From scandal to secondaries?

Pressure is mounting on China’s unofficial GPs and the easy IPO exit is no longer an outlet.

More than 1,000 citizens reportedly took to the streets in October to protest the Tianjin government. The reason for the outrage? Allegedly lax oversight of local “private equity” funds that did not perform as promised, taking many families’ life savings with them.

The protests remain unconfirmed, but O’Melveny & Myers partner James Ford says that it points to a very different side of China’s private equity market: the small, local, non-institutional funds that raise capital primarily from ordinary individuals.

Such firms began appearing several years ago, when China’s private equity industry was booming. Many cities like Tianjin wanted to attract investment, and thus lowered the bureaucratic barriers to setting up a fund – which unfortunately allowed many bogus funds to set up and fundraise, explains James Wang, partner at Han Kun Law Offices in Beijing.

Richard Guo, partner at Fangda Law in Beijing, says the phrase “private equity” was simply used “as a means to tap into investors’ pockets”.

Those investors have ended up in a range of funds. Some, like the well-publicised example of Tiankai Xinsheng Equity Investment Fund in Tianjin, turned out to be outright scams, while others were run by individuals that never had the skill-set – or appropriate governance structure – to carry out a true private equity strategy.

Some funds did try to follow a private equity investment model, but in a shorter time period, raising five-year funds rather than the industry standard ten-year fund. They now have an exit problem, as their model was predicated on the stock market providing surefire realisations. “They may have overestimated the liquidity of the Chinese stock market,” says Ford. 

These funds and their misfortunes are now impacting bonafide private equity firms – both from a dealflow and regulatory perspective.

“Local governments are taking [these collapses] in the wrong way,” Guo says, and some overreact for political reasons. He says local governments especially have failed to differentiate between wannabe and bonafide private equity firms, even though institutional firms had nothing to do with the local funds. 

The regulatory clampdown has been so strong that even brand name firms have run into difficulties. As one example, Tianjin now requires private equity firms to have RMB 200 million in start-up capital, twice the national standard.

The stringent law prevented SAIF Partners from fund registration, and it was not until one of SAIF’s executives complained on Weibo, the Chinese equivalent of Twitter, that the government agreed to negotiate, Guo believes.

“It’s no longer about coming out with new regulations, it’s about how to clean up the existing funds,” Wang explains. With an estimated 5,000 registered and unregistered private equity funds in Tianjin alone, applying regulations retroactively will take time.

Most of these local funds do not have fund life extension options built into their LP agreements, Ford says, so how each one will fare will come down to the “primitive conditions” of the original agreement. 

He believes one potential outcome is a rise in secondary activity, with institutional private equity firms purchasing assets from failing local funds. 

Although secondaries are a small part of China’s market, activity is beginning to pick up, according to Robert Partridge, China private equity leader at Ernst & Young. He can think of eight or nine such deals in the past year, but all are small and local and details have not been publicly disclosed.

Guo also believes that secondary buyouts will grow with government encouragement, because it is a convenient way to address collapsed funds. “Local governments are crazy about secondaries,” Guo says, citing especially Tianjin.