ASIAN LEGAL BUSINESS 40 PE funds April 2012

Flight to quality

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Flight to quality Chinese funds are facing a shake-up with the boom times ending for many, as fund raising dries up and new tougher rules are expected to be introduced later this year. The time is approaching when the wheat will be separated from the chaff. What will funds need to do to survive in this tough climate, and where are ’s most prominent sponsors headed? Candice Mak reports ASIAN LEGAL BUSINESS 42 PE funds April 2012

ccording to a Zero2IPO Research raised in the Chinese mainland in 11 months was $26.4 billion, a surging Centre report, Chinese private equity increase of 237 percent from the total in 2010. Zero2IPO estimated that (PE) firms are likely to encounter dif- new PE funds raised in 2011 may have reached $30 billion. However, the ficulties in fundraising and tougher report cautioned that fund raising by PE firms will become more difficult regulationsA this year. The report also noted that in 2012 with tightened liquidity in the market. the expected extension of regulations nation- wide will force some firms to start cleaning up Boom times are over their operations to avoid breaching the new rules The Zero2IPO report coincides with a analysis from December, (please see box on page 48: Regulatory update). 2011 that said the boom of thousands of PE funds in China appears to have Chinese PE funds are expected to undergo a come to an abrupt end. The proliferation of domestic fund launches since period of reshuffling in the coming eight months 2008 was sparked by the prospect of quick and easy money, and returns as owing to several market factors. These include high as 400 times on a cash investment. But domestic market weakness, the decrease in domestic a tight monetary policy, and growing economic uncertainty made both (IPO) valuations, the increased sophistication of fundraisings and exits for PE firms increasingly difficult. companies seeking financing, and the resulting As a result, many speculative funds which invest in companies just before increased emphasis on value-add that PE funds an IPO, only to sell out soon after their listings, could be wiped out.”China are able to provide, says Han Kun Law Offices has about 3,500 PE funds and that’s an awful lot,” said Gao Jianbin, a partner James Wang. “As a result, many do- -based partner at PricewaterhouseCoopers, to Reuters.”At the mestic PE funds will be getting more pressure end of the day, only those with management expertise and the ability to finding good investments with an attractive grow invested companies can survive,” he said, adding that many funds price-to-earnings ratio; have a harder time would be forced to focus on and trying to exit their investments through IPOs; businesses. and will have to explore other ways to exit such China’s PE boom started immediately after the 2008 global financial as trade sales or secondary sales to other PE funds,” he says. The funds will need to diversify their invest- ment strategy from and pre-IPO to other strategies like earlier-stage investment, consolidation or special situations play. Unlike in mature markets, most Chinese fund manag- ers, including venture capitalists, have until now only focused on pre-IPO deals, betting on listings that would typically boost the value of their investments. Currently, 90 percent of exits are made through IPOs. Wang says Chinese PE funds should also become more specialised in terms of industry focus, and equip themselves with specialised professionals. “PE funds that cannot meet such challenges will find it hard to survive,” he says. The year 2011 saw China’s PE market experi- encing a boom. According to Zero2IPO data, 323 new funds were launched in the mainland from January to November; a growth of 204 percent from the total in 2010. The total amount of funds

“The variations make our work more interesting as fund lawyers because not only is international experience highly relevant in this field, but we also become part of the force that is shaping the PE fund industry in China with unique China characteristics.” James Wang, Han Kun Law Offices REUTERS/Siu Chiu WWW.LEGALBUSINESSONLINE.COM : @ALB_Magazine : Connect with Asian Legal Business PE funds 43

