A PE tale of three cities

Cleaning robot is showcased at an exhibition of environmental protection industry (EPI) in Beijing earlier this year. About 10 percent of PE went to EPI in 2008 in China. Photo: CFP

By Sun Zhe

A Deloitte survey conducted over the past two months of over 30 foreign and domestic private equity funds released last Tuesday said that 90 percent of them believe that PE will grow in China during the next 12 months.

But despite their confidence the country's PE policy remains a work in progress.

The regulatory draft on PE investment was submitted to the State Council for approval in early August by the National Development and Reform Commission (NDRC), the country's PE regulatory body.

Private equity is an asset class consisting of equity securities in operating companies that are not publicly traded on a stock exchange. Investments in PE most often involve either an investment of capital into an operating company or the acquisition of an operating company. Capital for PE is raised primarily from institutional investors.

Developing a sophisticated PE system is widely taken as a step toward the country's opening of its financial markets, said Wang Xiaoguang, a researcher with the policy consultation section of the National School of Administration.

While the NDRC's draft awaits approval, for the past three years Beijing, Tianjin and Shanghai have been exploring existing methods to grow the PE industry while waiting for a firm decision on how far China will allow the market to go.

Since 2006, the country has approved the creation of 11 local currency pilot industry funds with a total capital of $10.6 billion in the three cities, according to the Center for Asia Private Equity Research.

However, in August 2008 the State Administration of Foreign Exchange ruled out using foreign currencies – even ones that have been converted into yuan – to invest in the country's PE market.

The government is selectively using PE in the three cities to help restructure and upgrade the country's economy, said Guo Tianyong, professor with the banking research center of Beijing-based Central University of Finance and Economics.

Beijing's example

"For example, Beijing launched its PE industry fund of 10 billion yuan ($1.46 billion) earlier this month, opening three initiation funds to try to attract more PE funds to the city's high-tech, green economy and cultural industries," said Guo.

Beijing is focusing on the high value-added tertiary-industry, which is tuned to the country's economic transition from the export-oriented manufacturing type to the domestic-demand-driven mode, according to Guo.

"The country needs to direct its excess liquidity to the real economy as most of small- and medium-sized enterprises have long suffered from a lack of financing channels, and that is why PE is so hot lately," said Zhu Xiaodong, a Beijing-based independent finance analyst.

"Also, the launch of the growth enterprises board (GEB) on the Shenzhen Stock Exchange may also account for the heating up of PE," said Zhu, "because the GEB is mainly targeted at small- and medium-sized high-tech enterprises, and initial public offerings (IPO) are the major exit channels for PE."

About 80 percent of PE funds chose the IPO option as their exit in the past three years, according to Zero2ipo, a Beijing-based PE research center.

A three-horse race

Bohai Industry Investment Fund, China's first PE industry fund was launched by a subsidiary of the Bank of China in Tianjin at the end of 2006. At the time 15 cities and provinces had applied to found their own industry funds and only 10 were approved by the NDRC.

So far, more than 200 PE firms are registered in Tianjin. And NDRC granted Tianjin the right to approve the registration of PE funds with capital under five billion yuan ($732 million), which Ruan Banhui, sectary general of Tianjin Private Equity Investment Association, said would give Tianjin an edge over its rivals Shanghai and Beijing.

Tianjin's Binhai New Area, a pilot high-tech and financial zone, has preferential policies from the central government, which is also an advantage, said Ruan. Tianjin was the first of the three cities to unveil its PE regulatory policy when it was made public in October 2008.

"Binhai, Zhongguancun and Shanghai's Pudong New Area are enjoying similar preferential investment policies," said Zhu. The cities offer similar lures, such as income tax rebates, office rental subsidies, and rewards based on capital amount a single fund may raise.

But Tianjin is no rival to Beijing and Shanghai when it comes to PE capital raising because most of the large-scale commercial bank headquarters are based in those two cities, said Zhu the analyst.

During 2008 and the first quarter of 2009, 734 enterprises in the country received investments from PE firms, totaling 110 billion yuan ($16 billion). Twenty nine percent of the enterprises were Beijing-based and 22 billion yuan ($3 billion) or 20 percent of all the investments went to Beijing, which ranked No 1 in investment cases or fund amounts among all the cities and provinces.

Beijing-based Zhongguancun Science Park, the only State-level innovation demonstration park in China, has more than 20,000 enterprise registered, and it enjoys an annual growth of 10 percent. Comparatively, Tianjin's Binhai New Area is striving to attract 200 more high-technology enterprises to bring its total to 550.

But Shanghai made the first step in registering foreign PE firms in August this year when four foreign PE firms were signed on thanks to a city government policy of allowing them to be registered as PE managers. This opened the door to the first foreign-owned PE firms in the country.

To date, six foreign PE firms have registered in Shanghai, with plans to raise total capital worth 30 billion yuan ($4.39 billion).

The city intends to count the foreign PE firms as domestic enterprises, saying that a majority of the funds they will raise are domestic capital.

Foreign models needed

The introduction of foreign PE firms would benefit the domestic market both for the growth of foreign direct investment, and also as experienced models from which to learn mature PE investment management styles, said Ruan.

In China, the roles and styles of managing general partners (GP) and limited partners have yet to mature, said Zhu the analyst.

Usually, the government is playing the GP itself, while money from insurance companies, commercial banks and some other large capital owners is difficult to inject into the PE market due to tight regulations.

"When US dollars are forbidden in the PE market, foreign and domestic GPs find that yuan is hard to raise as capital," said Zhu.

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