Banking & Finance

Barbarians at the gate

Why China’s private equity industry is as “chaotic as Shenzhen”

Barbarians at the gate

Huang: the bane of Bain's life

As chaotic as when Shenzhen first opened up to economic reform,” was how one government official explained it to CBN Weekly. “Everyone is busy making money – yet there are no rules and regulations – it’s a mess.”

After years of encouragement, a homegrown private equity industry seems to be taking root in China. Local institutions have set up a number of renminbi-denominated funds, often in conjunction with foriegn partners. Citic, the country’s largest financial and industrial conglomerate, grabbed headlines earlier this year when it launched a fund with $1.3 billion in backing – the country’s biggest.

In 2009 private equity deals in China totalled $3.6 billion, accounting for one-third of PE transactions in the Asia-Pacific region. This year the country is on track to break numerous records, from the number of deals to the amount of capital raised and invested, says Zero2IPO Research Centre.

“Every other day a new fund is launched. From aerospace to healthcare; from Shanxi to Shanghai,” is how CBN Weekly describes the sector. But analysts warn that a lack of regulations could stunt the industry’s growth.

Last year the National Development Reform Commission (NDRC) submitted its “Provisional Measures for Equity Investment Fund Management” – a legal framework for regulation – to the State Council. So far, little has been approved or implemented.

That may lead to systemic weaknesses. According to the Caixin website, only the funds bigger than Rmb500 million are required to keep detailed records with local governments. And funds smaller than Rmb100 million are largely unregulated. In Tianjin alone, there are 272 such funds registered.

In addition, China lacks the experienced pension fund and large institutional investors that provide the backbone of private-equity funding in the Western world.

The largest and most professional private equity investor in China currently is the National Social Security Fund (NSSF), a $100 billion state pension fund. Domestic banks and insurance firms are not allowed to invest money directly into private equity funds. And the remaining financial backers – mainly high-net-worth individuals looking for a place to park their money – have little experience in investing in private equity funds.

Exiting investments is also a complicated process. Arranging IPOs is time-consuming and highly political, says Peter Fuhrman, chairman of boutique investment bank China First Capital. A good relationship with the China Securities Regulatory Commission (CSRC), the country’s top securities regulator, is often critical, as the Beijing-based commission has final say on who gets to IPO – a crucial decision, since it’s the funds’ most likely way to exit their investment.

That means that building good relations with the CSRC is almost as important as choosing the right investments in the first place. Local firms that have the connections can help clear the regulatory hurdles to a listing in a way that foreign funds will never be able to, agrees 21CN Business Herald.

Fuhrman points out that this makes it less surprising that of the 20 domestic private equity firms to receive NSSF funds, a significant majority have chosen to be based in Beijing. Recipients include SAIF, CDH, New Horizon and Legend Capital. New Horizon boasts some of the best connections in town. Winston Wen, Premier Wen Jiabao’s son, is in the management team.

This proximity to decisionmakers has made Beijing the preferred location, Fuhrman says, in spite of Shanghai’s designation as the nation’s ‘financial’ hub.

Aware of the Beijing challenge, Shanghai has been trying to win favour with tax breaks. US-based Blackstone was the first to bite, partnering with the Pudong government to launch its own renminbi-denominated fund (see WiC28).

But analysts say local players will continue to have home-field advantage. Foreign firms will also have to settle for minority stakes in most of their investment targets, and not the controlling stakes that they usually insist on elsewhere.

Bain Capital will testify to some of the idiosyncracies of the local investment environment. The US-based private equity fund acquired 10% of Gome Electric Appliances last year, convinced that it could turn round sales in one of China’s leading consumer companies (see WiC36). The company’s founder Huang Guangyu, once the richest man in China, was in prison awaiting trial at the time. He has just been sentenced to 14 years for insider trading, bribery and illegal business dealings.

Although he’s now behind bars, Huang still owns about a third of Gome. And he doesn’t seem too impressed by Bain’s contribution. At last week’s Gome AGM, he used affiliates to vote the Bain-backed directors out. At least Bain seems to have prepared for such an indignity (their exclusion would have triggered huge penalty payments), so the board reappointed the ousted directors immediately afterwards.

“Investing in China requires immense creativity and the agility to respond to fast-changing circumstances,” Kathleen Ng, managing director of the Centre for Asia Private Equity Research in Hong Kong, told the Financial Times. “Foreign private equity investors truly need to understand what they are getting into.”

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