crisis spurred by two things: a flurry of IPOs following the launch of the require that fund managers have a profound Nasdaq-style ChiNext board on the exchange, and the $586 understanding of the businesses they invest billion economic stimulus package put in place to ward off financial in,” said Vincent Huang, partner of global contagion. PE fund-of-funds manager Pantheon, at a According to fund consultancy ChinaVenture, 1,084 yuan-denominated financial conference in Shanghai in December PE and venture capital funds, including those of global giants 2011.”This is what made TPG, Bain and KKR Carlyle Group, Blackstone Group and TPG Capital, were launched in China global giants. But 90 percent of Chinese fund over the past three years, raising a combined $68.7 billion. Comparing this managers are not equipped with that ability.” figure with Thomson Reuters data revealed that 925 funds were launched Juan Delgado-Moreira, the managing in the United States during the same period, raising $236 billion. director of PE management firm Hamilton However, fund raising has become difficult as local governments, which Lane, says the inexperience and missteps of typically provide seed capital for new funds, are now struggling to manage some new Chinese fund managers will benefit debts worth more than 10 trillion yuan ($1.57 trillion) that have accumulated those more established and mature Chinese over the past few years. Private entrepreneurs, another important investor PE players. “The good news for those funds base for Chinese PE firms, are also feeling squeezed by slowing business with a full complement of skills is that those conditions and tightening credit. As such, there is no official data on the without are likely to fade from the competitive sector and latest available industry figures are outdated because they do set as market tides turn, as it currently seems not reflect the current fundraising environment. But fund managers say to be happening,” he says. the sharp downturn in the sector has been evident. The looming shake-up is seen by many as a natural and necessary step in developing Natural selection China’s nascent PE market, and not neces- Industry analysts told Reuters that for survival, PE managers will need sarily a death knell.”There’s so much wealth to do more than just bet on IPOs to win investors. “Investors would in China that this industry will not die out as many commentators predict. But it needs to be managed,” says one senior executive at a Western PE firm. “Developing core disciplines found in the most successful and time-tested Western and Chinese groups — rigorous investment diligence, responsible capital deployment, sophisticated management and operational improvement strategies — will become critical success factors for RMB PE players as well,” says Moreira. Shanghai-based Boss & Young partner Hubert Tse, who has worked with PRC and global private equity funds, views the devel- opment of the PE funds market as beneficial to the legal space. “As Chinese PE partici- pants mature, they will need to become more professional and sophisticated to get funds from LPs to make good investments and get good returns,” he says. “That means lawyers will be more involved, and relied upon more, to assist them on closing deals.”

Strong get stronger Despite a dulled outlook for PE funds as a whole, the growing group of sophisticated and prominent Chinese sponsors which in- cludes CDH Investments (a spin-off of China Investment Corp), , Citic PE, FountainVest Partners, Fosun International, Legend Capital and New Horizon Capital, continues to flourish.“A few offshore funds of high-profile PRC players don’t use placement agents,” says -based Debevoise & Plimpton partner Andrew Ostrognai. “My guess is that they have developed this prod- REUTERS/Siu Chiu uct on their own over time, and have done so ASIAN LEGAL BUSINESS 44 PE funds April 2012

“A potential medium to long-term opportunity for law firms could come from increased outbound investment activity from China; probably in more varied industries than the natural resources focus we’ve seen until now, and with some of the outbound capital being channeled through the PE industry” John Fadely, Weil, Gotshal & Manges

