Lust, caution

How are LPs in the West approaching the Chinese market? Jennifer Harris tests the waters.

A rising tide lifts all boats. In China, the GDP tide – which rose to the tune of 11.4 percent last year – has doled out success in a very egalitarian fashion to the private equity industry, to the extent that most funds in the country seem able to boast of at least a few impressive success stories. In 2007, venture capital and private equity-backed companies raised $34 billion (€22 billion) through initial public offerings on domestic and overseas markets, according to the China-focussed Zero2IPO Research Center. Aided by this, funds appear to be having little trouble raising ever-increasing amounts of capital for investment in the country. CDH Investments closed its second China fund on $310 million in 2005, and a year later came back to the market to raise $1.6 billion for its third.

Amid this heady rush to deploy capital in China, how should limited partners approach the next fundraising cycle? Today, even more traditionally risk-averse LPs are looking to get in on the action. Opportunities in China are simply too good to ignore. But uncertainties also abound. For one thing, to understand China means understanding China's language, culture and political system – a challenge for Western LPs.

Other risks are numerous. It is still unclear to what extent China would suffer should a recession in the US deepen – inexperienced fund managers could be shaken out in the event of a downturn. The danger of China's white-hot economy overheating has long been a concern as well. On top of this is the possibility that the Government may change the ground rules: the last few years have seen the state introduce a number of regulations aimed at promoting exits on local versus international exchanges, and promoting RMB-denominated funds over offshore vehicles, for example.

Mitigating those risks is a major concern for institutional LPs like pension funds and endowments. These LPs' approaches differ based on how much uncertainty they are willing to take on. LPs can invest in global buyout funds that invest some portion of their capital in China, dedicated China funds run by international firms, or dedicated China funds run by local managers. Global or pan-Asian buyout funds offer risk diversification within the fund. They offer long track records and established relationships in China, plus the experience of having weathered several market cycles in their time.

China-focussed funds provide full exposure to the country. Local managers offer the benefits of greater understanding of China's business culture, and possibly advantageous connections with key players in the Government or the business community.

The local market is still immature though, and few of these managers are tried and tested. On the other hand, if an LP passes on a first-time fund which then brings in dazzling returns, they might find themselves crowded out of the second vehicle.

Once an LP has settled on a mode of access, there is still the matter of choosing a specific fund manager. The due diligence on these managers is highly time-consuming. How does one assess a manager's ability to add value to companies 7,000 miles away? Before going into China, it is crucial that an LP have some familiarity with the conditions and players in the market. Having conversations with other industry participants active in China is key: other LPs, fund of funds, bankers, placement agents, etc.

Western LPs come at China from a variety of angles. Everyone is interested in the country and the stories of outsized returns to be found therein. But few are rushing in without reservation. Below are examples of the approaches of some leading limited partner groups:

TIAA-CREF
Keeping the door open
US retirement plan administrator TIAA-CREF invests about 15 percent of its private equity portfolio in emerging markets, of which 10 percent is in Asia. The firm, which manages around $435 billion, has been investing in Asia since the inception of its private equity programme in 1997. It achieves its China exposure primarily through pan-Asian funds, as well as global buyout funds. For now, this is sufficient, says Sheryl Schwartz, the firm's head of alternative investments.

“It would be rare that we would go into a first-time fund that doesn't have a demonstrated track record, and most of the China-specific funds don't have a demonstrated track record of exiting,” she says. “They may have gone into some companies; they may have marked some things up based on public market valuations; but most of them have not exited all that many investments in the buyout area.”

The firm looks for teams of managers who have worked together for a long time, have worked through various economic cycles, and can add operational value to their underlying portfolio companies. That said, the firm does maintain a dialogue with emerging managers in China, regularly meeting with them and keeping track of their activities.

“It's not that we don't meet with them and keep the door open,” she says. “We meet with them and we express to them ‘You sound interesting and promising, and we'd like to meet with you and hear about your updates, and when you have more of a track record we would seriously consider backing you.’”

