Kpmg rmb funds march 2013 by Conrad Turley

Foreign sponsored RMB Funds - Still worth the effort? RMB Funds Report

kpmg.com/cn

Message from John Gu, China Leader, Private Equity and Inbound Mergers & Acquisitions Tax, KPMG China

I am delighted to introduce our new KPMG China publication, “Foreign sponsored RMB Funds – Still worth the effort?”. This report is being released at a time when recent regulatory and market developments have led to a tempering of the motivation and interest, among international private equity houses, to establish RMB funds. The question facing many leading global PE firms is how, subsequent to these changes, the costs and benefits of establishing and operating an RMB fund now weigh up, how the RMB funds space will develop going forward and whether pursuit of an RMB funds strategy is ‘still worth the effort’. This publication, which draws on the latest market intelligence and analyses recent developments and trends, sets out to answer that question. It concludes that the RMB fund market is simply too important to be missed out on given 1) the cash on offer from the Chinese institutional investors in the current challenging global fundraising environment and 2) the increasing importance of RMB funds in the global M&A market, as fuelled by more favourable outbound investment-driven policies and the inevitable internationalisation of the Renminbi. While at the present moment and under current regulations, foreign sponsored RMB funds are hindered competitively relative to their domestic fund manager sponsored rivals, with the regulatory environment in flux, certain key regulatory changes could quickly permit foreign sponsored RMB funds to re-enter the fray and compete effectively in the China market. As such, we conclude that Foreign sponsored RMB funds are, indeed, still worth the effort. I hope that you find this publication informative and useful as a guide to the China PE/VC sector’s ever-evolving competitive scene.

Yours, John Gu

In recent years there has been a high level of interest among international private equity houses in establishing onshore Renminbi (RMB) funds in China. Rapid growth from 2007 to 2012 saw RMB funds eclipse once predominant China-focused offshore funds in terms of new funds established, funds raised, and investments made. Further, regulatory change promised to enable participation by different limited partnership (LP) classes, including all-important Chinese institutional investors. Naturally, international private equity houses wanted to be in on the game.

International private equity houses establishing RMB funds made varying use of the special incentivised arrangements offered for fund managers at national and local levels, but generally tried to structure their arrangements so that their funds would be recognised as ‘pure’ RMB funds. The hope and expectation was that these would be then treated as “domestic” investors for regulatory purposes, allowing the funds to make and exit from investments unburdened by the sectoral restrictions and approval processes which generally impede foreign investors in China. But this was not to be. In April 2012, the National Development and Reform Commissionl, China’s national economic planning body, ruled that a Blackstone sponsored RMB fund should be treated as foreign-invested for regulatory purposes due to the foreign equity participation in the general partner. The net effect of this ruling is that, until this position is reversed or local incentive schemes provide a workaround, foreign sponsored RMB funds cannot make or exit from investments at any substantial advantage over offshore funds. Critically, given the regulatory competitive handicap compared to domestic fund manager sponsored funds, foreign sponsored funds are less well positioned to tap the PRC institutional LP money only now coming on stream. So is it still worthwhile for international private equity houses to establish and operate an RMB fund?

This publication seeks to answer that question. In Part 1, we examine the ascendancy of RMB funds over USD funds, detailing the China LP classes and the money they bring to the table. In Part 2, we look at how the foreign sponsored RMB funds match up against their domestic fund manager sponsored rivals, pinpoint the regulatory handicaps the foreign sponsored funds face when it comes to establishing, investing and exiting funds, and explain what this means in practice for their competitive position. We look to highlight what needs to change at the regulatory level for foreign sponsored funds to get back in the game. Part 3 examines some potential developments. We conclude that the RMB fund market is simply too important to be missed out given 1) the cash on offer from the Chinese institutional investors in the current challenging global fundraising environment and 2) the increasing importance of RMB funds in the global M&A market, as fuelled by more favourable outbound investment driven policies and the inevitable internationalisation of the Renminbi. While at the present moment and under current regulations, foreign sponsored RMB funds are not in the running when compared to their domestic fund manager sponsored rivals, the regulatory environment is in flux, and, if certain key regulatory changes can be secured, foreign sponsored RMB funds could quickly re-enter the fray and compete effectively in the China market.