well they don’t need doors opened anymore; gave no timetable for the fund launch, but said two-thirds of HAO they have done it themselves already.” In fact, Capital’s second dollar fund had been invested, adding that she expects these high-profile funds continue to raise re- two portfolio companies to conduct IPOs in China this year. cord amounts for their onshore and offshore Earlier in January, Hony Capital said in a statement that it had raised funds, and to announce new launches in the nearly $4 billion from investors, defying the increasingly tight fundrais- coming months. ing climate. It raised close to $2.4 billion for its fifth dollar fund, and This is big business for fund formation law 10 billion yuan ($1.6 billion) for its second local currency fund. These firms in Hong Kong. Ostrognai regularly rep- numbers are almost double the sizes of previous dollar and yuan funds resents CDH Investments and Hony Capital on for Hony Capital, which is backed by Ltd. offshore fund formations. Simpson Thacher “Changes that were not found in foreign markets over the past two & Bartlett’s Hong Kong-based partner Philip or three decades are taking place in China,” said John Zhao, the CEO of Culhane says that the key drivers of his busi- Hony. “The emergence of China provides rare opportunities for China’s ness are local indigenous GPs with Asia-based PE insiders to explore a new way with Chinese characteristics, based on investment committees and Asian investment our experience in the Chinese market.” The speed of Hony’s fundraising professionals. “Clearly, there are going to be - which began in September 2011 for the dollar fund with a target of $2 homegrown competitors. We see this as our billion - underlines the appetite of international investors for investing in key market,” he says. His team counts New China through funds like Hony, which have an established track record. Horizon and NewQuest Capital as clients. With its dollar fund, Hony said it will continue to focus on reform of On Feb. 16, according to Reuters, govern- China’s state-owned enterprises, as well as growth capital investments. ment-backed Sailing Capital International In the aftermath of the 2007 and 2008 global financial crisis, China launched a 50 billion yuan ($7.93 billion) fund stepped up efforts to promote international use of the yuan in a bid to in Shanghai to aid overseas acquisitions by reduce reliance on the U.S. dollar, and it encouraged domestic com- Chinese companies, and build the commercial panies to acquire crisis-hit foreign companies. It has also been aiding hub into a global financial centre. The fund will acquisitions through government-backed funds and commercial banks. back Chinese companies’ overseas expansions For example, state-owned policy banks have invested in PE funds through loans and equity investment, with such as Mandarin Capital Partners and Infinity Group to aid outbound the yuan as the preferred currency for pricing, investment. transaction and settlement in cross border investments. Investors in the newly-launched Looking outward Sailing Capital International fund include both As China’s top tier PE funds search for new ways to deploy capital, state and non-state owned enterprises, listed industry analysts have recognised a growing outbound trend. “A po- firms and financial institutions, the Shanghai tential medium to long-term opportunity for law firms could come from government said without disclosing details. increased outbound investment activity from China,” says John Fadely, a Shanghai vice-mayor Tu Guangshao says Hong Kong-based funds partner at Weil, Gotshal & Manges. “Probably that launching the fund “meets Chinese com- in more varied industries than the natural resources focus we’ve seen panies’ strategic needs to venture out, and until now, and with some of the outbound capital being channeled would also play an important role in building through the PE industry,” he says. One way a Chinese PE fund may Shanghai into a center for asset management get involved is by looking at investing in a domestic company that has and cross border investment denominated in plans to expand to a foreign country, making the fund’s asset offshore. yuan.” According to a Reuters analysis, after years of focusing on their home Reuters reported on Feb. 27 that China- turf, Hony Capital and other China funds are also beginning to expand focused PE firm HAO Capital planned to abroad. A small portion of the Hony fund may be used for overseas launch its third U.S. dollar fund this year, as investment, sources said. Zhao previously told Reuters that technology it eyes more exit opportunities in China for its companies in the United States, and Japan could improve their portfolio companies amid sluggish markets value significantly if they could get their products into China. overseas. Founder and partner Elaine Wong, “The outbound aspirations of China’s biggest sponsors are a terrific who previously worked at the Carlyle Group, development for our practice area,” says Culhane. “It is one more piece of WWW.LEGALBUSINESSONLINE.COM : @ALB_Magazine : Connect with Asian Legal Business PE funds 45

