Report and Recommendation of the President to the Board of Directors

Project Number: 53185-001 September 2019

Proposed Equity Investment CDH VGC Fund II, L.P. (People’s Republic of )

This is a redacted version of the document approved by ADB's Board of Directors, which excludes information that is subject to exceptions to disclosure set forth in ADB's Access to Information Policy.

ABBREVIATIONS

ADB – Asian Development Bank ESMS – environmental and social management system IFC – International Corporation PRC – People’s Republic of China US – United States

NOTE

In this report, "$" refers to United States dollars.

Vice-President Diwakar Gupta, Private Sector Operations and Public–Private Partnerships Director General Michael Barrow, Private Sector Operations Department (PSOD) Director Janette Hall, Private Sector Investment Funds and Special Initiatives Division, PSOD

Team leader Yee Hean Teo, Senior Investment Specialist, PSOD Team member Elizabeth Alpe, Senior Transaction Support Specialist (Integrity), PSOD Ian Bryson, Senior Safeguard Specialist, PSOD Laurence Genee, Senior Safeguard Specialist, PSOD Catherine Marsh, Assistant General Counsel, Office of the General Counsel Gloria Paniagua, Senior Results Management Specialist, PSOD Kervin John Torchiva, Senior Investment Officer, PSOD

In preparing any country program or strategy, financing any project, or by making any designation of or reference to a particular territory or geographic area in this document, the Asian Development Bank does not intend to make any judgments as to the legal or other status of any territory or area.

CONTENTS Page

PROJECT AT A GLANCE I. THE PROPOSAL 1 II. THE FUND 1 A. Investment Identification and Description 1 B. Business Overview and Strategy 2 C. Ownership, Management, and Governance 2 D. Financial Performance 4 III. THE PROPOSED ADB ASSISTANCE 4 A. The Assistance 4 B. Financial Analysis of Expected Returns and Assumptions 4 C. Implementation Arrangements 4 D. Value Added by ADB Assistance 5 E. Risks 5 IV. DEVELOPMENT IMPACT AND STRATEGIC ALIGNMENT 6 A. Development Impact, Outcome, and Outputs 6 B. Alignment with ADB Strategy and Operations 6 V. POLICY COMPLIANCE 7 A. Safeguards and Social Dimensions 7 B. Anticorruption Policy 8 C. Investment Limitations 8 D. Assurances 8 VI. RECOMMENDATION 8

APPENDIXES 1. Design and Monitoring Framework 9 2. List of Linked Documents 11

I. THE PROPOSAL

1. I submit for your approval the following report and recommendation on a proposed equity investment of up to $30,000,000 in CDH VGC Fund II, L.P. (VGC Fund II or the fund), a fund investing in the People’s Republic of China (PRC).

2. Rationale for proposed ADB assistance. The proposed investment in VGC Fund II will provide about 20 private companies with growth capital to help fast track their development. In doing so, the fund will help increase the depth and diversity of venture and growth capital business models, encourage entrepreneurship, and support the transition of the PRC economy from one focused on manufacturing to one driven increasingly by innovation and technology.

II. THE FUND

A. Investment Identification and Description

3. Description. Founded in 2002 by six founding partners, CDH China Management Company Limited and its affiliate (collectively known as “CDH”) is a pioneer private equity fund manager that invests in companies with significant operations in the PRC.1 CDH has developed in-depth knowledge and expertise within target sectors from its long record of managing different funds before VGC Fund II, which intends to invest in early to growth stage companies. 2 The fund may also invest a limited portion of its capital opportunistically outside of its primary investment objectives.3 VGC Fund II intends to focus on companies in the health care, logistics and/or consumer goods, and artificial intelligence and technology sectors.4 VGC Fund II’s investment team is led by Wang Lin and comprises 25 investment professionals, including 10 partners across its four offices.5

4. Since its inception, CDH has raised 14 private equity and funds denominated in United States (US) dollars and renminbi, exceeding $10 billion in commitments.6 [This information has been removed as it falls under the exception to disclosure in ADB’s Access to Information Policy, para. 17.2.(v)].

