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According to Li Baomin, Director of the State-owned Assets Supervision and Administration Commission’s (SASAC) research arm, "The [new] guidelines made clear for the first time that equity funds can be set up between private investment entities or between a private investment entity and a SOE." Such funds may co-invest with SOEs to strategically invest in emerging industries and evaluate outbound investment opportunities. These new guidelines allow Beijing to act as a matchmaker, helping Hong Kong and mainland firms to form consortiums to invest overseas. Investing abroad is hardly unchartered territory for Chinese PE firms. For example, state-backed Hony Capital bought a stake of about 18 percent in Compagnia Italiana Forme Acciaio SpA, an Italian machinery marker, back in 2008. The new guidelines however, are a sign that the government is looking to have greater control of the process, while simultaneously encouraging increased PE activity among Chinese firms.
Beijing began encouraging SOEs to invest abroad in 2007, but regulatory hurdles and foreign political opposition made overseas acquisitions difficult. While SOEs have generally attempted to act independently and acquire majority stakes, the idea of Chinese SOEs acquiring majority control of foreign companies has never sat well with their respective governments. Government-backed equity funds will encourage minority transactions which given the inherently smaller size of the individual stakes, tend to reduce the risk of foreign political resistance while helping to also help lower risk, gain access to better assets, and build upon existing management teams.
As a result of the policy reform, mainland companies can invest up to US$ 25 billion a year in direct European investments to 2022, according to a Rhodium Group report published in June 2012.
As investing power from abroad declines, home-grown investment vehicles and local PE has begun to flourish. China’s self-sufficiency in this regard is the product of its highly adaptable economic system that has engaged in incremental privatization of its enterprises over the past two decades. Under Mao, the government controlled everything, producing less than ideal results. Since 1993 Beijing has encouraged “gaizhi” (meaning “changing the system”) for SOEs. Between 1995 and 2001, the number of state-owned and state-controlled enterprises fell by nearly two-thirds, from 1.2 million to 468,000. This “changing of the system” began a systematic privatization of state-controlled enterprises culminating into what are now firms that are fuelled by investment from local government, often through municipally owned venture capital or private equity funds.
These funds typically back businesses that are in clean tech or that hire locals. With some state influence, they invest patiently as they are less driven by short-term demands of the stock market. Additionally, they help their governments pursue their long-term goals and support strategic industries such as energy and telecommunications.
China-based CDB Capital, a private-equity fund established only in 2009 has already raised US$ 6.3 billion. In 2012, it joined China’s US$ 136 billion National Social Security Fund (NSSF) and other limited partners in a US$ 571 million investment in Chinese venture firm IDG Capital Partners’ Harmony Capital Fund. The fund will invest primarily in telecommunications, media and technology businesses.
Though it boasts China’s largest local PE fund, CDB is hardly alone. China has been building a domestic PE industry to challenge the dominance of foreign firms for the better part of a decade. In 2006, the government of Tianjin set up Bohai Industrial Investment Fund Management Co., whose shareholders include China Life Insurance Co. and China’s social security fund. This was the first government-backed domestic PE fund with 20 billion yuan (US$ 2.6 billion in Dec. 2006) under management.
Hony Capital, sponsored by state-backed Legend Holdings Ltd., has raised US$6.8 billion since its founding in 2003. Citic Private Equity Funds Management Co., the investment arm of state-owned Citic Group, China’s largest conglomerate, raised 9 billion yuan (US$ 1.4 billion) since it was set up in June 2008 with plans to raise the same amount for a second fund.
Domestic private-equity funds like those of CDB, Hony, and Citic are seen as direct competitors to more established and well known overseas funds such as those of TPG Capital and Carlyle Group. Such local funds have the advantage of local expertise and backing by the state. More importantly, they are generally smaller in size and have an edge over global funds because they’re more focused in the country, and thus can make quicker decisions, according to Hony Capital Chief Executive Officer John Zhao, who raised 10 billion yuan (US$ 1.6 billion) last year for the firm’s second Renminbi fund, doubling the size of a previous one in 2008.
Renminbi (yuan) PE funds are now becoming the world’s fastest-growing major pool of discretionary investment funds, with over US$ 20 billion raised in 2011. The shift to investors using Renminbi has coincided with a 45 percent drop in investments by foreign funds in 2011, even as the value of PE deals has doubled since 2009.
The number of foreign-currency funds in China fell from 44 in 2008 to 25 last year. In monetary terms, foreign-currency funds focusing on China fell to US$10.2 billion last year from US$39.2 billion in 2007, according to Bain & Co.
In a sign that PE activity is switching to China-based funds, Renminbi funds focusing on China increased to 129 from 70, with their average size increasing to US$ 171 million from US$ 54 million.
Renminbi funds have become increasingly attractive as managers have advantages in terms of speed of execution as well as easier exit opportunities within China, according to Chris Meads, head of Pantheon, a British PE company. Hony Capital Chief Executive Officer John Zhao echoes this sentiment stating, “Our decisions will be quicker [than foreign funds] with a sharper focus and better execution. The global powerhouses can’t afford to spend as much time as we do in China, as they have many markets to focus on.”