CULTURAL DIFFERENCES Chinese characteristics of RMB funds Prior to the 2008 financial crisis, industry experts estimated the total size of the entire global industry to be around 3,000 to 4,000 funds. But the definition of a PE fund in China compared to the rest of the world can be quite different. PE deals normally involve a firm putting a small amount of cash down for a takeover, and borrowing the rest. After streamlining the company, the firm sells it at a premium and pockets the money, keeping part of the profit and handing the rest back to institutional investors. In China, ownership restrictions are widespread and leveraged markets are still in their infancy. As a result, the vast majority of deals are done in cash and for a minority stake. In that sense, it is often REUTERS/Aly Song hard to tell the difference between a PE, venture capital, and hedge fund deal in partners (LPs). Partner James Wang of because the default rate on these funds China. Chinese funds generally lack the Han Kun Law Offices explains another can be quite high, sponsors are keen to kind of institutional backing that their chief variant when he says: “The capital get their money upfront. “It is a little bit of Western peers have. “True PE funds make call mechanism typical for international protection on the manager and GP (general investments in private companies; it is funds is significantly twisted in the China partner) side, to precall some capital and equity. But private funds can mean a lot context, with most funds requiring capital have a cushion against default,” he says. of things – it could just be people pooling commitments to be contributed in one For Chinese investors, it is a significant together funds and investing in everything lump sum or at predetermined time philosophical step to relinquish control which can reap profits,” says Shanghai- intervals.” Fadely says that due to the over their investment decisions to someone based Boss & Young partner Hubert Tse, different mentality of Chinese investors, else and many are not yet comfortable with who describes his experience with hybrid many sponsors have decided to call all the this. “Most Chinese LPs and high net worth funds – which are private, but not focused capital down at the very beginning of the individuals are still getting accustomed on PE – as an example of the lack of a clear fund in order to eliminate default risk later to giving money to others to manage or definition of what exactly constitutes a PE on. As the blind pool fund remains a novel invest, and they have yet to go through fund onshore. concept to Chinese investors, sponsors the volatility of certain investments,” says Apart from a blurry understanding of have been identifying the portfolio assets Tse. “They may not fully comprehend and how Chinese PE funds are delineated, early on and marketing these, giving understand the possible downside risks there are also peculiarities – “Chinese investors security and compacting the involved, but only think of the upside as characteristics” – of these onshore funds. investment period. they have not really experienced the kind “RMB funds can have features that diverge Why Chinese funds ask for a lot more of downside risks associated with more from the PE model as generally understood capital up front could be a result of several sophisticated investments. So, it will take outside China, and the variations can be things. One is that they tend to have a time for them to get used to this, and major because they affect the typical PE lot more high net worth individuals as become more mature in their investment incentive structures,” says Hong Kong- investors as opposed to institutions. It philosophy.” based Weil, Gotshal & Manges partner, would likely be burdensome for individuals Wang says the variations of Chinese John Fadely. One distinction between to receive constant capital calls and so it PE funds make his team’s work more western PE funds and Chinese ones is likely that they prefer to provide their interesting because “not only is are the time horizons: the life terms, money in just a few tranches. “Chinese international experience highly relevant in investment periods, and post investment investors may find it operationally easier to this field, but also we become part of the periods are generally shorter due to the fund less frequently in larger chunks,” says force that is shaping the PE fund industry in quick exits through domestic IPOs and Hong Kong Debevoise & Plimpton partner China with unique China characteristics.” shorter investment outlooks of limited Andrew Ostrognai. Another reason is that ASIAN LEGAL BUSINESS 46 PE funds April 2012

