a renminbi secondaries market so these exits can be by sale rather than by default.

In June, the Beijing Financial Assets Exchange (BFAE) launched the China PE Secondary Market Development Alliance, which will promote secondaries trading. An actual platform for the exchange of LP interests is slated to follow. To date, over 150 representatives from venture capital and private equity firms, banks, brokerages and financial services institutions have joined the alliance. LGT Capital Partners, Shengzhen Capital Group and Jiuding Captial are among its members.

"Globally, around 4-5% of the total committed capital flows back to the secondary market, but when you compare the total transactions of LP interests with the fundraising amount in China, the ratio here is definitely a lot lower. This is why we consider this new alliance of great potential," Brooke Zhou, executive director at LGT Capital Partners, tells AVCJ.

Information asymmetry

BFEA's targets are ambitious: 2,000 member organizations and 1,000 secondary deals worth a collective RMB30 billion ($4.7 billion) by the end of 2015. However, some market observers are skeptical about such a target.

One key issue raised is whether this platform can guarantee quality transactions with transparent information. Top -tier funds such as Hony Capital, CDH Investments or CITIC Private Equity pick their LPs carefully in the first place and few are likely to offer any secondary interests. Meanwhile, GPs who are going out of business and have poor-quality portfolios are not incentivized to advertise the fact that their LP interests are being sold or facilitate any transactions.

"An open platform will theoretically help LPs to exit; in reality, though, it is very difficult to operate because LPs usually need to get consent from GPs before selling anything and both parties prefer to reach settlements in a private manner," says Bohai's Han. "What will others think if you tell everyone that you not doing well and your LPs are leaving?"

Furthermore, there is often insufficient knowledge regarding the quality and valuation portfolios for investors to know what they are buying into. Developing direct, long-term relationships with GPs is crucial in this respect.

"There are a number of renminbi fund managers out there and the spectrum of quality is huge. Some are quite good with thoughtful people, strong portfolios and experiences whom we would certainly partner with; others don't know what they are talking about," says Andreas Baumann, partner and co-head of the Singapore office at Partners Group.

Where there is uncertainty, an existing LPs or someone close to the GP is best position to price fund interests. Those that are familiar with a fund's performance might only be willing to buy it at a very attractive discount and, even if such a discount is available, there is no reason why they should complete the transaction on a public exchange and pay a fee for the privilege of doing so.

"I have discussed this renminbi secondary opportunity with the largest LPs and relevant regulators in China. While it is compelling, finding the right model to tackle it can be challenging," says Vincent Huang, a partner at Pantheon. "Basically, Chinese firms don't have the skill set and experience required to evaluate secondaries properly, while foreign sponsored funds are not allowed to participate due to regulatory restrictions."

Long-term capital

Huang adds that the only solution to this mismatch is developing long-term institutional capital that can gradually replace the current short term-oriented LP base dominated by individual investors. Looking forward, the most natural buyers of renminbi secondaries will be Chinese insurance companies and the scattering of established institutional LPs such as the National Social Security Fund. It is unclear when these players might be allowed to participate and to what extent.

As for the foreign LPs, there is a certainly a desire to get involved, but they face two major obstacles. Firstly, getting capital into China is much easier than getting it out. Secondly, the National Development and Reform Commission's recent statement that a local currency vehicle containing foreign capital will lose its local status has created uncertainty.

It is difficult to envisage foreign firm not having some role in the long term, but for now, they can only wait and watch.

"The renminbi space is something that we cannot ignore but there are a lot of things to be done on the regulatory and structural sides," says LGT's Zhou. "As such, the formation of the alliance is not just about an exchange platform, but more an industry association which starts gathering information and statistics to solve many of the questions we cannot answer today."

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• Topics
• Secondaries
• Greater China
• LPs
• Renminbi fund
• China
• Secondaries
• Pantheon
• LGT Capital Partners
• Partners Group
• Renminbi