5. VGC Fund II is a closed-end private equity fund with a target capitalization of $500 million. CDH VGC II Holdings Company Limited, a Cayman Islands exempted company, will manage the fund as the general partner. CDH Mid Market Management Company Limited, a Cayman Islands

1 The founding partners are Wu Shangzhi, Jiao Shuge, Stuart Schonberger, Hu Xiaoling, Wang Lin, and Wang Zhenyu; CDH VGC II Holdings Company Limited (general partner), CDH Mid Market Management Company Limited (manager), CDH Investments Management () Limited (investment advisor), and any other entities that acted and/or will act as advisors to CDH VGC Fund II, L.P. and CDH’s other funds are collectively referred to as CDH. 2 CDH is an investment platform that, in addition to private equity funds (both onshore and offshore), manages different asset classes, including private equity, real estate, mezzanine, public fixed income, public equity, and private wealth management. 3 The ability to make opportunistic investments will provide the fund greater flexibility to create a balanced portfolio, given its focus on early to growth stage portfolio companies, and will include the ability to invest in publicly listed securities. 4 The fund may also invest in other sectors. A climate change target amount cannot be specified as this is an investment in a fund (as opposed to an investment in a company), and the composition of the underlying investee companies is not yet known. 5 As of 31 July 2019, CDH employed more than 300 staff, including more than 150 investment professionals across , Hong Kong, China, , and that manage different asset platforms. 6 As of 31 March 2019; excludes CDH real estate, mezzanine finance, public equities, fixed income, and wealth management businesses.

2 exempted company, will provide management and administrative services to the fund as its manager. It will also enter into arrangements with CDH Investments Management (Hong Kong) Limited, the advisor and a Hong Kong, China limited liability company, to obtain advisory services.7

6. Investment identification. Through market mapping of 40 private equity funds focused on the PRC, the Asian Development Bank (ADB) identified CDH as one of the top performing and consistent fund managers investing growth capital in small and medium-sized companies. CDH has a strong investment track record and has demonstrated its ability to anticipate and capitalize on fast-growing sectors in the PRC.

7. ADB initiated dialogue with CDH in 2015 and has actively tracked the platform since then. ADB views the proposed investment to be consistent with its private equity fund investment guidelines. The investment would provide development benefits, including skilled jobs generation and technological innovation and adoption, particularly in the PRC health care sector.

B. Business Overview and Strategy

8. VGC Fund II aims to make about 20 investments averaging $10 million–$30 million each in early to growth stage companies. The fund may provide additional capital to certain companies that have grown significantly since the initial investments. It will generally seek to invest in businesses with experienced and driven management teams; strong alignment of interests with business owners and management; significant growth prospects; mutually agreed exit strategies; and opportunities for the general partner to add value through its operational, strategic, and/or capital markets expertise. VGC Fund II may invest a limited portion of its committed capital for opportunistic investments outside of its primary investment objective (footnote 3).

9. VGC Fund II will adopt a top-down, research-intensive approach to identify key players in targeted sectors and source investment opportunities with leading entrepreneurs. The fund’s investments are expected to improve the PRC’s supply and demand imbalances, increase efficiency and/or reduce costs through technology advancements and/or business model upgrades to deliver long-term sustainable growth. CDH also aims to build an ecosystem of stakeholders with complementary businesses in each sector that will benefit and add value to existing and potential portfolio companies.

10. CDH’s extensive investment experience in each identified sector has allowed it to proactively address the challenges and opportunities arising from the PRC’s fast-evolving economy. The investment team will rely on CDH’s extensive relationships to identify attractive investment opportunities and build a complementary network including leading entrepreneurs and management teams in PRC. The investment team may use industry experts to analyze specific issues to mitigate particular risks and seek operational improvements.

C. Ownership, Management, and Governance

11. Ownership. VGC Fund II is an exempted limited partnership registered in the Cayman Islands. Its limited partners include institutional investors and family offices. ADB will be the first development financial institution to invest in VGC Fund II and will therefore add value in terms of corporate governance, environmental and social safeguards, and heightened focus on

7 Detailed information on the structure of the fund is in Ownership, Management, and Governance (accessible from the list of linked documents in Appendix 2).

3 development investments. [This information has been removed as it falls under the exception to disclosure in ADB’s Access to Information Policy, para. 17.2.(v)].