the puzzle that will lead to global best practic- es being the benchmark for significant market “What we are really participants.” The aim of the funds is high, with waiting for is the managers stating their hopes to compete for convergence of investment dollars as well as deal opportuni- offshore and ties with Western giants like Blackstone, TPG and the Carlyle Group. The barriers are high as onshore, where well, as expanding overseas is always difficult, domestic and foreign and the acceptance level of Western executives investors commit to a and fund of fund investors for Chinese players common vehicle that is still fairly untested. Intense competition for deals at home in addition to international receives domestic treatment.” ambitions of Chinese companies like consumer Andrew Ostrognai, Debevoise & Plimpton goods group Bright Food, is fuelling the move to send China PE businesses across borders. “As China continues to climb up the value Home advantage chain over time, it wouldn’t be surprising at In luring money from Western institutions such as pension funds and all for China’s outbound investment activity banks, analysts say some Chinese firms have an advantage over their to diversify into other industries,” says Fadely. much larger global rivals. This is because of their strength in the China PE executives in China stress the move is market - an area the Western institutions want exposure to. Some gradual, though whatever the speed, it’s hap- Chinese firms now have both a dollar and a yuan fund at their disposal, pening. “As the world’s most vibrant economy, which gives them an advantage over firms with only a U.S. dollar fund. China has attracted the world’s best compa- During the past two years, at least six homegrown Chinese firms, nies, resources and wealth,” said Zhao at a including Fortune Venture Capital and Jiuding Capital, have launched Shanghai ceremony in September 2011 that or plan to launch their first dollar funds, according to Zero2IPO data. was attended by local government officials, as Highlighting the fundraising ability of Chinese firms, Citic PE Funds well as scores of overseas institutional inves- Management Co raised $1 billion in May 2011 in its first dollar fund after tors. “Chinese companies have also started attracting foreign demand. The fund, which was heavily oversubscribed, sailing abroad. This is Hony’s opportunity,” obtained investment from 39 overseas institutions including sovereign he had said. wealth funds, pension funds, endowments, family offices and insurers. The venerable Chinese sponsor is not PE research group Preqin estimates that there are 538 Asia and global alone in its international plans. Citic Capital, funds on the road looking for a total $177 billion in capital. That broad owned by China China array allows investors to be choosy about who they fund. Some are Investment Corp (CIC) and the state-backed expected to still be cautious about the fast growing, heavily regulated Citic Group, has a Japan fund and unpredictable China market. and an international co-investment fund. The By launching dollar funds, many Chinese PE and venture capital firms firm has done five deals in Japan and is closing hope to win more deals from foreign rivals, as many Chinese companies in on a seventh deal in the United States. In ad- seeking an overseas listing prefer hard currencies funding. For example, dition to seeking deals that they and Chinese many Chinese internet companies, including Baidu and Sina, used off- corporations can take part in, the cross border shore structures to obtain foreign venture capital investments ahead of push of Chinese firms such as Hony, Citic and their Nasdaq IPOs to avoid rigid Chinese regulations. Foreign currency CDH Investments has another motive: attract- funding is also preferred by a growing number of Chinese companies ing overseas investors into their funds. seeking acquisitions abroad. Hony, for example, helped Chinese con- struction and mining equipment maker Zoomlion in its acquisition of Italy’s Compagnia Italiana Forme Acciaio SPA. “I think the most The future of funds “Convergence will happen, and to some extent, is happening,” says likely outcome is that Culhane. When speaking to ALB, lawyers consistently bring up the term eventually there is a “convergence” to describe their funds market forecast for China. “What market with multiple we are really waiting for is the convergence of offshore and onshore, product types and where domestic and foreign investors commit to a common vehicle that receives domestic treatment,” says Ostrognai. “Right now, we have two similar standards types of funds - onshore and offshore - on two parallel tracks, trying to for those products, find a way to operate in harmony.” The combined product would be a whether they are RMB fund that can have up to 25 percent of the right type of offshore inves- tors, and still be considered domestic. Culhane offers another direction funds or offshore funds.” the market could take when he says: “I think the most likely outcome Philip Culhane, Simpson Thacher & Bartlett is that eventually there is a market with multiple product types and WWW.LEGALBUSINESSONLINE.COM : @ALB_Magazine : Connect with Asian Legal Business PE funds 47

REUTERS/Petar Kujundzic similar standards for those products, whether they are RMB funds or it. One theory floated by a lawyer is that regu- offshore funds.” lators will learn to trust foreign managers as Whether it is one common vehicle or multiple product types with simi- they prove over time that they are not bringing lar standards, this is where the top offshore fund formation law firms will in hot money. Right now, a foreign player can find a niche to market their international experience and familiarity with set up a domestic fund, provided it does not global standards. But market insiders agree that a common vehicle con- put in more than 5 percent of the capital. If vergence – if possible – will take a number of years to reach, and would the offshore sponsors continue to manage the wholly depend on the promulgation of a regulation that allows funds funds prudently, the regulators will recognise to remain domestic by definition but have up to a certain percentage of this and raise the capital contribution bar for foreign . “Convergence of offshore and RMB funds the right type of foreign investors. has been a gradual process with the occasional partial breakthrough Tse predicts a similar time frame of five to here and there, and full convergence doesn’t appear to be around the ten years before the market liberalises. “But it corner, in part because it would probably have to unfold together with will change because market forces will bring the opening of China’s capital account,” says Fadely. Currently, foreign more experienced and talented people into exchange controls and foreign investment restrictions are roadblocks the market, and they’re going to raise the bar for a converged fund model. “It may take five to ten years, no one can and drive convergence,” he says. “More impor- say,” says Ostrognai. “But when the (regulatory) switch flips, this is tantly, new laws and rules will provide more when the market will revolutionise.” clarity and transparency, bringing them in line Optimism of this convergence becoming a reality buoys on the matura- with international standards. It’s going to take tion of China’s PE market, and the government’s security in regulating time, but I do believe that we’ll get there.” ASIAN LEGAL BUSINESS 48 PE funds April 2012

