Yuan-Denominated Private Equity Funds in China

Thinking Globally, Funding Locally

An increasing number of Western private equity (PE) firms are raising yuan-denominated (local currency) funds in China. Recent data reveal that the number of yuan funds raised grew 8x in 2008. According to press reports, the Chinese cabinet is evaluating regulatory changes that would let foreign PE firms that raise yuan-denominated funds be treated as domestic companies. In such an environment, foreign PE investors using foreign currency would face greater difficulties in generating deal flow, and in securing government approval to exit their investments through listings on local equity markets. Will foreign PE investors who fail to raise local currency funds effectively be locked out of the Chinese PE market?

Insights from the Ergo Network

To answer this question, Ergo asked four experts to comment on the sustainability of this trend and its impact on foreign PE investors.

• Expert 1: Director of a China-based private equity/venture capital fund

  “Three reasons for launching a yuan fund are: the strength of the Chinese currency; access to deals is stronger; and the legal process for onshore deals is less cumbersome. Entrepreneurs prefer to work with yuan funds because it’s easier. Also, a lot of yuan funds have government and regional support, so they get benefits for facilities and taxes, etc.”

• Expert 2: A Western venture capitalist with decades of experience in China

  “This is the new thing. PE and venture capital [VC] in China was always invested in offshore structures. Over time, China has made it more difficult to create offshore PE investment structures. At the same time, it’s made it easier to make more rational structures onshore. China prefers to have more and more companies listing on domestic markets, as do entrepreneurs. Another big reason for this trend is the buckets of domestic money. Private equity funds want to raise capital from Chinese investors – they’ve got the money, the rest of the world is broke.”

• Expert 3: Founding Partner of an investment advisory firm in China

  “This is a long-term trend. Large PE funds will definitely want to raise local currency funds in China for three reasons: it’s easier to do deals; you can exit at a higher price/earnings ratio; and there is a lot of capital that is ready to be deployed. There are a lot of limited partners in China, but they’re not similar to those in other countries – they’re just beginning to enter the PE/VC community. These LPs may not accept the typical PE investment terms (the 2 and 20 fee structure). You have a lot of government institutions, state-owned enterprises, and private institutions ready to deploy capital. The government is even opening the door for insurance companies to allocate portions of their capital to PE.”

• Expert 4: A pioneer in emerging markets private equity, with extensive experience in China

  “The big question is whether there will be a level playing field, or if, as in the past, the government will skew it to favor domestic funds. A lot of disadvantages [to foreign currency funds] will be subtle. The government has a way of making its preferences known, above or below board. This is China. A lot of the deal flow for the larger funds – which will be the candidates most interesting to foreign PE funds – are state-owned enterprise privatizations. Municipal, provincial, and federal level officials will have a say in these privatizations [and they may] have the ability to subtly direct these mandates to those whom they prefer. Unlike any other country I’ve worked in, the government drives this process. In most other countries, government has a secondary role – in China, they’re front and center.”

Looking Ahead

While the precise details of the Chinese government’s regulatory approach toward foreign PE remains uncertain, our experts suggest that those PE investors who raise yuan funds will have a distinct comparative advantage in deal flow and exit opportunities. Given China’s frothy equity markets that are prone to higher valuations, the ability to exit an investment through an IPO on a Chinese exchange could deliver substantially higher returns – one expert mentioned valuation premia of 100% over Western exchanges.

A key indicator of the trajectory of the yuan-denominated fund trend will be whether a recent proposal from Dr. Fang Xinghai – the Director General of Shanghai’s Financial Service Office – is accepted by the Ministry of Commerce. Dr. Fang’s proposal would allow foreign PE funds that raised at least 80% of their capital in yuan to operate as domestic firms.

While many foreign investors look to large state-owned entities, such as the National Social Security Fund and the State Administration of Foreign Exchange, as the key LPs, the municipalities, with their deep pools of capital, are becoming increasingly attractive potential sources of funding.

For global private equity investors, the rise of yuan-denominated funds is a trend not to be ignored.

Ergo has conducted numerous studies in China and for private equity clients. We have uncovered key insights on shifting regulatory policies, identified and conducted due diligence on local partners, and evaluated the landscape of Limited Partners. Leveraging the access of our in-country teams, we are able to provide penetrating insights into the subtleties of deals in China.