Dealing with the Localization Trend

Given China’s recent economic growth, it’s no surprise that the country’s venture capital and private equity sectors have boomed. However, recent trends point to the Chinese government’s increased caution regarding foreign investors, in part to encourage domestic investors and grow local capital markets. This paper is a synopsis of research conducted as part of Kellogg’s Global Initiatives in Management program into the challenges confronting foreign private equity investors in China. Based on extensive research, including in-country meetings with industry professionals, the research identified four main areas of concern: due diligence, regulatory policies and approvals, exit opportunities, and debt financing. Recent regulatory changes and initiatives, along with the formation of government-backed sovereign and industrial development funds, have driven a strong localization trend requiring foreign investors to act strategically to compete with local players.


Overview of the China Private Equity and Venture Capital Market

China’s private equity and venture capital markets were born in the 1980s, when the government began to sell state-owned enterprises to private-sector entrepreneurs and businesses. Since then, private equity and venture capital firms have enjoyed great success in the Chinese marketplace, with the amount of capital raised increasing from $15.5 billion in 2006 to $35.5 billion in 2007. Further, a total of 177 private equity backed transactions were completed in 2007, mostly growth investments rather than leveraged buyouts.

Due to legal and regulatory restrictions in China, private equity firms tend to operate as growth investors purchasing minority interests in target companies (especially in fast-growing fields such as healthcare and alternative energy), with investment strategies including bridge loans and mezzanine financing. These firms are most often international players. For example, purely domestic private equity funds represented only 10% of all active private equity funds in China in 2007. However, this does not include “international domestic funds,” or local private equity funds, such as Hony Capital, which raise offshore capital in foreign currencies. Hony Capital, with $1.5 billion under management, is the investment arm of computer-maker Lenovo. CDH Investments, another international domestic fund, is the top-ranked private equity fund in China, according to Zero2IPO.


Challenges for Private Equity and Venture Capital Players

Despite their successes to date in China, foreign private equity and venture capital players face challenges in several domains.

Due Diligence. China’s unique social, economic, and legal circumstances require that investors undertake particularly thorough due diligence. To meet this need, most local and foreign players use local talent to assess investment risk. Many industry experts view the lack of quality information as the largest obstacle to private equity and venture capital activity in China. Wendy Cai, Director of Deloitte’s Chinese Services Group, notes that the “unwillingness of companies to share complete information . . . makes the due diligence process even more challenging.” Some potential targets have even passed false information to acquirers’ due diligence teams—such integrity-related issues are commonplace. Similarly, administration and accurate record-keeping are often given less emphasis than daily operations by Chinese firms, a problem compounded by underinvestment in IT and an often high volume of off-book sales. To alleviate these concerns, China’s government recently aligned domestic accounting standards with International Financial Reporting Standards. Another challenge for investors is contingent and hidden liabilities in Chinese targets, often the result of poor regulatory compliance. Finally, the rights to many assets in China, especially land, can be very imprecise and may include limitations on use. For example, a recent transaction had to be abandoned when the investor discovered that the target company hadn’t actually paid for land rights associated with a large manufacturing facility, thus requiring that the investor pay an astronomical current market price for the rights.

Regulatory Policies and Approvals. Regulatory uncertainty is a major obstacle for private equity and venture capital firms focused on China. According to Feng Xue, partner at law firm DLA Piper US, “China’s regulatory guidelines are evolving every day.” Onshore acquisitions of Chinese businesses by foreign investors require a multi-step, multi-agency government approval process, often resulting in costly delays for special approvals. For example, the China Securities Regulatory Commission blocked a 2006 transaction between investor Goldman Sachs and China’s Midea because the target’s share price rose more than five times in the better part of a year it took Goldman Sachs to obtain necessary approvals. State governments often compound the problem by misapplying national regulations.