12. Management. The investment team consists of 25 investment professionals led by two managing partners—Wang Lin and Huang Yan—who are supported by eight senior partners, each with an average of 10 years of private equity and/or operational experience in the PRC. The two managing partners, along with chairman Wu Shangzhi and chief executive officer Jiao Shuge, will form the investment committee, which approves investments by majority decision. CDH also has 59 back-office staff, including legal and compliance, finance and accounting, investor relations, and human resources, to support the investment platform.

13. ADB conducted integrity due diligence and enhanced tax integrity due diligence on CDH and its related entities and identified no significant integrity risks.8 The results are in the ownership, management, and governance linked document (footnote 7). ADB’s review of the entity does not give the bank cause to believe that CDH was established or is being used for money laundering or terrorism financing. ADB has obtained reasonable assurance that the transaction is not being used for tax secrecy, tax evasion, or tax fraud; and that the tax integrity risks are low and acceptable to the bank.

14. Governance structure. VGC Fund II follows a three-stage investment and divestment process: sourcing and underwriting, portfolio monitoring, and exiting.

15. A typical investment would be led by one partner and up to four investment professionals, depending on the deal size. The investment team evaluates a deal, prepares its investment thesis, and conducts due diligence on the target company. The sourcing and underwriting of investments are further divided into a four-stage process: (i) Project brief. The investment team drafts a project brief on the opportunity. (ii) Initiating memorandum. The investment team conducts initial due diligence on the target company’s business model and growth prospects, industry analysis, valuation, and key risks; and presents its findings to the investment committee. (iii) Investment decision memorandum. The investment team completes the necessary financial, legal, and technical due diligence; and prepares a formal memorandum for the investment committee’s approval. (iv) Final investment decision and execution. The investment team closes the deal and enters into binding legal documentation.

16. The investment team also manages the portfolio investment through the planned exits. Monitoring may include (i) active participation at the board level, (ii) regular dialogue with management and company visits, (iii) budget and strategy reviews, and (iv) management information analysis. The team also works closely with company management to execute the growth strategy. Key focus areas for value creation include (i) active involvement in strategic decisions to enhance market position, (ii) navigation of complex shareholding structures, (iii) external growth through , and (iv) long-term financing solutions via capital markets access. The investment team also monitors market conditions that could impact the exit strategy and timing.

8 ADB. 2003. Enhancing the Asian Development Bank's Role in Combating Money Laundering and the Financing of Terrorism. Manila; and ADB. 2016. Anticorruption Policy: Enhancing the Role of the Asian Development Bank in Relation to Tax Integrity. Manila.

4

17. In addition to the investment committee, an advisory committee comprising of up to eight limited partners will be formed to advise the general partner, with the primary role of reviewing transactions involving conflicts of interest.9 [This information has been removed as it falls under the exception to disclosure in ADB’s Access to Information Policy, para. 17.2.(v)].

D. Financial Performance

18. [This information has been removed as it falls under the exception to disclosure in ADB’s Access to Information Policy, para. 17.2.(v)].10

III. THE PROPOSED ADB ASSISTANCE

A. The Assistance

19. ADB will provide an equity investment of up to $30,000,000 in VGC Fund II. The ADB investment will not exceed 25% of the fund’s total committed capital and will not result in ADB being its single largest investor.

B. Financial Analysis of Expected Returns and Assumptions

20. The general partner aims to achieve a target gross internal rate of return of 25% in US dollars for the fund. Consistent with market practice but subject to certain limitations, the general partner can recall a portion of ADB’s capital (previously distributed to ADB) for reinvestment. In such instances, ADB’s total capital commitment to VGC Fund II will remain unchanged.

C. Implementation Arrangements

21. Exit strategy. CDH will have a 10-year term from final closing, subject to two 1-year extensions. The anticipated exit strategies of CDH’s investments include (i) public offerings on the Hong Kong, China; PRC; and/or other international stock exchanges; (ii) trade sales of portfolio companies to local and foreign strategic buyers; and (iii) secondary sales to other private equity funds.

22. Reporting arrangements. The general partner will provide ADB with unaudited quarterly reports, audited annual reports with financial statements, quarterly and annual fund overview reports with summary description of each portfolio company, and annual development effectiveness monitoring reports. ADB will review this information and follow up with the general partner if more information or clarification is needed. If the information received from the general partner raises issues that could impair the value of ADB’s investment in VGC Fund II, ADB could decide to put the fund on a watch list for more frequent and detailed review.