Despite recent declines in foreign direct investment in Chin – primarily due to the global economic slowdown – inbound investors looking to private equity funds as investment vehicles are still well-received in China. Once regarded less favorably by Beijing, PE investment is increasingly viewed as a positive force and an economic driver in the past few years – as indicated by China’s emerging local PE industry. Private equity has been seen as an asset class capable of filling the gap left by domestic banks in the small and medium sized enterprises space, particularly following the global economic downturn in 2008.
After Beijing’s stimulus programs, there was no shortage of financing for state-owned or hybrid-private enterprises, but small and medium sized enterprises struggled to gain the same level of attention. PE financing has filled that gap by providing growth capital investments in these smaller companies, which often operate in emerging industries.
However, as local PE’s star continues to rise, foreign private equity firms looking for greater inroads into China may experience fewer advantages than what they may have previously enjoyed. There are reports that the State Administration of Taxation may alter the draft tax rules to unify the tax treatment of partnerships nationwide and seek to impose tax on unrealized gains of partners in Chinese partnerships. In short, the rules would eliminate local incentives for private equity investments. A recent memo issued by Baker & McKenzie warned that investors interested in investments with underlying Chinese companies should be prepared that tax authorities may force them to accept their tax assessments by asking the purchasers to withhold.
This follows another recent roadblock for foreign-based PE firms. The Chinese government now treats local companies that receive U.S. dollars or other foreign currencies as foreign-invested enterprises, which means additional scrutiny and layers of approvals from regulators. This discourages local Chinese companies from engaging in joint investments with foreign firms, which has, up to now, been the go-to method for foreigners looking to avoid the taxes and pull-out burdens endured by those with no local ties. “Many Chinese companies realize taking money from any foreign-currency fund will result in more restrictive scrutiny, and they just can’t stand the red tape,” said Jessie Jin, a Shanghai-based partner at GGV Capital.
So while such joint investments with Chinese PE firms are attractive to entrants as they offer local expertise, speed, and sharper focus unattainable by foreign firms, the government policy appears to make the attraction one-sided. Nonetheless, foreign PE firms have been establishing their own Renminbi funds, in addition to joint investments with domestic private equity funds in record numbers – a testament to the robustness of the China’s emerging markets and the growth of its PE industry despite regulations. There were US$ 13 billion in joint investments last year, more than double that of 2010 (US$ 5.1 billion) and firms such as Carlyle, Goldman, TPG Capital and Morgan Stanley have all starting raising Renminbi funds in recent years.
Even still, it is unclear whether Renminbi investments by foreign PE managers are treated the same as money from domestic funds, as China has not yet passed nationwide rules governing the industry. Due to little cooperation between the National Development and Reform Commission (NDRC), the China Securities Regulatory Commission and the People’s Bank of China, local governments have had to come up with their own regulations that are equally unclear and invariably tentative.
In 2009, the Shanghai government said it would treat non-Chinese firms in Shanghai the same as domestic Renminbi funds as long as they received no more than five percent of their capital from overseas PE funds. Reportedly (but not confirmed) in April 2012, the NDRC overruled Shanghai authorities, issuing policy guidelines that funds run by foreign managers will still be subject to foreign-investment rules, even if they have 100 percent local funding.
While inexact and still subject to frequent changes, regulatory hurdles such as these, coupled with foreign direct investment in China being down for a seventh month in a row as of June 2012, would suggest that the old days of the Chinese government favoring foreign companies for their capital injections and know-how will soon come to an end. Though recent declines in foreign investment into China can mostly be attributed to a slowing economy, limited prospects for gains in the yuan, and renewed concerns that Europe’s debt crisis will worsen, there is no doubt that tides are changing for foreign PE players in China.
China's 12th Five-Year Plan for National Economic and Social. Development outlined an intention to allow for greater foreign investment in modern agriculture, high-tech businesses, and environmental protection. These industries will be propped up by government investment, which will also be looking for co-investors from abroad. In developing the services and emerging strategic industries, the use of private capital will accelerate and play a much larger role. Service sectors such as IT, consumer financing, education and retail are also significantly underdeveloped, so the potential for growth is huge.
Additionally, as demand for high-quality healthcare has risen in China, companies are taking advantage of abundant investment opportunities in the nation's private and specialized hospitals. There were 158 investment deals in the medical and healthcare sector last year, worth US$ 4.14 billion, around the same amount as the total deals in the sector from 2006 to 2010.
China, more so than most countries, demands significant due diligence, given the opaque nature of its markets and business environment, and a deft hand at developing the right “guanxi”. As such, successful PE firms in China often have to go to great lengths to foster associations with the right dealmakers and to identify and mitigate against underlying risks in what seems like a tenuous yet fruitful business environment.
It is useful to remember that Chinese cities, and their officials, will back companies that provide local jobs and that local PE can sometimes be investment vehicles for the children of powerful officials. Such factors do not always make it a level playing field for outsiders. Moreover, little is disclosed about the operations and returns of these growing public funds in China.
The investment climate is also directly under the direction of Beijing. This is particularly true in light of pending changes in tax laws that will eliminate many of the local tax incentives currently enjoyed by private equity or venture capital investments. PE investors should keep on the look out for the release of new partnership tax rules that may affect the China tax position of investments in Chinese partnerships, or any other regulations on the horizon.
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