Offshore LPs invested with prominent China-focused GPs are feeling a little like Cinderella right now: left behind while everyone else dances at the ball.
The issue is that US dollar-denominated funds in China are still subject to restrictions on investment and long-winded and unpredictable approval processes on deals, while RMB funds have far fewer obstacles. As such, some of China's most established managers, currently investing from their first RMB funds, have found they suddenly have access to deal flow and sectors they can't touch with their USD funds – and are focusing their investment capabilities on their RMB pools accordingly.
So while foreign investors watch the RMB-denominated vehicle make deal after attractive deal, the sister USD-denominated fund they committed to lies largely idle.
It is a situation that has not gone unprotested by disgruntled LPs. When PEI Asia published its inaugural funds of funds survey in May this year, several respondents stated that specific terms and conditions were needed in China to address this conflict of interest. Another LP told us recently he was “disappointed” managers were not doing more.
However, the fact is that for those funds already raised, there is little that can be done except rely on the willingness of the manager in question to address the imbalance and thus maintain strong ties with its foreign investors.
However, for those funds currently being raised from both onshore and offshore investors, this potential conflict is the single biggest topic of discussion between GPs and foreign LPs, says one Beijing-based fund formation lawyer.
It is also where fund formation law is likely to see the greatest level of innovation in Asia as – rather than wait for the Chinese government to ease restrictions on foreign capital – it attempts to swerve and dodge its way through the uneven regulatory landscape and level the playing field for both domestic and offshore investors.
The Beijing-based lawyer states his firm currently has a list of about 20 elements that could be applied to limited partnership agreements to this end. He adds that ideas that are at the discussion stage now are likely to become market norms within a short time frame.
That it is in the interests of both GPs and LPs (and their lawyers) to reach a fast consensus – or at least a satisfactory compromise – on the issue of conflict is self-evident.
Though offshore LPs do not like the imbalance created, they do want to keep investing with the best GPs in China and they appreciate the credibility – and access to deals – a parallel RMB vehicle brings. After all, as the lawyer noted, who would want to invest with a manager who couldn't raise money locally?
For GPs meanwhile, the presence of more sophisticated long-time private equity investors in their LP base is also an endorsement and a mark of distinction in a crowded market. Many GPs understand that foreign LPs are needed to help institutionalise China's youthful private equity industry and guide local LPs.
So with the issue of credibility driving parties on both sides of the divide, we can expect to see some fancy legal footwork emerge in China-focused fund documentation. Next time LPs go to China, they'll be expecting to go to the ball.