Chinese rule change could boost domestic secondaries

Yuan-denominated funds have raised far more than dollar-denominated funds, though a lack of buyers has hindered the growth of a secondaries market.

The yuan-denominated market has certain attractive features for secondaries buyers. China has nearly as many unicorns – privately held businesses valued at more than $1 billion – as the US, with companies such as Ant Financial and Bytedance among the world’s most valuable. Yuan-denominated funds raised the equivalent of $163 billion in 2019, according to investment manager Schroder Adveq and China-based research firm Zero2IPO, so there is no shortage of net asset value to be explored.

Difficult regulatory conditions have prevented the entry of foreign buyers, though this has started to change.

Foreign investors have typically been restricted from investing onshore in China. Underlying companies have effectively had to change their corporate structures in order to take US dollar funding, which few have been incentivised to do.

Launched in 2010, the qualified foreign limited partnership programme enables foreign managers to invest onshore in yuan with capital raised offshore. Initially used to invest in the stock market, QFLPs are increasingly being employed as conduits for private equity investment, a key step towards attracting more foreign secondaries buyers.

“It will get easier for LPs to exit and a lot of approaches, like buyout [M&A transactions] and secondaries, will become more mature,” George Di, chief operating officer of secondaries trading platform Zerone, told sister title Secondaries Investor. “The secondaries market is at a very early stage in China. Only a few LPs know they can use it as an exit approach.”

The market is very buyer-friendly, he added, with very little trading at par or above: “A majority of sales at the moment are by liquidity-constrained LPs.”

Yuan-denominated funds tend to have four-to-five-year terms, so vehicles are left with significant amounts of unrealised capital at the end of their lives. Time to liquidity among yuan-denominated funds is among the longest, with a considerable majority of value remaining unrealised, according to Zerone’s data.

At the same time, according to an October 2019 report from data provider eFront, China became the top-performing market for venture capital in terms of TVPI in 2018, delivering 1.72x versus 1.63x for US funds.

“There are people that seek liquidity which they didn’t get in the promised horizon and want to use that money elsewhere,” said head of private equity at Schroder Adveq, Rainer Ender, whose firm was given QFLP status in the second quarter of 2020. “So, the secondary market has special appeal, and there’s not many buyers on the RMB side.”

GP-led opportunity

A recent development is the advent of yuan-to-dollar restructurings, a trend that has gathered momentum over the past 18 months. For buyers, such deals can provide access to rare and potentially brilliant assets.

For Chinese GPs, it allows them to approach international investors with seeded, dollar-denominated funds, which are less risky for an investor than making a blind-pool commitment.

A Chinese GP may want to list a portfolio company overseas in order to drive a higher valuation. As yuan investors are restricted from participating in initial public offerings outside China, this creates an opportunity for secondaries investors to buy them out.

The first such example involved Chinese buyout manager Loyal Valley Capital, which Secondaries Investor reported on in August 2018. Limited partners in one of the buyout firm’s yuan-denominated funds were given the option to roll into a dollar-denominated vehicle or sell their holdings to GIC and Asia secondaries specialist NewQuest Capital Partners in a $390 million deal. The fund contains stakes from a number of Chinese unicorns, including highly prized Bytedance. Loyal Valley followed up a year later with a second similar process, this time worth $465 million.

Foreign investors are considered by Chinese GPs to be “harder to access but more stable, less fickle compared to RMB”, Bonnie Lo, chief operating officer at secondaries firm NewQuest Capital Partners, told Secondaries Investor last year. “Many Chinese GPs are rough diamonds… You work alongside them to help put in place an operation that can allow them to continue to raise US dollar funds.”

In February 2020, TR Capital led a yuan-to-dollar restructuring on a fund managed by Beijing-headquartered Kinzon Capital. The $100 million deal was centred around seven portfolio companies, including artificial intelligence company AiBEE and intelligent imaging firm Beijing Moviebook Technology, and led by niche secondaries firm TR Capital.

“From renminbi LPs’ perspective,  [distributed-to-paid-in] is really the key,” Kinzon founder Jun Wang told Secondaries Investor at the time. “You can say I’ve doubled the valuation [of a company] but where is the DPI? Many Chinese RMB LPs want to see DPI. For that, they’re willing to take some discounts and sell the assets.”

In September, Secondaries Investor reported that HarbourVest Partners and LGT Capital Partners had backed a $600 million deal involving Beijing-based IDG Capital. It was understood to be the first time a QFLP structure had been employed in a yuan-to-dollar GP-led deal.

“Usually, the underlying companies have to change their corporate structure in order to take US dollars and to be able to go into a US dollar fund and that is very difficult for a GP to orchestrate,” says a source with experience working in China of the new QFLP structure.

Even with QFLP, the yuan-denominated market brings challenges. The yuan is not freely convertible, so government approval is necessary for currency conversions. The secondaries market has little intermediation and few defined processes, making it difficult to access without real local expertise. Some strategically important sectors, such as telecoms, still cannot be directly accessed by foreign capital, though the list of prohibited sectors is shortening by the year.

However, for a secondaries fund with the ability to size up Chinese assets and the patience to see them to exit, the potential rewards are clear.