23. VGC Fund II will adopt an environmental and social management system (ESMS) compliant with ADB’s Safeguard Policy Statement (2009) before its first disbursement and must report annually on environmental and social safeguard issues. ADB will monitor the timing and quality of the ESMS reports and offer guidance if the general partner requires clarification on ADB’s safeguard requirements.

9 Voting representatives of the advisory committee will not be affiliates of the general partner or the advisor. 10 [This information has been removed as it falls under the exception to disclosure in ADB’s Access to Information Policy, para. 17.2.(v)].

5

D. Value Added by ADB Assistance

24. Promote private sector development. The proposed investment is in line with ADB’s objectives to promote private sector development by supporting the PRC’s rapidly growing private sector economy. Through this investment, ADB will help finance small and medium-sized companies in the PRC, thereby potentially reducing the economic dominance of large state- owned enterprises. VGC Fund II is expected to identify and support strong, capable business leaders, thereby helping to foster a new generation of entrepreneurs in the PRC. By supporting the fund, ADB also aims to increase business efficiency, labor productivity, and overall employment in the investee companies.

25. Raise standards. As the second development financial institution investor in a CDH- managed fund, ADB will enhance VGC Fund II’s ESMS to comply with the bank’s environmental and social safeguard standards and report on development indicators. In addition, ADB and other advisory committee members will provide oversight on important governance matters, which are critical for companies to demonstrate as they seek additional sources of growth capital.

26. Mobilize cofinancing opportunities. CDH values ADB’s ability to provide debt and equity financing directly to portfolio companies to help them grow. In addition to providing capital from its own balance sheet, ADB can help mobilize financing from third-party sources.

E. Risks

27. [This information has been removed as it falls under the exception to disclosure in ADB’s Access to Information Policy, para. 17.2.(v)]. 11

28. [This information has been removed as it falls under the exception to disclosure in ADB’s Access to Information Policy, para. 17.2.(v)].

29. [This information has been removed as it falls under the exception to disclosure in ADB’s Access to Information Policy, para. 17.2.(v)]. 12

30. [This information has been removed as it falls under the exception to disclosure in ADB’s Access to Information Policy, para. 17.2.(v)]. 13

31. [This information has been removed as it falls under the exception to disclosure in ADB’s Access to Information Policy, para. 17.2.(v)].

32. [This information has been removed as it falls under the exception to disclosure in ADB’s Access to Information Policy, para. 17.2.(v)].

11 [This information has been removed as it falls under the exception to disclosure in ADB’s Access to Information Policy, para. 17.2.(v)]. 12 [This information has been removed as it falls under the exception to disclosure in ADB’s Access to Information Policy, para. 17.2.(v)]. 13 [This information has been removed as it falls under the exception to disclosure in ADB’s Access to Information Policy, para. 17.2.(v)].

6

IV. DEVELOPMENT IMPACT AND STRATEGIC ALIGNMENT

A. Development Impact, Outcome, and Outputs

33. Impact. The depth and diversity in venture and growth capital business models and entrepreneurship in the PRC is enhanced, and the transition from a manufacturing-focused to an innovation and technology-oriented PRC economy is supported.

34. Outcome. Financial sustainability and operational value addition of private equity investments to the fund’s portfolio companies is demonstrated.

35. Outputs. With respect to VGC Fund II, (i) an advisory committee is established, and (ii) capital is invested.

B. Alignment with ADB Strategy and Operations

36. Consistency with ADB strategy and country strategy. The investment is aligned with the operational priorities of ADB Strategy 2030, including addressing remaining poverty and reducing inequalities by generating quality jobs, improving , and achieving better health for all.14 Strategy 2030 also supports using private equity funds as an important modality to extend ADB’s reach because of their significant leveraging and mobilizing effects, as well as to promote financial inclusion.

37. Consistency with country strategy. The investment is aligned with ADB’s PRC country partnership strategy, 2016–2020, which prioritizes enhancing finance sector infrastructure and supporting commercially viable business models to assist in continued domestic rebalancing from industry to services.15

38. Consistency with sector strategy and relevant ADB operations. ADB’s Operational Plan for Health strongly supports private sector approaches to address quality, affordability, and accessibility in the health sector.16 By investing in VGC Fund II, ADB would be partnering with a leading PRC-focused private equity fund manager that has developed deep expertise and a network in health care. Investments made by the fund are expected to support the generation of innovative solutions to improve the quality, accessibility, and affordability of health care services in the PRC.