Contents

1: Is there still a reason to establish an RMB fund?

1: The dominance of RMB funds 2: Chinese LP classes, who they are and what they want

2: Foreign sponsored RMB funds â&#x20AC;&#x201C; can they compete?

1: Who are the competitors to the foreign managed RMB funds? 2: What are the regulatory hurdles for foreign managed RMB funds? 3: What is the impact of PRC investment restrictions on foreign sponsored RMB funds? 4: Why do foreign sponsored RMB funds have a harder time exiting their investments? 5: The regulatory web for wholly-domestically invested and foreign sponsored funds in overview

3: A way forward?

1 | Foreign sponsored RMB Funds - Still worth the effort?

Is there still a reason to establish an RMB fund?

Foreign sponsored RMB Funds - Still worth the effort? | 2

In recent years numerous fund managers with international private equity houses have stated in industry surveys that one of their main motivations for being in the RMB funds space is simply to be seen to be in the RMB funds space. According to the Foreign Investment in RMB Funds Survey carried out by CVCA and KPMG, 91.2% of surveyed foreign venture capital(VC)/private equity (PE) institutions believe that the rise of RMB funds is an irreversible trend. To not be in this space is perceived to be on the wrong side of history on a number of counts. International fund managers focussing on China investments naturally wish to tap the expanding domestic Chinese LP base. Funds may be raised in RMB and deployed domestically without need for foreign exchange settlement. The importance of the domestic LP base for China focussed funds is made evident by the statistics showing the increasing dominance in fund raising of the RMB funds over China focussed offshore funds. However, the interest of foreign fund managers in RMB funds goes beyond this1. While RMB funds increasingly dominate in terms of the proportion of China investments made and exited, offshore China focussed funds, funded by both Chinese and foreign LPs, still raise and invest significant sums in China. To date, China focussed offshore funds have been largely the preserve of non-Chinese PE houses. However, the dominance of foreign fund managers in the offshore China focussed fund space may, in time begin to face some challenge if China domestic fund managers use their dominance of the RMB fund space to leverage their control of the offshore China focussed fund space. China domestic fund managers may be better placed to run parallel offshore-RMB fund arrangements and may draw foreign, as well as Chinese money, away from the foreign-fund-manager-managed offshore China focussed funds. However, for the medium term at least the latter will remain dominant in the offshore space.

Lastly, international fund managers will be highly conscious of the wave of Chinese money set to look for investment opportunities overseas. At present, foreign fund managers with extensive international experience are best placed to serve this enormous potential market. Their absence from the RMB fund space may allow domestic fund managers, through managing domestic investments, to build the relationships which allow them to serve China LPs as they seek to invest overseas. However, given their accumulated expertise and network, international PE firms should continue to predominate in this space in the medium term, by leveraging off the breadth of their global experience and credentials.. In summary, there are a number of compelling reasons for foreign fund managers to have a presence in the RMB funds space. As is clear from the above, the two factors most pertinent to foreign fund managers when considering whether there is still a reason to establish an RMB fund are: (i) the progressive dominance of RMB funds over offshore funds (ii) the nature of the Chinese LP classes, and what they want. These two matters are the focus of Part 1.