RECENT CHINA-FOCUSED FUNDS IN THE MARKET

FUND MANAGER FUND NAME STATUS CATEGORY
21VC 21st Century Investment Holdings (China) Limited Open Country
ARC Capital Partners, Ltd. ARC Capital Holdings, Ltd. Closed Country
China Century Capital Limited China Century Capital Limited Closed Country
Citic Securities Co., Ltd. Gold Stone Investment Co. Closed Country
IDG Ventures, China film group corporation IDG China Media Fund Closed Country
James & Hina Capital Management Co., Ltd. Capital Partners Wenzhou Donghai Venture Closed Country
New China Capital Management Cathay Capital Holdings II Closed Country
Northern Light Venture Capital Northern Light Venture Capital II, Ltd. Closed Country
CBC Partners, L.P. China Broadband Capital Partners, L.P. Open Country
CDH Investments CDH China Fund III Closed Country
CEL Partners China Equity Links Open Country
China Renaissance Capital Investment Inc China Spring Fund Closed Country
China Science & Merchants Capital Management United World Chinese Investment Inc Closed Country
China Seed Ventures China Seed Ventures Fund I Closed Country
Victoria Capital Limited China New Enterprise Investment (CNEI) Closed Country
Citic Capital Partners CITIC Capital China Partners LP Closed Country
CITIC Capital Partners and Bright Food Dairy CITIC Food Fund Closed Country
Citic Capital Partners Starr International TBD Closed Country
Hi-Tech Technology Venture Investments LLC Accel Partners Hi-Tech Gobi Binhai Venture Capital Fund Open Country
IDG Ventures/Accel Partners IDG-Accel China Growth Fund II Closed Country
Japan Asia Investment Co Ltd (JAIC) CyberAgent Investment CA-JAIC China Internet Fund Closed Country
Jiangsu High Tech Investment Group Jiangsu Ko Shing Fund II Closed Country
Kleiner Perkins Caufield & Byers China Fund Closed Country
Richlink International Capital Research Co Bohai Value Investment Closed Country
Sequoia Capital Sequoia China Growth Fund Closed Country
Sequoia Capital Sequoia China Venture Capital Fund II Closed Country
Shanghai-Pudong Technology Investment Huiyan Investment Fund Closed Country
Shenzhen High-tech Property Exchange Nahai Venture Capital Fund I Closed Country
Shenzhen Oriental Fortune Capital Co. Shenzhen Oriental Fund Open Country
SIG Capital Partners Venture Star Shanghai Open Country
DT Capital Partners, L.P. DT Ventures China Fund II Open Region
GSR Ventures / Mayfield GSR Ventures II Closed Region

THE WELLCOME TRUST
On the verge
UK research-funding charity The Wellcome Trust does not yet have any direct exposure to China, but the $13.9 billion trust is “very actively looking,” says senior investment officer Robert Coke. In the past few weeks the trust has sent colleagues to the country to look for property and private equity ideas. The trust is interested in fund commitments rather than funds of funds in order to avoid the added level of fees.

The Wellcome Trust is somewhat unique in that it is looking for “smaller, country-specific rather than regional Asian opportunities.” But the endowment maintains high standards for fund managers, and will “only consider teams who we can trust to do the right thing for their investors” Coke says.

In terms of risk factors, Coke says he is wary of sectors in which the state is likely to have more involvement, such as media or energy. But on the whole he thinks political risk in the country is mitigated by the fact that China has fully subscribed to the capitalist model, which is a trend that would be very difficult to unwind.

The biggest opportunity the trust currently sees in China arises from a lack of available credit in the country, and the trust will look to capitalise on that, he says. But he stresses that it will proceed with caution.

“We have been cautious given the difficulties of finding people with investment experience, local connections and a strategy that copes with exit, competition and pricing issues,” he says.

FUND GOAL ($M)

FUNDS RAISED

SECTOR

STAGE

100

Technology

VC

282

457

Growth

15

15

Growth

111

111

VC

50

0

Technology

VC

66

0

Growth

500

550

Growth

0

Generalist

Growth

300

50

Technology

VC

1,600

1,630

Generalist

Buyout

94

57

Generalist

Growth

120

Generalist

VC

64

64

Generalist

Growth

30

45

Technology

VC

100

113

Growth

250

425

Infrastructure Industries

Buyout

265

265

Agriculture/Agribusiness

Growth

64

64

Generalist

VC

39

20

Technology

VC

500

510

Generalist

Growth

5

23

Technology

VC

41

41

Technology

VC

360

360

Generalist

VC

67

67

Technology

VC

500

500

Generalist

Growth

250

250

Generalist

Growth

47

47

Generalist

VC

12

12

Technology

VC

120

Technology

Growth

50

15

Technology

VC

130

122

Environment

VC

200

200

Technology

VC