renminbi private equity

Renminbi Funds: Can They Rewrite the Rules of Profitable Investing?

Renminbi private equity funds are the world’s fastest-growing major pool of discretionary investment funds, with over $20 billion raised in 2011. These Renminbi funds also play an increasingly vital role in allocating capital to China’s best entrepreneurial companies. Despite their size and importance, these Renminbi funds often have a structural defect that may limit their future success.

Most Renminbi funds are managed by people whose pay is only loosely linked, if at all, to their performance. They are structured, typically, much like a Chinese state-owned enterprise (“SOE”),  with multiple managerial levels, slow and diffuse decision-making, rigid hierarchies and little individual responsibility or accountability. The resemblance to SOEs is not accidental. Renminbi funds raise a lot of their money from state-owned companies, and many fund managers come from SOE background.

Maximizing profits is generally not the prime goal of SOEs. They provide employment, steer resources to industries favored by government plans and policies. A similar mindset informs the way many Renminbi funds operate. Individual greed along with individual initiative are discouraged. There are no big pay-outs to partners. In fact, in most cases, there are no partners whatsoever.

This represents a significant departure from the ownership structure of private equity and venture capital firms elsewhere. Partnership matters because it efficiently harnesses the greed of the people doing the investing.  The General Partners (“GPs”) usually put a significant percentage of their own money into deals alongside that of the Limited Partners who capital they invest. GPs are also highly incentivized to earn profits for these LPs. The usual split is 1:4, meaning the GP keeps 20% of net profits earned investing LPs’ money.

Of course, partnership structure doesn’t guarantee GPs are going to do smart things with LPs’ money. There’s lot of examples to the contrary. But, the partnership structure does seem to work better for both sides than any other form of business combination. GPs and LPs both know that the more the GP makes for himself, the more he makes for investors.

Renminbi funds, in most all cases, are structured like ordinary companies, or as subsidiaries of larger state-owned financial holding companies. Instead of partners, they have large management teams with layer upon cumbersome layer. The top people at Renminbi funds are picked as much for their political connections, and ability to source investment capital from government bureaus and SOEs, as their investing acumen. They are wage slaves, albeit well-paid ones by Chinese standards. But, their compensation might not even be 5% of what a partner at a dollar-based private equity firm can earn in a good year. A Renminbi fund manager will rarely have his own capital locked up alongside investors, and even more rarely be awarded that handsome share of net profits.

Renminbi funds differ in other key ways from PE and VC partnerships. The Renminbi funds usually have relatively flat pay scales, modest bonuses and a consensus approach with often as many as 20 or more staff members deciding on which deals to do.  A typical dollar-based PE fund in China might have a total of 15 people, including secretaries. A Renminbi fund? Teams of over 100 are not all that uncommon. The investment committee of a dollar PE firm might have as few as five people. Partners decide which deals to do. A Renminbi firm often have ICs with dozens of members, and even then, their decisions are often not final. Often Renminbi funds need to get investors’ approval for each individual deal they seek to do. They don’t have discretionary power, as PE partnerships do, over their investors’ money.

Renminbi funds have abundant manpower to scout for deals across all of China, and can throw a lot of people into the deal-screening and due diligence process. This bulk approach has its advantages. It can sometimes take a few months of on-the-spot paper-pushing, coaching and reorganizing to get a Chinese private company into compliance with the legal and accounting rules required for outside investment. Dollar funds don’t have that capacity, in most cases.

Also, Renminbi fund managers often have similar backgrounds to the middle management teams at private companies. They are comfortable with all the dining, wining, smoking and karaoke-ing that play such a core part of Chinese business life. The dollar funds? From partners on down, they are staffed by Chinese with elite educations, often including stints in the US working or studying.  Usually they don’t drink or smoke, and prefer to get back to the hotel early at night to churn through the target company’s profit forecast.