39. Lessons from previous operations. The project team considered lessons from previous ADB private equity fund investments and incorporated the same into the proposed transaction. For example, an evaluation report published in 2019 on ADB Private Sector Equity Investments concluded that ADB should refine its approach to private equity fund investments to ensure their financial sustainability and appropriately prioritize value addition and development impact.17 In this case, ADB comprehensively assessed CDH as a platform, including the quality and depth of the management team, performance of its portfolio companies, and investment and exit record of prior funds. ADB also confirmed CDH’s alignment with the bank’s development mandate in terms

14 ADB. 2018. Strategy 2030: Achieving a Prosperous, Inclusive, Resilient, and Sustainable and the Pacific. Manila. 15 ADB. 2016. Country Partnership Strategy: Transforming Partnership: People’s Republic of China and Asian Development Bank, 2016–2020. Manila. 16 ADB. 2015. Health in Asia and Pacific: A Focused Approach to Address the Health Needs of ADB Developing Member Countries—Operational Plan for Health, 2015–2020. Manila. 17 Independent Evaluation Department. 2019. ADB Private Sector Equity Investments. Manila: ADB.

7 of sector focus. The project team proceeded with the investment after confirming through due diligence that CDH meets financial sustainability, value addition, and development impact criteria.

V. POLICY COMPLIANCE

A. Safeguards and Social Dimensions

40. ADB has categorized the investment in compliance with ADB’s Safeguard Policy Statement.18

41. Category FI. ADB has assessed the investment's potential environmental and social impacts, its risks associated with VGC Fund II’s existing and/or likely future portfolio, and its commitment and capacity for environmental and social management. The potential fund investees’ business activities are not expected to generate significant environmental and social impacts or risks, require involuntary resettlement, or adversely or beneficially affect distinct and vulnerable ethnic minority communities. Environmental impacts caused by expected investee business activities are, however, possible during the construction and operation of buildings, such as health care and manufacturing facilities. Such environmental impacts are expected to be site- specific, few are irreversible, and in most cases mitigation measures can be incorporated in the project designs and operational controls. All other prospective investments are expected to be small-scale and operate in leased premises in urban and peri-urban locations. ADB will have the right to be exempted from contributing capital to any proposed investment that it assesses as being noncompliant with the ESMS and any safeguards category A investment.

42. VGC Fund II has established and implemented an ESMS commensurate with identified portfolio risks and impacts. The ESMS was established following the Performance Standards on Environmental and Social Standards of the International Finance Corporation (IFC) after IFC’s investment in CDH Fund V in 2013 and was last updated in January 2018.19 During due diligence, ADB has identified the following actions to enhance the ESMS: harmonize the fund’s exclusion list with ADB's prohibited investment activities list; update procedures for categorizing projects based on Safeguard Policy Statement requirements, and for compliance with national laws and regulations; include measures to comply with internationally recognized core labor standards pursuant to ADB’s Social Protection Strategy (2001); include a grievance redress mechanism; include project information disclosure and meaningful consultation with affected people following ADB requirements; and provide supervision, monitoring, and reporting of fund investees’ environmental and social performance to ADB.20 The ESMS will be enhanced following Safeguard Policy Statement requirements and approved by ADB before ADB’s first disbursement. CDH will include in its regular reporting information to ADB for VGC Fund II (i) the nature of subprojects and categorization, (ii) compliance with the safeguard and social requirements, and (iii) compliance with applicable national and international laws and standards.

43. No gender elements. The project team discussed opportunities with CDH to undertake an internal gender diversity and inclusion policy review and include gender indicators in their investment appraisal process. However, CDH does not view such measures to be necessary for a PRC-based and -focused private equity firm given the country’s strong policy and legislative

18 ADB. Safeguard Categories. 19 IFC. CDH Fund V (accessed 19 August 2019). 20 Summary Poverty Reduction and Social Strategy; and Environmental and Social Management System: Audit Findings and Details of Arrangement (accessible from the list of linked documents in Appendix 2).

