PE in China gets tougher? No, actually...

I tell you, its a full-time job correcting the mis-impressions about China PE created by the MSM. Okay, that's a bit harsh. Actually the Reuters article below isn't a bad summary of two important trends - but as is often the case, it lacks context and gives the impression that things are worse than they are. The typical article on China investing either makes it look much worse or much better than it is. Reality is less exciting and tougher to get a handle on. But that's why you read my blog!

Okay, the first trend, very well-established, most of us China-obsessed guilos know all about, is the central government's shift away from a policy of embracing all foreign capital regardless of source or target, to a more nuanced policy whereby some FI is embraced, some accepted, and some rejected. The Xugong deal (or non-deal I should say) is obvious evidence of this. What is important for the non-China obsessed guilos to keep in mind is, the new China attitude towards FI makes perfect sense! It's not mindless xenophobia. It is sensible, rational, macroeconomic development policy. The kind that just about every nation has practiced and continues to practice including the US (although the US has shown a bit of the mindless xenophobic variety in recent years, witness Dubai Ports).

In simple terms, from the perspective of what is best for the Chinese people over the next 25 or 100 years, it's dumb for them to sell off a 'family jewel' (or potential family jewel) like Xugong. Xugong has the potential to be the Chinese Caterpillar. Keeping a potential global industry player in Chinese hands is nothing more than sensible long term macroeconomic development policy. What genius at Carlyle thought that China would allow them to buy control of this thing? Blinded by arrogance. If a Chinese company tried to buy CISCO or Intel or Google would US politicians and policy makers object? If you were Chinese would YOU think its a good idea to sell to Carlyle?

So... don't overeact to the unwillingness of the Chinese to allow KKR & Co to buy up all their leading companies. It does NOT mean they are rejecting foreign capital - but it does mean that large control deals of attractive targets WON'T happen. This is exactly what I told our investment committee two years ago (Damn I'm good!) when I said I had no interest in investing in the 'safe' pan-Asian PE funds managed by 'first tier' 'high quality' US PE funds and instead said the only funds I want to invest in are obscure smallish newish local funds. Our IC is beginning to think I'm not as dumb as I look. Clearly all the Asian one billion plus mega funds are not going to do ANY meaningful amount of investing in China. And since KKR, TPG, Blackstone, and Carlyle can't do much in Japan or Korea either - and since large buyouts in India are years away - all they have to do is bid in hyper-competitive Aussie auctions.

Which brings us to the other important trend highlighted in the Reuters piece: rule changes making offshore corporate structures difficult if not impossible in China. Salata of Barings and Paton of 3i capture the essential situation: the Chinese authorities want FI for SME private companies and they are slowly establishing an institutional framework for PE. But in a massive, recently totalitarian state starting from scratch - it's a bumpy ride. Important to note that one of the key drivers for the new M&A regs put in place last year that are causing lots of nail-biting among FI funded PE funds - was an effort on the part of the authorities to stop Chinese from illegally shifting assets (without foreign ownership) offshore in order to avoid taxes, launder money, or other schemes. The main point for US LPs is that the Chinese want your money and need the expertise of the GPs you have funded (for the most part) and the specifics of the laws and regs will eventually get straightened out. It won't be smooth or fast but it will happen. And be prepared for on-shore investment. No one comes to the US to invest and then sets up off-shore structures. Whether it is this year or next or five years from now, the end-game is on-shore, RMB investment leading to eventual listing on Shanghai exchange. And somehow, someway, you get more money out. We just don't quite now exactly how yet. Comrade! Oppressed LPs of the world unite!

Private equity buys in China get tougher

Thu Apr 12, 2007 7:21AM EDT

By Alison Tudor, Asia Private Equity Correspondent

HONG KONG (Reuters) - Private equity firms are queuing up to invest in fast-growing Chinese companies, but Beijing wants to limit access to partners it thinks can build world-beaters and help develop its capital markets.

In response, private equity firms are falling over each other to prove that they can help Chinese companies grow and improve corporate governance. Some are also foregoing their preferred options of majority control and structuring deals offshore.

"The government has to want you as an investor. You can't horn your way and expect to come in and wave around a fist full of dollars and expect to walk off with something," Ralph Parks, chairman of Oaktree Capital (Hong Kong) Ltd., told the Reuters Hedge Fund and Private Equity Summit in Hong Kong.

Some investments by private equity firms have run aground in China because of Beijing's perception that funds make short-term investments in Chinese firms, while trade buyers offer more in terms of long-term technology-sharing and operational experience.

Private equity is fighting its case, but picking its battles.

"If they want a Volvo, a Caterpillar, a Ford -- it's not you, mate," said Parks, stressing that Oaktree's investments are long-term in nature and leverage the experience of its portfolio companies spanning the globe.

Other private equity buyers also play up their ability to raise shareholder value and argue that trade buyers are using local players as a springboard to bring their own business into China's expanding market.

CARLYLE CURBED

Washington-based private equity firm Carlyle Group (CYL.UL: Quote, Profile, Research) scaled back its original bid for majority control of leading Chinese machinery maker Xugong to a minority stake in order to win Beijing's blessing.

Approval of Carlyle's deal for 8 percent of Chongqing City Commercial Bank is also taking its time. Sources familiar with the matter said the delay was due to the fact that the process was easier for a trade buyer, such as Hong Kong's Dah Sing Banking (2356.HK: Quote, Profile, Research), which has already had its purchase of a 17 percent stake in Chongqing approved.

New investments in China by private equity funds slipped 4 percent in 2006 to $8.6 billion, according to the Asian Venture Capital Journal.

Baring Private Equity Asia Group, which has made the bulk of its investments in China, is diversifying its portfolio into countries including Japan and India, partly because of the risks posed by China's constantly shifting regulatory framework for private equity investing.

LABYRINTH

Beyond headline-grabbing buyout deals such as Xugong, smaller growth-capital investments are also changing to appease Beijing.

To invest in a Chinese firm, a private equity firm would typically transfer ownership offshore, making it easier to eventually sell via a listing on international stock exchanges.

A more onerous regulatory landscape came into effect last September containing catch-all restrictions and new approval procedures for deals, effectively giving China the ability to say no to transactions it perceives to not be in the country's interest.

"We estimate that there have been no more than five approvals over the past 6 months. People are nervous," said Maurice Hoo, partner in law firm Paul, Hastings, Janofsky & Walker LLP's Asia Private Equity Group.

A few fund managers believe China is gradually closing the door on the route to an overseas listing and is encouraging private equity funds to invest directly onshore and eventually list on China's domestic markets.

Private equity firms are adapting.

"In every other country in the world, we invest onshore," Jamie Paton, co-head of Asia for 3i Group (III.L: Quote, Profile, Research), told the Reuters Summit. "It's part of the development of the market. We can provide our expertise and knowledge."

One way to invest onshore is to form a joint venture, which can be tricky to eventually exit as agreements with other shareholders and government officials are required.

To be sure, many private equity managers believe that the new laws are part and parcel of China's development and they plan to continue investing by adapting their investment processes.

"It is all moving in the right direction but like a lot of things in China it is an evolving picture -- a pendulum which swings one way and swings the other way," said Jean Eric Salata, Founder and Chief Executive of Baring Private Equity Asia.