Kill-joys though they may be, the PE dollar funds still have, in my experience, some large – and most likely decisive — advantages over the Renminbi funds. Decision-making is nimble, transparent and centralized in the hands of the firm’s few partners. If they like a deal, they can issue a term sheet the same day. At a Renminbi fund, it can take months of internal meetings, report-writing and committee assessments before any kind of term sheet is prepared. Internal back-stabbing, politicking and turf battles are also common.

We’ve also seen deals where the Renminbi fund’s staff demand kickbacks from companies in return for persuading their firms to invest. An executive at one of China’s largest, oldest Renminbi fund estimates 60% of all deals his firm does probably include such under-the-table payoffs.

It’s often futile to try to figure out who really calls the shots at a Renminbi fund. Private company bosses, including several of our clients, are often loath to work with organizations structured in this way. The boss at one of our clients recently chose to take money from two dollar PE firms because he couldn’t get a meeting with the boss of the well-known Renminbi fund that was courting him hard. That firm compounded things by explaining the fund’s boss was anyway not really involved in investment decision-making and would certainly not join our client’s board.

The message this sent: “nobody is really in charge, so if we invest, you are on your own”. For a lot of China’s self-made entrepreneurs, this isn’t the sort of message they want to hear from an investor. They like dealing with partners who have decision-making power, their own money at stake alongside the entrepreneurs. PE partners almost always take a personal role in an investment by joining the board. In short, the PE partner acts like a shareholder because he is one, directly and indirectly.

At a Renminbi fund, the managers do not have skin in the game, nor a clear financial reward from making a successful investment. A Renminbi fund manager can be fired or marginalized by his bosses at any time during the long period (generally at least 3-5 years) from investment to exit. Private equity investing has long time horizon, and the partnership structure is probably the best way to keep everyone (GP, LP, entrepreneur) engaged, aligned and committed to the long-term success of a company.

It is possible for Renminbi funds to organize themselves as partnerships. But, few have done so, and it’s unlikely many will. The GP/LP structure is supremely hard to implement in China. Those with the money generally don’t accept the principle of giving managers discretionary power to invest, and also don’t like the idea of those managers making a significant sum from deals they do.

All signs are that Renminbi funds will continue to grow strongly in number and capital raised. This is, overall, highly positive for entrepreneurship in China. Hundreds of billions of Renminbi equity capital is now available to private companies. As recently as three years ago, there was hardly any. Less clear, however, is how efficiently that money will be invested. I know from experience that Renminbi funds find and invest in great companies. But, they also are prone to a range of inefficiencies, from bureaucratic decision-making to a lack of real accountability among those investing the money,  that can adversely impact their overall performance.

One way or the other, Renminbi funds will rewrite the rules for private equity investing, and eventually provide a huge amount of data on how well these managers can do compared to PE partners. My supposition is that Renminbi firms will not achieve as high a return as dollar-based PE firms investing in China. The reason is simple: investing absent of greed is often investing absent of profit.

Taxed At Source: Renminbi Private Equity Firms Confront the Taxman

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The formula for success in private equity is simple the world over: make lots of money investing other people’s money, keep 20% of the profits and pay little or no taxes on your share of the take. This tax avoidance is perfectly legal. PE firms are usually incorporated as offshore holding companies in tax-free domains like the Cayman Islands.

Depending on their nationality, partners at PE firms may need to pay some tax on the profits distributed to them individually. But, some quick footwork can also keep the taxman at bay. For example, I know PE partners who are Chinese nationals, living in Hong Kong. They plan their lives to be sure not to be in either Hong Kong or China for more than 182 days a year, and so escape most individual taxes as well. Even when they pay, it’s usually at the capital gains rate, which is generally far lower than income tax.

The tax efficiency is fundamental to private equity, and most other forms of fiduciary investing. If the PE firm’s profits were assessed with income tax ahead of distributions to Limited Partners (“LPs”), it would significantly reduce the overall rate of return, to say nothing about potentially incurring double taxation when those LPs share of profits got dinged again by the tax man.

