Thinking of launching an RMB strategy? Here’s what you need to know

As China’s dollar-denominated fundraising slows, a growing number of international firms are considering a foray into the country’s yuan-denominated private equity market.

Warburg Pincus, for example, is seeking 3 billion yuan ($436 million; €403 million) for its debut fund in this space, according to a February report from Reuters. Global consumer giant L Catterton reached a first close in October on a 2 billion-yuan fund targeting early-stage investments in China, according to a Chinese-language post on messaging platform WeChat.

Many firms expanding into this strategy are doing so via China’s Qualified Foreign Limited Partnership scheme, which grants approved entities permission to convert a limited amount of US dollars into yuan for domestic investments. L Catterton RMB Fund I, for example, has raised yuan from Chinese strategic investors and local government entities, and from global strategic investors via a QFLP sleeve, Private Equity International understands.

Hamilton Lane also received QFLP authorisation in May 2022, and this year launched a Shanghai office to pursue a yuan-denominated secondaries strategy. Beijing’s Primavera Capital, meanwhile, launched a $100 million QFLP fund to back artificial intelligence, intelligent manufacturing and next-generation information technology companies in February. Schroder Capital launched a QFLP strategy in 2020.

“People do not expect US investors to be as active in China as before; managers are… preparing for trips to Southeast Asia, Singapore, Indonesia, Hong Kong – basically to Asia and to the Middle East,” Ying White, a Beijing-based partner who leads Clifford Chance‘s Funds and Investment Management Group in China, tells Private Equity International, noting that others are looking at placement agents in Europe.

“They are also now thinking of setting up RMB funds, as the concern is that USD fundraising will not be so quick to recover. You’ve got to keep growing AUM, right? So, you are basically starting thinking about or even expanding into the RMB funds business.”

Of course, the motivations for launching such a fund are not solely political. “We think investing in Chinese consumer companies via RMB is a huge opportunity, for fundamental reasons,” says Scott Chen, a Beijing-based managing partner at L Catterton.

“Over the past decade, 80 percent of capital raisings by Chinese early-stage consumer companies have been in renminbi, and two-thirds of domestic consumer businesses that have held an IPO did so in China. The US and China are the two largest consumer markets of scale, and we want to be able to tap into the full spectrum of opportunities in China like we do in the US. Having an RMB fund alongside our USD Asia fund now enables us to do so, and is a natural extension of our strategy.”

Scott Chen declined to comment on fundraising.

Entering yuan private equity is not a decision firms will make lightly; the domestic market has a number of idiosyncrasies and nuances that must be considered before taking the plunge.

Limited partners

GPs targeting domestic LPs will likely need their fund anchored by one of China’s mammoth local government vehicles, which essentially act as funds of funds that encourage investment within their respective province or city.

“Global sponsors – especially if they want to raise a first-time RMB fund – may have to admit the local government-backed fund of funds,” says Zhen Chen, a Beijing-based partner specialising in private equity funds at law firm Fangda Partners. “And typically after they build a connection with the local government, the sponsor can attract market investors.”

These hefty commitments often come with specific requirements, such as asking the fund manager to relocate to their respective city or invest a certain multiple of their commitment – 1.5x or 2x, for example – in the area, Zhen Chen notes.

“Those requests are sometimes quite hard to achieve within the fund life,” she adds. “And if the task cannot be completed, there may be some kind of punishment. For instance, they will suspend the contribution into the fund, or they will sometimes request to withdraw or transfer to other LPs.”

So, how do GPs determine which of these funds to partner with?

“There is competition among the local government funds, so the sponsors will have some choice,” says Zhen Chen. “For instance, if you have an offer from a western city and another from an east coast city like Shanghai or Xiamen, based on my observation, most global sponsors will choose somewhere that is more developed and that is more promising in terms of portfolio companies.”

Guidance funds can also be industry-focused. “There are a bunch of government-backed funds of funds that are deploying capital to specific sectors like green energy and new materials,” adds White. “If you fit into one of those, your chances of getting funding from those government-backed funds are pretty good, and so people are optimistic about that.”

For the remainder of a yuan-denominated fund, GPs can expect to raise capital from pensions, insurance companies, family offices, state-owned enterprises and high-net-worth channel products from entities akin to wealth managers or private banks.

