Beyond the Hype, Shenzhen Qianhai Economic Zone — Article in AVCJ Magazine

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AVCJ China First Capital



The Qianhai economic zone in Shenzhen is being primed as China’s next global financial services hub, a place where private equity firms can raise local currency funds from overseas investors. How is it getting on?

A small but burgeoning town on the outskirts of Shenzhen, Qianhai already has a fulsome epithet to which it can aspire – the “Manhattan of the Pearl River Delta.” With an imposing urban skyline sketched on architects charts and potentially even bolder financial reforms in the pipeline, local residents are quick to draw parallels between iconic downtown New York and ambitions writ large on the walls of the well-appointed Qianhai Authority Bureau Office.

The reality – a 15 square-kilometer site that is still basically a muddy piece of muddy reclaimed land – reminds visitors of just how far this economic zone has to go.

Much the same can be said of Qianhai’s attention-grabbing financial initiative: allowing renminbi to flow freely across the boundary with Hong Kong. This latest effort to internationalize China’s currency will, in theory, see locally-registered companies receive renminbi-denominated loans from Hong Kong banks, and locally-registered private equity funds raise renminbi capital from Hong Kong investors.

Several high-profile PE players have already bought into the idea. The Blackstone Group and KKR have reportedly held preliminary talks with the Qianhai authorities; John Zhao, CEO of Hony Capital, expressed interest in raising his next local currency fund via Qianhai; and Yawei Wang, who built a reputation as one of China’s top stock pickers during a 14-year career as a mutual fund manager with China Asset Management, registered a company in the zone.

But there remains a lot of talk and little action. Yung-Hoi Tse, chairman of Hong Kong-based BOCI-Prudential Asset Management, who also served as a consultant in the Qianhai Advisory Committee, attributes this to a lack of clarity as to what can be done with capital once it gets there.

“It is still a small universe because the offshore renminbi can only be invested in Qianhai as it stands,” Tse says. “Foreign enterprises expect to be able to ramp up their business and investments in Shenzhen, and in neighboring cities in Guangzhou province, later on. However, there is still uncertainty because no detailed rules have been introduced.”

This means a Hong Kong bank can lend to property developers responsible for building Qianhai, but not to those operating elsewhere. Similarly, a private equity firm could deploy its newly raised renminbi corpus in local companies, but no further. Little wonder they are still sitting on the sidelines.

A bright idea

Unveiled three years ago, the Qianhai Shenzhen-Hong Kong Modern Service Industry Cooperation Zone is intended to be part-port, part-trading hub, an integrated financial services, logistics and information technology platform on the threshold of China, just half an hour’s drive from Hong Kong. A total of $45 billion has been earmarked for the project.

As an added sweetener for the financial sector, firms that set up shop in Qianhai will receive tax breaks and permission to issue renminbi-denominated bonds.

The problem is China’s economic zones are no longer that special – there are too many of them and they offer similar incentives packages. President Xi Jinping chose to visit Qianhai on his first official trip outside Beijing in January, so clearly there is high-level support. And the new economic zone clearly wants to leverage Hong Kong’s financial strength and status as an offshore renminbi center. But can the magic last?

Seven years ago, Binhai New Area in Tianjin municipality became China’s first testing bed for financial services reforms. Located by the Bohai Sea, Binhai was supposed to replicate development seen in Shenzhen and Shanghai’s Pudong New Area. This coincided with the emergence of domestic private equity and it led to the creation of Bohai Industrial Investment Funds, a vehicle backed by a slew of state-owned enterprises that invested in small-scale high-tech manufacturing businesses.

Tianjin won its own epithet – the “private equity paradise” – thanks to tax incentives and easier registration processes. However, loose controls have proved liberating and limiting, with thousands of individual investors – who suffered losses after investing in unqualified managers – taking to the streets in protest at what they saw as poor government oversight of fundraising.

“Each local government has been aggressively looking to the central government to approve preferential policies, in particular to attract private equity investment,” says Frank Han, executive director at Bohai Industrial Investment Fund Management. “Qianhai was doing a massive amount of PR work last year. However, what they have is just a regulatory framework with no detailed implementation rules.”

As such, Qianhai risks running into the same problem as Tianjin – aggressively promoting the industry while underlying policy is uncertain and inadvertently straying beyond the central government’s comfort zone.

Replicating the success of Tianjin will also be difficult because the industry has changed enormously since 2006, when to all intents and purposes domestic private equity did not exist. By contrast, Qianhai’s renminbi fundraising initiative was announced at a time when local managers had no trouble attracting capital.

Had the astonishing highs of 2011 been maintained – $32.2 billion went into 235 renminbi funds in 2011 – or moderated slightly, by now firms might have been expected to be laying the groundwork. Instead, they are fighting for survival. Hurt by uncertainty in the IPO market, 46 local funds attracted just $8.9 billion in commitments in the first seven months of 2013.

“Long term, China private equity should have an outstanding future and Qianhai should become an important cluster of investors, bankers, lawyers and accountants. By an accident of timing, however, Qianhai launched during a time of unprecedented crisis and downturn in China PE,” says Peter Fuhrman, chairman and CEO of Shenzhen-based China First Capital.

Limited activity

This state of affairs has no doubt contributed to the slow pick up in Qianhai. About 600 enterprises have registered to open offices in the zone, 70% of which are financial institutions, including a handful of private equity firms.