Reasons for foreign fund managers to want to be the RMB fund space China LPs in RMB funds

LPs in China focussed offshore funds China LPs looking to invest overseas

Fundraising by RMB funds has outpaced China focussed offshore funds, so foreign fund managers focussed on China investment need to tap this LP pool

Growing importance of RMB fundoffshore fund co-investment strategies means that offshore fund managers need strong RMB funds to support attractiveness of their offshore funds

Foreign fund managers need RMB fund presence to build relationships with China LPs who will in time look to invest abroad

1 This consideration of the reasons for foreign fund managers to establish RMB funds sets aside for a moment the intended use of RMB funds to compete with domestic fund managers on a regulatory level playing field. The NDRC ruling has put paid to such a strategy, at least for the moment. We address the competitive position of the foreign sponsored RMB funds relative to the domestic manager sponsored RMB funds in Part 2

3 | Foreign sponsored RMB Funds - Still worth the effort?

1: The dominance of RMB funds China progressively dominates Asian PE fund raising market The first thing to note is that China is a dominant focus of Asian PE. This holds for China both as a source of fundraising and as a destination for investments. According to data from the Asian Venture Capital Journal, in 2011 and 2012, and despite a recent relative decline, China accounted for more than 50% of all fundraising and around 40% of all investments in Asia. To the extent that RMB funds dominate China PE, they also dominate Asian PE.

â&#x20AC;Ś and RMB funds dominate China fundraising and investment The PE/VC fund raising figures for the first three quarters of 2012 indicate clearly how far RMB funds have come to supplant USD funds. In 2012, RMB funds accounted for 590 new funds and USD 25 billion, representing approximately 95% of all new funds and 72% of the amount raised. From 2007 to 2012, the amount raised by RMB funds grew at a compound annual growth rate (CAGR) of 42%. Foreign currency funds made up 5% of new funds (31) and 28% of the amount raised (9.6 billion). The decline in foreign currency funds can clearly be seen compared to 2007, when 67% of funds raised were raised by foreign currency funds. Although now a smaller part of the market compared to RMB funds, foreign currency funds still tend to be larger than their RMB counterparts.

Investment by location, China vs rest of Asia, 2011 to 2012

Fundraising by location, 2011 to 2012 100%

100% 34%

50%

57%

62%

43%

38%

2011

2012

50% 66%

50%

2011

2012

Other Asia

China

Other Asia

China

Number of new PE/VC funds by amount raised and funds raised, 2007-2012 80

700 68.4

USD billion

67.1 560

60 50 40

500

23.3 41.0

44.8

30 20

36.6

79 4.4 39

590 600

2007

18.8 6.5

21.2 217

23.6108 59

105 12.3 19

17.5 23

2008

2009

2010

Amount rasied by RMB funds No. of foreign currency funds Source: Zero2IPO, KPMG analysis

400

38.8

34.6 9.6

200

43.8 57 2011

300

25.0 31 2012

100 0

Amount rasied by foreign currency funds No. of RMB funds

Foreign sponsored RMB Funds - Still worth the effort? | 4

To understand the significance of this development it is worth considering briefly the short history of the Chinese PE/VC fund industry and how the offshore funds initially were of most importance. CAGR(%) Amcunt rasied by RMB funds Amcunt raised by foreign currency funds Total

2007-2012 42% -24% -3%

Source: Zero2IPO Research

China progressively dominates Asian PE market The Chinese PE/VC fund industry story only started in a substantive way following the accession of China to the WTO in 20012. In the early phase, Chinese institutional investors were excluded from investing in private companies. This excluded from PE investment opportunities institutions such as and insurance and securities firms (who have more recently been allowed to invest) and banks and pension funds (who still are excluded). Some cash-rich state-owned enterprises (SOEs) and a number of listed private companies did set up a number of domestically invested funds. However, these were largely captive funds operating as extensions of the sponsorsâ&#x20AC;&#x2122; existing businesses. In this early period, foreign fund managers were becoming increasingly present in the Chinese market through their USD funds. They also set up small scale foreign-invested RMB funds under the foreigninvested venture capital investment enterprise (FIVCIE) regulations, which were effective from 2003, but these were fairly minimal in scale.