Some limited partner advisory committees in China encourage weighted votes. “Sometimes even for the advisory committee membership, large Chinese LPs want to vote based on the commitment size of the AC members they are representing – not just like one member, one vote,” Zhen Chen notes.

Changes to fund terms

Fund terms in China’s private equity market have become more idiosyncratic over the past decade, in line with the rising sophistication of domestic investors.

“The first batch of RMB funds were sponsored by foreign managers, so their terms are quite similar to the USD funds,” Zhen Chen says. “But after a decade of development, actually, nowadays the fund terms have, maybe inevitably, become more localised. I think this is partly because PRC [People’s Republic of China] investors are becoming more sophisticated, but also perhaps because regulation on the private funds industry is becoming stricter.”

GPs seeking capital directly from Chinese investors should be prepared to offer terms different to those seen in their USD funds.

For starters, fund lives in China are often shorter than their USD peers. Between them, White and Zhen Chen place the average fund life at between three and eight years, depending on the strategy. This is compared with the standard 10-plus-two in USD funds.

With regards to fees, though 2-and-20 is also often the norm, investors often expect GP expenses to be paid for by the management fee, rather than the fund, White says. “Chinese LPs will require that as one way to control expenses, given the whole industry is still developing and relatively immature.”

Fee and expense negotiations can be hotly contested in China. Some investors, for example, will push for a cap on fund expenses, or side letter provisions that cap their own contribution to expenses that are charged from the fund, Zhen Chen notes. Others want reduced management fees.

“Sometimes extremely low organisational fees are enforced by the anchor investors,” she adds. “We typically see 1 percent, but sometimes if the fund size is quite large – for instance, over 10 billion yuan – it could be a lower percentage, like 0.3 or 0.5 percent.”

While USD-denominated firms often call capital from LPs on a quarterly basis across the investment period of the fund, yuan GPs may need to call a large proportion much earlier.

“RMB funds typically call capital up-front because of the high default rate, so you either have everything called in at the beginning because you already have a very good pipeline, or you call 50 percent of the capital at the beginning,” White says. “Occasionally, you do see one-third called upfront, but very rarely do you see Western-style capital calls on an as-needed basis.”

QFLP schemes

Though there are now thought to be as many as 30 to 40 QFLP schemes across China, not all of them have been created equal. Each is vying to lure overseas investment to their respective locales and offer different advantages or terms accordingly.

“Places like Shanghai and Shenzhen have very established QFLP programmes and the officials have lots of experience,” White says. “To compensate for their lack of experience, other local governments are offering more favourable policies – for example, the entry barrier and capital requirements are much lower. However, what is top of mind for our clients is the foreign exchange policy, ie, how easy it is to get the money in and get the money out.”

Shanghai in particular has succeeded in attracting foreign private equity interest. “Shanghai and a few other local governments now have optimised the foreign exchange policy to make it much easier for QFLP funds to remit money out of China,” White notes. “That is expected to solve one of the pain spots of the QFLP managers, and we think there will be a lot more interest in this space going forward.”

Other considerations around QFLP domiciles can include tax treatment and the talent landscape. Some, like the northeastern city of Tianjin, do not require a QFLP investment vehicle with non-PRC investors to file as a private fund with the Asset Management Association of China (AMAC), or the vehicle to have a fund manager registered with AMAC – an exemption that can greatly expedite the launch process for overseas sponsors.

QFLPs can be used to supplement a debut yuan fund; the sponsor raises US dollars from its existing international LP base, converts this into yuan and commits to its yuan-denominated vehicle.

“Local government funds will not invest alone and cannot be the sole LP of the RMB fund – they usually want at least two-thirds of the money to come from other LPs in the market,” Zhen Chen notes. “But especially for global sponsors, because they do not have an RMB fund track record, it will be quite difficult for them to raise a first-time fund from PRC investors. So maybe as a way to build up their track records and also their onshore AUM, they will use the QFLP as a feeder fund.”

And though QFLPs are subject to foreign exchange quotas, these have relaxed somewhat in recent years.

“The QFLP quota is not that tight – as long as you show the local authorities what kind of fund you are going to form, the fund size and what kind of investments these funds [will make], I think it’s quite easy to get the quota you are applying for,” Zhen Chen adds. “In Shanghai and Hainan, for example, I think usually like 500 million yuan or 1 billion yuan can be approved. They’re getting more flexible.”