A qualified success?

Private equity may be booming in China – but dollar funds are struggling to compete. In 2007 and 2008, they accounted for over 80 percent of private equity funds raised in China; in 2010 and 2011, only around 50 percent. And part of the reason for this is that foreign firms are getting tangled up in red tape. 

There are fundamentally two big problems for foreign private equity firms in China. First, the process of converting money from foreign currencies to renminbi (RMB) is time-consuming and clumsy. And because of the RMB’s continued appreciation, the exchange rate causes problems for companies seeking foreign investment. “With deals priced in dollars, the exchange rate has been appreciating enough that the investments are a terrible deal for the company when finally converted to RMB,” says Walker Wallace, a Shanghai-based partner at law firm O’Melveny & Myers.

Secondly, foreign funds have to apply for permission for every project that they want to invest in, even if they are in the ‘encouraged’ category. There are four categories in total – ‘encouraged’, ‘permitted’, ‘restricted’ and ‘prohibited’ – and industries can move between them, depending on macroeconomic aims. For instance, some categories of real estate are currently prohibited, because the government wants to cool the housing boom. 

“For Chinese companies the process of changing ownership is easy, but foreign firms have to jump through a lot more hoops. The system is unnecessarily cumbersome,” says Steven Xiang, head of the China practice at law firm Weil, Gotshal & Manges. 

That’s why the new rule on Qualified Foreign Limited Partners announced last year – which was widely interpreted as a radical liberalisation of private equity in China, potentially opening it up to a serious inflow of funds from overseas – caused so much excitement. 

A REGIONAL CLASH

The new regulation, it seemed, would go some way towards clearing up the second problem. Firms would be allowed to become Qualified Foreign Limited Partners, meaning that they would be able to bring money on-shore without specifying where it would be invested. Up to 5 percent of the fund could be foreign money. These funds would also be able to invest just as a domestic renminbi fund does (see box). On the best reading, this meant that foreign money could be quickly invested. Could this be the start of a Chinese private equity gold-rush? 

Well, no. In a recent communique from the NDRC, the national regulator (dated 23 April 2012 but only widely circulated two weeks later), it emerged that the new QFLP scheme will not be going ahead after all. 

This has been portrayed in some quarters as a real blow for firms operating in China. But according to old hands in the country, it’s not such a disaster – and not particularly surprising, either. 

“It is in my view a non-event,” says Vincent Huang, a partner at private equity firm Pantheon. He points out that the QFLP scheme was actually a trial program carried out by the Shanghai city government. “The central government never agreed to this 5 percent exemption; as far as they are concerned, one dollar of foreign money makes it a foreign fund. Plus, the national government adheres to a strict industry guideline for foreign investments based on a WTO agreement, and never said that it would make an exception for foreign PE investors.” The NDRC simply clarified this situation publicly, Huang says. 

That might seem odd, but it’s a common tale in China. While the regions want to encourage growth, central government often has larger aims – such as controlling inflation nationally – that sometimes clash with regional aims. When this happens, the national regulator outranks the regional ones. But that doesn’t stop the regions trying their luck. David Pierce, the CEO of Squadron Capital who has been involved in China since the 1980s, says: “The pattern in developing the legal system has often been to experiment locally, on a trial basis, in many cases legalising practices that have already started without permission.”

In fact, the QFLP issue is part of a larger story. Tension between the central and regional authorities is more intense right now than normal because of the jockeying for position ahead of the once-in-a-decade transfer of power later this year. While the workings of the ruling party are opaque, it’s probable that the squashing of QFLP is part of a political play. The toppling of Bo Xiliai, ex-head of the Chongqing province, was all about the centre asserting its power over the regions; it’s possible that the QFLP story is also part of that. 

GONE BUT NOT FORGOTTEN 

Just to make things more complicated, this actually doesn’t mean that new QFLP status is dead. “There are a lot of bottom-up forces in certain locations including Shanghai which wanted to make those changes,” says Xiang. “Central government has not made up its mind yet. There are major philosophical issues that the government has been grappling with.” For example: how much freedom to give to foreigners operating in China, and how much autonomy to give to the regions.

So what will happen? Offshore private equity money is seen as ‘hot’ money that will look for short-term returns, which sits uncomfortably with the Chinese government’s desire to funnel capital into long-term growth. But there’s a widespread belief that the Party will overcome its scepticism and welcome foreign money sooner or later. 

As such, QFLP will become a reality eventually, because it’s clear that the industry is currently over-regulated. “The government doesn’t need control over bringing currency onshore, control over the specific projects, and control over what categories foreigners can invest in; it’s overkill,” says Xiang. As the currency controls are unlikely to be scrapped any time soon, it’s the others that will probably be relaxed.  

Despite this setback, private equity clearly has a bright future in China –because on the whole, it is still perceived favourably. “It’s a country that favours private equity,” says David Pierce.

To outsiders, the tensions between the centre and the regions seem like a tough circle to square. How can it be done? “As the regulatory regime is still a work in progress, issues will arise,” Pierce says, “but experience suggests that pragmatic solutions will emerge.”