The story changed rapidly in 2005/2006. A surge in activity was triggered, with offshore funds initially leading. The successful overseas listing by a number of USD funds of Chinese portfolio investments made in the early and mid-2000â&#x20AC;&#x2122;s showed how much profit could be made in the Chinese market. This success drew a wave of capital allocation from foreign LPs to China focused offshore funds and some to Asian funds. It was these offshore funds that initially dominated, recording particularly heady growth between 2002 and 2006 when per annum funds raised grew from USD500 million to USD15.5 billion, a growth rate of 136% p.a. In 2007, USD funds constituted 67% of new China focussed funds and 90% of funds raised3. RMB funds take over However, a number of important developments then set the expansion of the RMB funds industry in motion. From the RMB fund establishment perspective, the passage of the 2007 Partnership Law made available a vehicle for operating RMB funds in line with the global classic PE GP-LP model. An exit mechanism for RMB funds came into existence with the establishment of the small and medium enterprises (SME) board (2004) and ChiNext (2009) in Shenzhen, allowing the realisation of returns on domestic exits similar to the outstanding ones being achieved by offshore funds on foreign exchanges. Taken together with a growing interest among increasing sophisticated and affluent Chinese investors in higher yielding investment products, the net result was an explosion of RMB fund establishment and investment from 2007. 2 While even as far back as the 1980s some local governments sponsored funds to foster new businesses, and foreign fund managers such as IDG entered the market as early as 1992, this was pretty small scale activity. 3 Zero2IPO

5 | Foreign sponsored RMB Funds - Still worth the effort?

A number of developments then served to help the RMB funds leapfrog the offshore funds. The global financial crisis of 2008 temporarily hobbled the fund raising and investment activities by the USD funds. At the same time, expansion of the RMB funds was fostered by the large amount of funds allocated by central and regional government agencies, notably the National Social Security Fund, the state development banks, and various local government asset and finance companies, intent on supporting industrial and regional development through PE/VC. These developments show up in the statistics. Since the 2007 explosion of RMB funds (recording 42% CAGR 2007 to 2012), foreign currency funds have declined, slowly at first and then rapidly falling, from 67% of new funds in 2007 to 5% of total funds in 2012. For 2012, a mere 15 out of 369 new PE funds and 16 out of 252 VC funds were foreign currency funds (accounting for 4% and 6% of funds raised respectively)4. The progressive dominance of RMB funds can be linked to key advantages over USD funds • RMB funds have ready access to domestic Chinese investors, who in the current regulatory climate would generally be unwilling or unable to invest in offshore USD funds • In making investments, and unless domestic vendors are willing to accept foreign currency as purchase consideration, USD funds must convert the purchase consideration into RMB, requiring lengthy settlement approvals from China’s State Administration of Foreign Exchange (SAFE) for each individual investment. Delays and complications may also arise on converting RMB to USD for repatriating income and gains out of China. • The onerous foreign ownership restrictions (of particular relevance to the highly attractive internet and value added telecoms sectors), pre-approvals and regulatory scrutiny, which stymie much USD fund investment, are not an issue for wholly-domestically invested and domestically sponsored RMB funds5 • The tax advantages previously available to offshore USD funds, relative to onshore funds, have progressively been narrowed over the last four years. The preferential tax treatments for target companies (as foreign-invested enterprise - FIEs) have disappeared; the granting of tax treaty benefits is now strictly policed; an offshore indirect disposal tax charge has been introduced; and the general enforcement of China’s international tax rules vis-a-vis nonresidents has tightened. • The effective ban on the establishment of round-tripping structures has complicated the conduct of offshore listings, the principal means of investment exit for offshore USD funds, as have accounting scandals at many overseas listed Chinese groups, which have dented demand for ‘China-concept’ stocks in overseas IPOs

