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:
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 |
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.
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