China, as everyone in the PE world knows, is very keen to foster growth of its own homegrown private equity firms. It has introduced a raft of new rules to allow PE firms to incorporate, invest Renminbi and exit via IPO in China. So far so good. The Chinese government is also pouring huge sums of its own cash into private equity, either directly through state-owned companies and agencies, or indirectly through the country’s pay-as-you-go social security fund. (See my recent blog post here.)

Exact figures are hard to come by. But, it’s a safe bet that at least Rmb100 billion (USD$15 billion) in capital was committed to domestic private equity firms last year. This year should see even larger number of new domestic PE firms established, and even larger quadrants of capital poured in.

It’s going to be a few years yet before the successful Chinese domestic PE firms start returning significant investment profits to their investors. When they do, their investors will likely be in for something of an unpleasant surprise: the PE firms’ profits, almost certainly, will be reduced by as much as 25% because of income tax.

In other words, along with building a large homegrown PE industry that can rival those of the US and Europe, China is also determined to assess those domestic PE firms with sizable income taxes. These two policy priorities may turn out to be wholly incompatible. PE firms, more than most, have a deep, structural aversion to paying income tax on their profits. For one thing, doing so will cut dramatically into the personal profits earned by PE partners, lowering significantly the after-tax returns for these professionals. If so, the good ones will be tempted to move to Hong Kong to keep more of their share of the profits they earn investing others’ money. If so, then China could get deprived of some experienced and talented PE partners its young industry can ill afford to lose.

It’s still early days for the PE industry in China. Renminbi PE firms really only got started two years ago. I’ve yet to hear any partners of domestic PE firms complain. But, my guess is that the complaining will begin just as soon as these PE firms begin to have successful exits and begin to write very large checks to the Chinese tax bureau. What then?

China’s tax code is nothing if not fluid. New tax rules are announced and implemented on a weekly basis. Sometimes taxes go down. Most often lately, they go up.  Compared to developed countries, changing the tax code in China is simpler, speedier. So, if the Chinese government discovers that taxing PE firms is causing problems, it can reverse the policy rather quickly.

The PE firms will likely argue that taxing their profits will end up hurting hundreds of millions of ordinary Chinese whose pensions will be smaller because the PE firms’ gains are subject to tax. In industry, this is known as the “widows and orphans defense”. Chinese contribute a share of their paycheck to the state pension system, which then invests this amount on their behalf, including about 10% going to PE investment.

PE firms outside China are structured as offshore companies, with offices in places like London, New York and Hong Kong, but a tax presence in low- and no-tax domains. But, there’s currently no real way to do this in China, to raise, invest and earn Renminbi in an offshore entity. Changing that opens up an even larger can of worms, the current restrictions preventing most companies or individuals outside China from holding or investing Renminbi. This restriction plays a key part in China’s all-important Renminbi exchange rate policy, and management of the country’s nearly $2.8 trillion of foreign reserves.

The world’s major PE firms are excitedly now raising Renminbi funds. Several have already succeeded, including Carlyle and TPG. They want access to domestic investment opportunities as well as the high exit multiples on China’s stock market. When and if the income tax rules start to bite and the firm’s partners get a look at their diminished take, they may find the appeal of working and investing in China far less alluring.

 

 

 

The End of the Line for Old-Style PE Investing in China

Ming Dynasty flask, from China Private Equity blog post

As 2010 dawns, private equity in China is undergoing epic changes. PE in China got its start ten years ago. The founding era is now drawing to a close.  The result will be a fundamental realignment in the way private equity operates in China. It’s a change few of the PE firms anticipated, or can cope with. 

What’s changed? These PE firms grew large and successful raising and investing US dollars,  and then taking Chinese companies public in Hong Kong or New York. This worked beautifully for a long time, in large part because China’s own capital markets were relatively underdeveloped. Now, the best profit opportunities are for PE investors using renminbi and exiting on China’s domestic stock markets. Many of the first generation PE firms are stuck holding an inferior currency, and an inferior path to IPO. 

The dominant PE firms of yesterday, those that led the industry during its first decade in China, are under pressure, and some will not survive. They once generated hundreds of millions of dollars in profits. Now, these same firms seem antiquated, their methods and approach ill-suited to conditions in China. 