8

support in this regard. CDH will report annually to ADB using sex-disaggregated data on (i) its compliance with such laws, and (ii) the measures taken.

B. Anticorruption Policy

44. CDH was advised of ADB’s policy of implementing best international practice relating to combating corruption, money laundering, and the financing of terrorism. ADB will ensure that the investment documentation includes appropriate provisions prohibiting corruption, money laundering, and the financing of terrorism; and remedies for ADB in the event of noncompliance.

C. Investment Limitations

45. [This information has been removed as it falls under the exception to disclosure in ADB’s Access to Information Policy, para. 17.2.(v)].

D. Assurances

46. Consistent with the Agreement Establishing the Asian Development Bank (the Charter),21 ADB will proceed with the proposed assistance upon establishing that the Government of the PRC has no objection to the proposed assistance to VGC Fund II. ADB will enter into suitable finance documentation, in form and substance satisfactory to ADB, following approval of the proposed assistance by the Board of Directors.

VI. RECOMMENDATION

47. I am satisfied that the proposed equity investment would comply with the Articles of Agreement of the Asian Development Bank (ADB) and recommend that the Board approve the equity investment of up to $30,000,000 from ADB’s ordinary capital resources in CDH VGC Fund II, L.P., a private equity fund investing in the People’s Republic of China, with such terms and conditions as are substantially in accordance with those set forth in this report, and as may be reported to the Board.

Takehiko Nakao President 20 September 2019

21 ADB. 1966. Agreement Establishing the Asian Development Bank. Manila.

Appendix 1 9

DESIGN AND MONITORING FRAMEWORK

Impacts the Project is Aligned with The depth and diversity in venture and growth capital business models and entrepreneurship in the PRC is enhanced, and the transition from a manufacturing-focused to an innovation and technology-oriented PRC economy is supported.a

Performance Indicators with Data Sources and Results Chain Targets and Baselines Reporting Mechanism Risks Outcome Financial a. At least 80% of the fund is a–d. The fund’s annual Market dynamics and sustainability and invested in target industries development sector cycles operational value by 2025 (2019 baseline: 0). effectiveness negatively impact addition of private monitoring report, and investment equity investments to b. Fund is profitable (DPI > 1) quarterly and annual opportunities within the fund’s portfolio at ADB’s exit (baseline: not reports target industries. companies is applicable). demonstrated Unfavorable c. Employment of fund macroeconomic investee companies grew by conditions lead to at least 10% during the general low returns holding period (baseline: not and unsuccessful applicable). exits from investments. d. Taxes paid by fund investee companies increased by 25% on an aggregate basis during the holding period. (baseline: not applicable). Outputs 1. Fund’s advisory 1. The advisory committee is 1–2. The fund’s annual The fund manager is committee is established by Q1 2020 (2019 development unable to raise the established baseline: not established). effectiveness targeted $500 million. monitoring report, and 2. Capital invested 2. At least 80% of the fund’s quarterly and annual The fund manager is capital is deployed to about reports unable to execute on 20 portfolio companies by intended pipeline 2025 (baseline: 0). opportunities.

Competition from other investors reduces the attractiveness of investment opportunities.

Key Activities with Milestones

Output 1: Fund’s advisory committee is established 1.1 ADB’s legal documentation is executed by Q4 2019. 1.2 ADB and other investors invest in the fund by Q1 2020. 1.3 The fund establishes an advisory committee with ADB representation by Q1 2020.

Output 2: Capital invested 2.1 The fund sources, screens, and invests in companies from 2019 to 2025.

10 Appendix 1

Inputs ADB: Up to $30 million (equity) Assumptions for Partner Financing Not Applicable ADB = Asian Development Bank, DPI = distribution to paid-in capital, ESMS = environmental and social management system, PRC = People’s Republic of China, Q = quarter. a Defined by the project. Source: Asian Development Bank.

Appendix 2 11

LIST OF LINKED DOCUMENTS http://www.adb.org/Documents/RRPs/?id=53185-001-4

1. Sector Overview 2. Ownership, Management, and Governance 3. Details of Implementation Arrangements 4. Contribution to the ADB Results Framework 5. Financial Analysis 6. Country Economic Indicators 7. Summary Poverty Reduction and Social Strategy 8. Environmental and Social Management System: Audit Findings and Details of Arrangement