Asia Centre

Good Bye Red Chips, Long Live A Market

Until September 2006, private equity funds traditionally operated in China according to an off-shore circuit. A fund that had been invested in foreign capital and registered outside China took a share in a Chinese company, (a so-called Operating Company) via an off-shore Special Purpose Vehicle (SPV), itself often registered in a tax haven. A merger of the two entities was made before proceeding to a public listing on foreign stock markets, most often Hong Kong or Singapore. A directive in September 2006[1] put a stop to this "red chip" method, by giving the Ministry of Commerce (MOFCOM) the right of refusal for any acquisition of a Chinese company by an off-shore SPV.

There are three main reasons for this change in regulation. The first is the concern the authorities have to keep hold of the country’s best assets. The second is the wish to attract firms of quality onto the domestic markets. The sole raison d’etre of private equity funds is to ensure that their investments can be taken out, and the best way for this to happen is through a public listing on the stock exchange. By having the A market as the focus of any investment in private equity in China, the regulators are reacting to the critical lack of successful listed companies on the domestic markets. The third reason is that the new legislation favours the establishment of funds in RMB, which enables to absorb a part of any surplus liquidity cash.

Since last June, an amendment to the law on partnerships in commercial law  ("合伙企业法[2]") allows local incorporation of private equity funds. These can now raise funds in RMB  and thereby benefit from a favourable fiscal policy enabling them to avoid the impost of double taxation. Local groups are gaining ground. Hony Capital (弘毅), the Lenovo fund, and CDH-Investments (鼎晖), whose manager, Wu Shangzhi, introduced the red chips method by listing Eagle Ceramics (鹰牌陶瓷) in Singapore in 1999, are enjoying the most success. Companies listed on the Stock Exchange, such as China International Capital Corp. and Citic Securities, have also set up their own private equity funds. A great many foreign franchises have also now sprung into existence: Temasek and Goldman Sachs have just entrusted this mission to some of their most experienced bankers, while Carlyle, Texas Pacific Group and CVC, among others, are also adapting to the new regulatory climate. All in all, Beijing has approved 11 funds in RMB since 2006, amounting to some 10.6 billion dollars US (according to the Centre for Asian Private Equity Research).

The government has also set up pilot investment funds that Caijing puts under the "Private Equity" label. The Bohai Industrial Fund in the Tianjin region, with a value of 20 billion yuan, was established in late 2006, while four further funds in different sectors, worth a total value of 46 billion yuan (4.3 billion euros)[3], obtained approval from the State Council in September 2007. At a time when the foremost investment fund, China Investment Corp., is officially starting up its asset management portfolio, with 200 billion US dollars, the setting up of public investment funds confirms the importance placed by the authorities in private equity investments in areas of strategic importance for Beijing. (energy, environment, new technologies, financial services). These funds, despite not having any asset portfolio, are nonetheless being felt as a threat to the "original spirit" of private equity, which in China is facing the twin problems of bureaucracy and political nepotism.

Directed Private Equity

The new  legislation largely determines the direction taken by private equity type investments in China. They are seen as a means of identifying the country’s best companies, of helping in their development through acquisition of interests and listing them on an A grade stock market keen to have quality assets. The Chinese authorities have noted the fact that companies involved with private equity funds turn in better performances over the long term than more traditional companies[4].

Private equity Chinese style is very far from what Michael Jensen has characterised as the "eclipse of the public corporation"[5]. It is grounded, according to  the Jingji Guancha, in a "Pre-IPO" logic in China, in which the cases of public-to-private, frequent though they are in well-developed markets, are here the exception[6]. The bulk of transactions take the form of  a partial acquistion (capital development) and rarely of a full buy-out. KKR’s recent acquiring of an interest in the cement manufacturer Tianrui to the tune of 43.2% is a typical example of the kind of operation likely to take place from now on in China[7]. KKR has invested 115 million dollars US of its own funds and has secured financing syndicated by Morgan Stanley worth some 335 million dollars US. Private equity expertise is thus of considerable assistance to Chinese firms in their search for new securities.

But companies need to have the regulatory bodies on their side. This has been recently shown with the tribulations of a major regional player, Carlyle. The Washington fund saw the rejection of one transaction with the construction equipment manufacturer, XuGong Construction Machinery Group  (XCMG), as well as of its acquisition of 7.99% of Chongqing City Commercial Bank.

A delicate balancing act

Granting a dominant place to private equity in the development of Chinese companies is a strategy that is paying off, and at first flush it would seem to justify the efforts being undertaken by the Chinese authorities.  Liu Chuanzhi, the manager of Hony Capital, identifies three key factors of success, in particular. To begin with, China is benefiting from the expansion of key sectors (public works, textiles, foodstuffs, pharmaceutical industries) where companies are able to produce high, stable and regular profit margins. The private equity funds then contribute to the introduction of better management practices which result in further wealth creation for the company and a better international profile. Lastly, private equity is a unique tool to pilot the reform of state-owned enterprises: Blackstone’s entry into the chemical group China National Blue Star via a 20% capital purchase (600 million dollars) is one striking example of this.

There are, however, some structural factors that paint a slightly different picture of the relevance of private equity, both as a government strategy and as a source of returns on investment.

First of all, while domestic markets are offering exceptional growth, they remain extremely volatile. This fact is important both in the light of the three-year waiting period, starting from the day of a public listing, before shares can be freely disposed of – compared with the period of six months in force in most of the world’s markets. We might add to that the fact that a company must also show three full years of positive results before being able to be publicly listed on the Stock Exchange. Taking the investment out is thus put off for 6 years if the regulation is strictly adhered to. The only fund to have managed to liquidate a part of its investment is IDG Venture Capital, which sold half of its holding in Guangdong Ygsoft for 50 million yuan (4.7 million euros). These structural constraints are likely to undermine the new role of private equity in China. As Wu Shangzhi, the managing-director of CDH-Investments, points out, the funds then tend to reduce the risks by giving preference to investments in more well developed companies and by downgrading the share of risk capital in their asset portfolio.

This situation further reduces the number of potential targets in a context where the supply of liquid assets exceeds demand. By way of illustration, over the same period, private equity transactions amounted to 752 million dollars while the funds raised reached 5.3 billion[8]. The increased competition between Chinese and international funds, combined with the scarcity of quality targets, will henceforth contribute to an overvaluation of assets and consequently to a greater difficulty for the funds to attain the hoped-for internal return. Moreover, the disparity between the amount of funds raised and the reserve of transactions runs the risk, moreover, of lowering their standard in order to use the funds, which are quoted in RMB, a non-convertible currency, during their lifetime.

The private equity market in China is a market with a strong growth potential, but whose outlook remains unclear by reason of the opacity of the decision-making process of the regulatory authorities. The success of the new role that those in power have entrusted to private equity will largely depend on the flexibility of the regulators, particularly concerning the operation of stock exchanges, as well as on the health of the domestic financial markets. By way of example, the lifting of the three-year moratorium following the date of a company’s public listing could allow private equity funds to engage in higher risk investments, something that would be of benefit to the best Chinese companies as it would to the partners of these funds, and would go a long way towards satisfying private equity’s new mission as a tool for improving the Chinese industrial landscape.