Friday Letter: China dreamin'

PEO was in Hong Kong recently talking to private equity people about the market that sits across the harbour: China.  

Unsurprisingly, it is on everybody’s mind. You need only sample some statistics to see why: a population of 1,306 million (go visit the China Population and Information Research Center’s website to see the counter tick up each second); GDP of $1,312 billion in Q3 of 2005 – up by 9.4 percent on the same quarter last year; retail sales for January to October inclusive this year of $637 billion – up 13 percent compared to 2004. This is an economy that’s humming.   

It’s clear too that local private equity professionals are keen to play a prominent role in the deployment of equity capital in China. There is considerable jockeying for position at present, with offices opening in both the shiny towers of Central and the key centres on the mainland. And the demand for seasoned personnel is intense – recruiting and then retaining good people is according to one local GP “a nightmare”.

Much is also made of the need for China know-how, that magic dust required to ensure that a dialogue becomes meaningful, that a deal actually gets done. Not only do you need to speak Chinese, you also need to understand the nuances of dealing with a market where the state still expects to shape the destiny of every institution and individual within it.

If that sounds too Orwellian, it’s worth remembering that Chinese entrepreneurs can be found the world over running small shops or giant conglomerates and that this spirit very much resides at home too. Even the Chinese government has it: a private equity fund manager reminded PEO that most China investments will see a state entity remaining as a shareholder in transactions where the GP will be a minority owner. And that the several home run trade sale exits this manager had enjoyed had seen these other shareholders exultant too. It’s just that, in China, success is rated most highly when it is invisible to others.

The Chinese authorities are currently installing the necessary regulatory infrastructure to make private equity investment a practical pursuit rather than a source of professional masochism. A vital advance was made when the State Administration of Foreign Exchange (SAFE) issued its Circular 75, lyrically entitled “Relevant Issues Concerning Foreign Exchange Control on Domestic Residents’ Corporate Financing and Roundtrip Investment Through Offshore Special Purpose Vehicles”. In this circular, SAFE pragmatically superseded earlier circulars issued this year (numbers 11 and 29 in case you were wondering) which many felt were a unilateral attempt to block the widely known practice of hui cheng, or roundtrip investment, where China residents effectively moved ownership and control of Chinese assets to an offshore holding company by transferring those assets to a foreign-owned offshore Special Purpose Vehicle (SPV).

The release of these earlier circulars had many private equity firms putting their investment plans on hold as it seemed that SAFE was keen to stamp this practice out. But in Circular 75 (applicable from 1 November), and in its accompanying news release, SAFE now describes this activity of obtaining offshore equity financing through the setting up of SPVs and roundtrip investments in onshore companies as part of the development of the private sector that will be “encouraged, supported and guided”.

This episode is also noteworthy as evidence that the Chinese government is itself a multi-facetted structure, and one that is experiencing its own internal evolution. Different state bodies are clearly eager to exert as much influence as they can as foreign capital queues at the door. Many China watchers saw the SAFE decrees as signs of an effort to head off both the Ministry of Commerce (MofCOM) and the State Administration of Industry and Commerce – neither of whom had been consulted over Decrees 11 and 29. Some banged heads later and you get Decree 75, and the message that China residents need to register with SAFE rather than obtain SAFE’s approval.  Clearly SAFE was reminded that its job was to manage foreign exchange activities rather than exercise investment control.

China is rightly seen as a huge opportunity for private equity and venture capital funds to participate in growth capital investing on a grand scale. The aforementioned metrics make the proposition beguiling, and the practical realities are becoming far less opaque. No wonder Hong Kong is abuzz, and no wonder the Chinese authorities are looking back across the ever-narrowing harbour and saying: “Come on in. Just understand you are entering on our terms.”