To date, Shenzhen Raytai Fund Management is the only one to raise a fund domiciled in Qianhai, targeting RMB10 billion ($1.63 billion) over a seven-year period (investments will be made concurrently). The firm was aiming for a first close of RMB10 million but reduced it to RMB5 million, with more than a half the capital coming from the GP’s own coffers.

“We see the IPO hiatus as a chance to make good M&A investments,” says Peter Kwong, a partner at the firm. “A lot of enterprises are under pressure to exit, having agreed to valuation adjustment mechanisms with PE investors, which guarantee a certain level of return from an IPO within a short period of time. We will buy majority stakes in these companies and exit them to listed companies that are looking to expand.”

According to the Qianhai registration center, only five foreign private equity firms have filed for permission from the Shenzhen government to raise offshore renminbi in Hong Kong. Their caution is rooted in uncertainty – about investment restrictions and, by extension, how big the Qianhai project could actually become.

“What does Qianhai have to offer that other places in China cannot? If it’s only the possibility for some offshore renminbi to come back legally into China, then that’s a bit of a damp squib.” a China-focused GP says. “That could happen anywhere, with the right policy, or everywhere once the renminbi becomes fully convertible.”

Hong Kong investors are more sophisticated than their mainland counterparts and have access to global markets. In this context, a fund that only invests in a particular Shenzhen district might not be attractive.

Furthermore, it is unclear whether the enterprises engaged in cross-border trading that hold most of the renminbi in Hong Kong would be interested in private equity at all. The traditional target investors – financial institutions – are subsidiaries of overseas entities and fund managers are skeptical of how much renminbi they could raise from local institutions.

“The Hong Kong subsidiaries of Chinese banks have large renminbi deposit bases, but they can’t invest in private equity. Large Chinese enterprises would have to be the primary fundraising targets,” says S.C. Mak, founding partner of Hong Kong-based Fuel Capital.

Foreign or local?

Another problem is that renminbi vehicles that include capital from offshore sources don’t qualify for local treatment on investments.

This is an extension of the “Blackstone guidance” issued in 2012. Following the introduction of the Qualified Foreign Limited Partnership (QFLP) program, which allows foreign capital to be channeled into renminbi vehicles, the Shanghai government said these funds would be able to operate on an equal footing with local players if less than 5% of the total corpus came from overseas. This implied less bureaucracy slowing down approvals and fewer restrictions on target investment areas.

However, when The Blackstone Group asked for clarification on this point, the National Development and Reform Commission indicated that local treatment would not apply to Blackstone “and this type of situation where the GP is foreign-invested.”

This has hampered the fundraising hopes of renminbi vehicles launched by global PE firms. The expectation is the same would apply to funds domiciled in Qianhai, which also operates a QFLP program.

BOCI’s Tse links the restrictions to wider government concerns about controlling inflows of speculative “hot money” that have the potential to destabilize the economy.

“They want to keep record of how that foreign capital is being used in the country and whether they are really supporting China’s physical economic growth,” he says. “Even though Qianhai is more convenient for foreign exchange conversion, every project is still examined by the regulator on deal-by-deal basis. This will dampen foreign investors’ appetite.”

Although plenty of companies have registered to open offices in Qianhai, so far none are in operation, which means investment targets are limited – unsurprising given the zone is still in its nascent stages.

There are plans for infrastructure that can support small- and medium-sized enterprises (SMEs). Three months ago, the Qianhai Equity Exchange launched with the bold ambition to become Shenzhen’s biggest over-the-counter exchange. Companies do not require administrative approval to list, there are no custodial fees or mandated changes in corporate structure, and information disclosure is limited.

More than 1,700 SMEs have listed via the online platform, but VC investors are unconvinced by it as a source of deals.

“It won’t help fund managers. Professional investors tend to work on their own targeted deal flows, which usually stay low-profile. Once a start-up is put online and enters the public domain the valuation jumps to a very high level. Investors therefore might not want to compete for these deals,” says York Chen, president and managing partner of iD TechVentures.

Even the tax breaks available to certain industries in Qianhai have drawn skepticism from some quarters. The corporate income tax rate has been set at 15%, compared to 25% nationally, and there are also plans to lower personal income tax rates for financial services professionals. Other cities in China have made similar promises but Danny Po, Asia Pacific and China national leader of M&A tax services at Deloitte, argues that comparisons should really be drawn with what is available to foreign PE firms offshore.

“In cases where a fund is managed entirely from offshore, it is only required to pay a withholding tax of 10% and zero corporate income tax because its tax transparent structure,” he explains. “As for individual income tax reductions, it really comes to a question of how much of a foreign executive’s income is driven by China business. If his salary is mostly generated from overseas operations, it isn’t important.”

Although the current prognosis might be negative, Qianhai remains a work in progress. Given a more favorable renminbi fundraising environment and a clear set of rules supporting the financial services industry, the project could still fly. The former is difficult to remedy but the latter can be addressed through more lobbying of the central government.

There is no doubt that Qianhai is well positioned to serve as a testing bed for capital account liberalization and currency convertibility, by which point the current rigid line between foreign and domestic investment will blur.

A number of industry participants therefore prefer to treat Qianhai as a broader financial sector play rather than a solely private equity phenomenon – not just because of government incentives for setting up financial institutions in the zone, but also because of the immense opportunities offered by China’s asset management sector.

“A rising tide lifts all boats,” adds Zhang Ying, counsel at domestic law firm Fangda Partners. “The developments in the onshore asset management sector will create a conducive macro environment for onshore private equity fundraising and investments.”