The latest gambit in Shanghai’s plan to turn itself into an international financial center involves bringing the brightest and best of the private equity (PE) world to the city. To this end, in June 2009 the municipal government unveiled a range of inducements – principally tax breaks – to foreign players willing to set up shop and establish renminbi-denominated funds in the city’s Pudong New Area.
Shanghai is not alone. Ever since Tianjin issued the first foreign fund management company business license in 2007, local authorities from Beijing to Chongqing have sought foreign participation in the development of their PE industries. But will overseas players bite?
With Beijing having tightened the noose on local companies listing on foreign bourses via offshore investment vehicles, a renminbi-denominated PE fund – which by definition enters and exits deals onshore – might be regarded as an easier way for these players to deploy capital in China. "There was a perception [that with a renminbi-denominated fund] your approval processes may be easier," said Bob Partridge, managing director and Far East transaction advisory services leader at Ernst & Young.
That perception seems to be becoming a reality.
"With this vehicle, we can execute deals in days instead of months," said Alvin Ho, managing director and head of China growth and expansion capital for CLSA Capital Partners, which manages the US$200 million renminbi-denominated Perennial Venture Capital Investment Enterprise Fund. "It allows us to be more competitive and is sort of a level playing field in executing a deal."
The number of funds has taken off. According to law firm O’Melveny & Myers, as of May 2009 there were an estimated 40 foreign-invested renminbi-denominated funds with a total size of more than US$1.5 billion. Further momentum was generated in July when Blackstone Group, the world’s largest PE firm, said it would create a US$732 million renminbi-denominated fund in partnership with the Shanghai government. Other major players thought to be in the process of setting up funds include the private equity arm of US investment bank Goldman Sachs.
Most foreign PE firms opt for Beijing as a base due to a perception that this eases central government approvals. However, many open a second office in Shanghai.
The down side
Though large in number, foreign renminbi-denominated funds are still in a minority compared with the 400-plus domestic renminbi-denominated PE funds. They are also less active in volume of deals than their domestic counterparts. This may in part be a reflection of the drawbacks that still exist for these investment vehicles.
There are some clear limitations on the investment side. The foreign funds are not permitted to invest in public equities; all their transactions must take place onshore with exits made via listing on the Chinese stock market or through domestic mergers and acquisitions; and they are barred from investing in certain industries, a restriction that doesn’t apply to their domestic counterparts.
The obstacles concerning fund raising might be even more daunting. Foreign funds with limited profiles in China are inevitably going to struggle to raise capital locally. Although they are allowed to work with overseas partners, it is the potentially more lucrative local partners that are hard to reel in.
"[Domestic] investors currently are not sufficient and you have large investors trying to catalyze the market, like the National Social Security Fund," said Edan Lee, managing director of Olympus Capital Holdings Asia.
The problem is rooted in the inexperience of many domestic institutional investors that might feasibly participate, such as securities and insurance companies, some government entities and private companies. They are new to the game, conservative in their approach and often not ready to make the long-term, illiquid investments – with high risk and high reward – that are typical to PE.
"You are talking about a 10-year commitment period for a traditional PE fund, but the market in China is not ready to accept that yet. People buy mutual funds from which you can withdraw cash fairly easily," Lee said.
In SAFE’s hands
Any foreign fund seeking to bring foreign capital into China and convert it into renminbi would come up against the might of the country’s foreign exchange regulations. The Ministry of Commerce is responsible for approving the foreign-invested venture capital enterprise structures that underpin renminbi-denominated PE funds set up by foreign operators. But it is the State Administration of Foreign Exchange that decides whether foreign currency can come onshore, and here the needs of the PE industry are weighed against China’s wider macroeconomic issues.
The Shanghai government sees currency non-convertibility as a major barrier to foreign PE involvement in the city and is lobbying for the regulations to be loosened in this case.
"Lots of time and foreign and domestic lawyers’ fees have been spent on advising clientele on how to bring in foreign currency," said Basil Hwang, a partner with international law firm Dechert in Hong Kong and head of the firm’s Asian private equity practice. "If the central government allows Shanghai to bring foreign currency into China easily, that’s really going to be a shot in the arm for the Shanghai fund management industry."
Nevertheless, many industry watchers are skeptical about the city’s chances of bringing about change any time soon.
There are other regulatory hurdles that must also be overcome. Most PE funds work on a partnership structure with a general partner who manages the investment and limited partners who are investors. Beijing drafted a foreign-invested partnership law in 2007 but has yet to pass it. The law would allow for foreigners to set up partnerships in China, but there are still some outstanding issues.
"There will be officially sanctioned foreign investment into a partnership, but what about the business license of that partnership?" asked Lawrence Sussman, a Beijing-based partner at law firm O’Melveny & Myers. "The thinking is if the trend continues, the localities will facilitate that."
Even with new partnership regulations, it looks like at least some foreign PE firms will take a wait-and-see approach – including M1 Capital Partners China.
"I think in the future when the A-share markets become more transparent, the benefit for having a locally denominated fund will increase," said Robert Abbanat, the firm’s managing director. "Right now it’s still a little bit dicey."
Lee said Olympus Capital has also considered establishing a foreign-invested renminbi-denominated fund, but no concrete plans have been put in place. However, much like Abbanat, he suggests that it is a case of when, not if.
"We know that over time [the Chinese] will get used to private equity. They will become a very large set of investors that can’t be ignored," he said.