In the end, success in PE investing comes down to one thing: maximizing the difference between your entry and exit price. This differential will often be twice as large for investors with renminbi as those with dollars. The basic reason is that stock market valuations in China, on a current p/e basis, are over twice as high as in Hong Kong and New York – or an average of about 30 times earnings in China, compared to fifteen times earnings in Hong Kong and US. 

The gap has remained large and persistent for years. My view is that it will continue to be wide for many years to come. That’s because profits in China (in step with GDP) are growing faster than anywhere else, and Chinese investors are more willing to bid up the price of those earnings. 

For PE firms, the stark reality is: if you can’t enter with renminbi and exit in China, you cut your profit potential in half. 

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If given the freedom, of course, any PE investor would choose to exit in China. The problem is, they don’t have that freedom. Only fully-Chinese companies can IPO in China. It’s not possible for Chinese companies with what’s called an “offshore structure”, meaning the ultimate holding company is based in Hong Kong, BVI, the Caymans or elsewhere outside China. Offshore companies could take in dollar investment from PE firms, swap it into renminbi to build their business in China, then IPO outside China. The PE firms put dollars in and took dollars out. That’s the way it worked, for example, for the lucky PE firms that invested in successful Chinese companies like Baidu, Suntech, Alibaba, Belle – all of which have offshore structure. 

In September 2006, the game changed. New securities laws in China made it all but impossible for Chinese companies to establish holding companies outside China. Year by year, the number has dwindled of good private companies in China with offshore structure. First generation PE firms with only dollars to invest in China have fewer good deals to chase. At the same time, the appeal of a domestic Chinese IPO has become stronger and stronger. Not only are IPO prices higher, but the stock markets in Shanghai and Shenzhen have become larger, more liquid, less prone to the kind of wild price-swings that were once a defining trait of Chinese investing. 

Of course, it’s not all sweetness and light. A Chinese company seeking a domestic IPO cannot choose its own timing. That’s up to the securities regulators. To IPO in China, a company must first apply to China’s securities market regulator, the CSRC, and once approved, join a queue of uncertain length. At present, the process can take two years or more. Planning and executing an IPO in Hong Kong or the US is far quicker and the regulatory process far more transparent. 

In any IPO, timing is important, but price is more so. That’s why, on balance, a Chinese IPO is still going to be a much better choice for any company that can manage one. 

Some of the first generation PE firms have tried to get around the legal limitations. For example, there is a way for PE firms to invest dollars into a purely Chinese company, by establishing a new joint venture company with the target Chinese firm. However, that only solves the smaller part of the problem. It remains difficult, if not impossible, for these joint venture entities to go public in China. 

For PE investors in China, if you can’t go public in Shanghai or Shenzhen, you’ve cut your potential profits in half. That’s a bad way to run a business, and a bad way to please your Limited Partners, the cash-rich pension funds, insurance firms, family offices and endowments that provide the capital for PE firms to invest.   

The valuation differential has other knock-on effects. A PE firm can afford to pay a higher price when investing in a Chinese company if it knows it can exit domestically.  That leaves more margin for error, and also allows PE firms to compete for the best deals. The only PE firms, however, with this option are those already holding renminbi. This group includes some of the best first generation PE firms, including CDH, SZVC, Legend. But, most first generation firms only have dollars, and that means they can only invest in companies that will exit outside China. 

Seeing the handwriting on the wall, many of the other first generation PE firms are now scrambling to raise renminbi funds. A few have already succeeded, including Prax and SAIF. But, raising an renminbi fund is difficult. Few will succeed. Those that do will usually only be able to raise a fraction of the amount they can raise is dollars. 

Add it up and it spells trouble – deep trouble – for many of the first generation PE firms in China. They made great money over the last ten years for themselves and their Limited Partners. But, the game is changed. And, as always in today’s China, change is swift and irreversible. The successful PE firms of the future will be those that can enter and exit in renminbi, not dollars.