Internal tensions

The marital analogy applied to China applies to anywhere. Only it doesn't. By most accounts - including this paper published in the Journal of Corporate Law Studies (JCLS) - the renminbi space represents a skewed version of this analogy. The GP is not so much henpecked husband as terrorized son-in-law as LPs demand a significant say over fund activities.

The JCLS paper offers some thoughts on why this is the case. It cites two fund structures in which LPs' active involvement is formalized: proprietary funds (set up by LPs who are responsible for investment decisions) and project funds (where the LPs select portfolio companies first and then raise the capital). Beyond this are the informal practices whereby LPs assert control over the investment committee.

Compensation is another concern. Management fees can be substantially lower than the standard 2% while carried interest tends to be lower than 20% and sometimes either fixed or subject to a hurdle rate. Furthermore, the GP contribution to funds can be very small, making interests even more misaligned.

The Wenzhou Donghai Venture Capital Fund is singled out as an example of LP dominance. The partnership agreement required that every investment proposal be approved by at least two thirds of the investment committee.

The committee had 10 members - nine LPs (private enterprises and wealthy individuals) and the GP. Voting power was based on capital contribution and because the manager's interest was so small, he had virtually no say over investments. The partnership fell apart due to internal conflicts.

The report concludes that this state of affairs is largely a product of industry immaturity. There are few qualified LPs, few competent GPs and a need for better governance and legal contracts that define GP and LP responsibilities. In short, China funds should be organized more along the lines of their Western brethren.

It would be interesting to know about the demise of the Wenzhou fund. One of the first onshore private equity partnerships, its mandate was to pursue pre-IPO deals. Did the fund implode because of disagreements over what to invest in or because, three or so years down the line, they found it was much harder to exit, regardless of what they invested in?

Many renminbi funds have been through the same process - as evidenced by a sharp consolidation in the market - and it remains to be seen what emerges alongside the handful of GPs that are more sophisticated and count China's small number of institutional LPs among their investors.

The level of state control in China's economy means that strategic funds bankrolled by local governments will remain. Whether categorized as proprietary funds, project funds or something else, if the manager is an offshoot of a municipal financial services arm, he would likely be treated as state employee. An alignment of interest between GP and LP based on shared economics is not an option.

As for funds that draw on capital from wealthy individuals and private enterprises, some of these investors have been scared away by underperformance, but not all. As long as an entrepreneur has ambition, an angle and like-minded associates, informal, IPO-driven arrangements will continue - they will just operate with other exit options in mind.

And there is no guarantee of more professional structures: at one end of the scale, LPs that dominate managers will want to have a say in strategy based on their own local knowledge; at the other end, all participants put in similar amounts of money without thinking about division of responsibility so the GP-LP distinction is blurred beyond recognition.

The balance will only be rectified when the LP base matures and there is a culture of institutional behavior, not just a set of legal contracts governing participation. However, it is difficult to imagine China falling wholly in line with Western models; it will be a compromise solution, with a reasonably strong seam of government and quasi-retail participation.

And the henpecked husbands and nagging wives will remain. They just might do it slightly more politely through established channels.

 

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• Topics
• LPs
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• Fundraising
• Greater China
• China
• LPs
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