China’s 2006 M&A rules also require foreign investors to notify the Ministry of Commerce (MOFCOM) if a proposed acquisition involves a key domestic industry and will result in foreign investors obtaining a controlling interest. Acquisitions of well-known national trademarks or brand names or touching national economic security are particularly vulnerable to intervention. MOFCOM is authorized to block such transactions even if advance notice has been filed, and the government body has been known to often exercise this authority.

Exit Opportunities. In part to avoid China’s 10% capital gains tax on the sale of Chinese company shares as well as strenuous government requirements, investors typically formed offshore holding companies in tax havens such as the Virgin Islands before pursuing exit opportunities. However, new regulations introduced in late 2006 have been used to encourage investors to use the Shanghai and Shenzhen stock exchanges for initial public offerings; these local IPOs require lengthy processes including multiple layers of regulatory approval, a barrier to investment that the government and private equity community are working to mitigate.

Debt Financing. Most deals in China are growth capital transactions, largely because the country continues to lack a liquid debt market to support leveraged buyouts. Several additional challenges exist for the debt financing of Chinese acquisitions by private equity investors: caps on leverage ratios that limit borrowing capacity, a lack of standard procedures for creating security interests in China assets, which makes foreign lenders reluctant to provide funds for Chinese acquisitions and difficulty reconverting foreign funds from Chinese currency and repatriating them upon a liquidation event.


A Trend toward Localization

Based on these trends, China’s government regulations and business environment have combined to promote the growth of onshore and Renminbi (RMB)-denominated funds, the use of mainland stock exchanges as exit channels, and the engagement of local human capital.

Growth of On-shore and RMB-denominated Funds. With roughly $2.5 trillion in domestic savings and $1.5 trillion in foreign currency reserves as of December 2007, China may have to export capital in the future to find attractive investments. China’s government has taken many recent initiatives to promote onshore funds, including the issuance of the “2005 VC Rules” that encouraged formation of onshore funds by foreign sponsors. Purely domestic and foreign-invested RMB funds have grown in popularity, in part because the RMB has appreciated steadily and such funds may facilitate exits due to their enhanced government support. One example is the recently formed RMB fund IDG Technology Venture Investment, with a target size of $68 million. The Chinese government recently became a limited partner for the first time through the launch of its Bohai Industry Investment Fund, an RMB fund. Despite local funds’ superior access to deal flow, their incentive structures tend to be less sophisticated than those of international funds, hindering their ability to retain top managerial talent.

Promotion of Exits via Local Stock Exchanges. In 2006, the amount of public equity raised through the Shanghai and Shenzhen Stock Exchanges totaled RMB 211.5 billion ($30.2 billion), a 70-fold increase from the previous year. This placed the Shanghai Stock Exchange sixth globally for total funds raised in 2006. Many government regulations have helped fuel this growth. In 2006, China prohibited local firms from registering offshore, and offshore holding companies must now wait three years before listing onshore assets overseas. The recently developed Growth Enterprise Board of Shenzhen can be used for domestic listings by firms planning a 2008 exit strategy; the board is expected to accelerate the exit process, which previously took up to a year or more.

Local Talent. Local market knowledge is crucial to private equity and venture capital efforts in China, and the best source of this expertise is local talent. For example, local professionals’ guanxi, or social networks, helps investor firms develop attractive and sustainable deal pipelines. With this in mind, firms have moved from using primarily expatriates in local Chinese offices to recruiting local business leaders, as TPG did when it invited retired Lenovo CFO Mary Ma to manage its Chinese operations. Firms are also recruiting Chinese nationals with strong work experience and MBA degrees from top US and European business schools to address this need.

China’s government has simultaneously taken steps to liberalize its economy and instituted regulations that reflect its caution with regard to foreign investors. These trends have driven the emergence and success of an unprecedented number of domestic private equity and venture capital funds. For foreign investors, China continues to be present attractive opportunities, but only firms adapting carefully to this highly regulated environment will be successful in the long-run.

GIM China 2008 China private equity researchers