formation and registration. There is a level. But now, the NDRC appears to be China REGULATORY 10 million yuan minimum investment emerging as the key central government UPDATE requirement for any single investor, which, regulator of the industry, which might mark according to James Wang of Han Kun the beginning of a new regulatory phase,” Circular 2864 Law Offices, is very high compared to he says. On Nov. 23, 2011, the National U.S. standards. Additionally, if funds wish Development and Reform Commission to raise money from the national social New securities fund law (NDRC) issued the Circular on Promoting securities fund, they must register or else The PE sector in China has been very the Standardised Development of Equity they will not t be able to qualify for funding. loosely regulated amid a power struggle Investment Enterprises – commonly Despite the circular, industry insiders between the securities regulator and known in the industry as Circular 2864. say registration numbers are still quite the top economic planning agency, both This was released after the Circular on low. Only the larger and more prominent of which are both eyeing control over Further Regulating the Development, onshore and offshore funds have what was once a fast-growing sector. and the Administration on Filings, of registered. A key reason funds (over 500 China’s current funds law came into Equity Investment Enterprises in Pilot million yuan in size) refuse to register, effect in 2004, and though it did not list Areas from Jan. 31, 2011 (Circular 253) and as Hubert Tse of Shanghai firm Boss & PE funds as a legal product, it did not supersedes it as the first nationwide set of Young points out, is because they would ban them outright either. The law also administrative rules on PE funds in China. be required to disclose information to the bars individuals working in the securities The new regulation was hailed by NDRC. “Some investors may not want to mutual fund industry from trading stocks many in the industry as a step forward be disclosed, and this may be one of the themselves. Particularly after the 2009 in the standardisation of PE funds, as disincentives because when you file with launch of China’s second board for start it aims to provide clearer guidance on the NDRC, the records are public,” he up companies, typically the target of their establishment and operation. Its says. An additional reason, he believes, is investments by PE funds, various circles in key features are: (i) The expanded scope due to the fact that enforcement of non- China’s financial system have called for the of the filing procedure to include equity registration is non-existent. “Unless there quick promulgation of an amended law. investment enterprises (EIEs) with a is a strong enforcement mechanism in On Feb. 26, Reuters reported that China fund size of at least 500 milion yuan; (ii) place or substantial penalties are imposed, may promulgate a revised securities fund Application to foreign-invested funds it’s more just a policy guideline than law,” law this year. A draft of a revised Securities and fund managers; (iii) Foreign-invested he says. John Fadely, a partner at Weil, Investment Fund Law has been completed EIEs are not extended national treatment; Gotshal & Manges, agrees that it is not and has been submitted to the State and (iv) The number and qualifications of clear whether China has the regulatory Council, or the cabinet, for deliberations. investors will be verified to conform with resources required to enforce registration, The draft law had been in existence China’s Company Law and Partnership which would be the first line of defence for more than a year now. But legal Law. against fraudulent funds. However, he is practitioners are optimistic that it will come The circular also requires mandatory optimistic. “China’s PE industry has come to fruition later this year, after the National registration of all PE funds in China and a long way over the past few years through Congress in the autumn. “The CSRC imposes stringent requirements on fund regulatory and tax competition at the local has been pushing through new reforms with the new chairman on board. He has issued many new policies including IPO reform, and is trying to build confidence and stability into the local stock markets, and promulgating the revised funds law is expected to be an item on the agenda,” says Tse. As the current PE legal framework is inconsistent, leaving many PE players operating in a grey zone, the amended law would provide clearer provisions on the definition, set up, and operation of their funds. PE funds are not officially under any authority’s supervision, even though the NDRC moved forward to bring them under its wing with its promulgation of Circulars 253 and 6824. So, a key revelation of the new securities law would be if it will bring PE funds into its jurisdiction, making the CSRC their main regulator rather than the NDRC.

REUTERS/Jason Lee