Despite the collapse in USD fundraising due to global financial crises, it is expected that USD PE funds will still play a visible, if declining, role in the Chinese PE market for a while to come. Foreign and domestic China-focussed fund-sponsor-managed funds will continue to establish USD funds to access Western capital which, though diminished since the financial crisis, is still drawn towards participation in the China-growth story. Foreign-currency funds also have a role in the PE financing of the growing number of Chinese companies seeking acquisitions abroad. In any case, if RMB internationalisation proceeds at pace, at least some of the disadvantages of offshore funds may be assuaged as FX conversion may become less of an issue for USD funds (and offshore funds may also come to be raised in RMB). It should also be noted that the success to-date of the RMB fund market may have temporarily accelerated the speed at which RMB funds have been raised. RMB funds are in relative infancy. There have been few busts, and domestic fund managers retain high confidence in China’s economic prospects and downplay risk concerns. This bullishness is reflected in RMB funds tending to accept higher valuations when making investments, driven by relatively high exit values in the A-share market, according to industry comments. Furthermore, with few exceptions, RMB funds in general tend to do less due diligence and the investment terms tend to be less sophisticated. As the Chinese economy slows, many of the potential deal opportunities for RMB funds may come to be viewed as riskier. If the pace of listing also slows significantly, then RMB fund managers may become more cautious in setting up new funds and the relative ease with which RMB funds raise cash relative to USD funds could also change. This could see some recalibration of the position of RMB funds relative to USD funds6. The future looks bright for RMB funds RMB funds are set to benefit from the growth and transformation of the Chinese economy and from deficiencies in the PRC capital market’s servicing of industry The Chinese economy is projected to grow at an average 8% rate over 2012 to 2016, with continued economic realignment driven by government policy to support urbanisation, a shift from exports to domestic consumption, and the expansion of the services sector.

4 It should however be noted that the 2012 figures present a time of particular stress for the PE/VC industry worldwide and the extremely low proportion of new US funds raised is accentuated by the poor state of Western economies, the European debt crises, and the impact of the China concept stock accounting scandals. It is worth noting that historically foreign currency funds raise more on average than their RMB counterparts representing the larger scale of the global funds that enter the market 5 The continued existence of these restrictions and their impact on foreign invested and foreign sponsored RMB funds is the principal focus of Part 2 of this publication 6 In this regard it might be noted that foreign LPs tend to require lower investment return and accept longer investment periods

Foreign sponsored RMB Funds - Still worth the effort? | 6

Development and adaptation of industry will create myriad opportunities for PE/VC to supply its unique blend of financing and hands-on support. Furthermore, with the banking system still overwhelmingly favouring SOEs and reform a slow process, the PE/VC sector is expected to play an outsized role in financing the Chinese SMEs which make up 90% of firms and 60% of Chinese GDP. PE/VC also supports Chinese companies as they expand their operations and investments into the wider world.

Private Equity penetration as a percentage of GDP, 2011 1.20% 1.00%

0.98% 0.75%

0.80% 0.60% 0.40%

0.33%

0.00%

India

China

Source: Emerging Markets Private Equity Association (EMPEA), H1 2012

US domestic assets by type, 2012

22%

China's domestic assets by type, 2012

Germany domestic assets by type

13%

19% 20%

33%

Set in the context of other financial asset classes in China, PE still makes up a small proportion of overall investment. Chinese investors currently hold a majority share of their liquid wealth in bank deposits, mutual investment funds (often via trusts) and direct investment in listed equities. As Chinaâ&#x20AC;&#x2122;s capital reserves continue to swell and as Chinese investors become more sophisticated, the demand for alternative investment products which generate potentially higher returns, such as PE, will grow. The diagram below shows current comparison of domestic asset allocations in the US, Germany andChina. Consequently, the LP monies drawn to RMB funds are expected to continue to swell and the predominance of RMB funds over China focussed offshore funds will become more pronounced. Where these LP monies are set to come from, and the demands of these LP classes are the focus of the next section.

0.14%

0.20%

There is plenty of room for PE funds to grow in China since, when set against the position in developed economies, PE penetration in China is still small in relation to GDP. According to the latest figures from the Emerging Markets Private Equity Association (EMPEA), China has under half the level of private equity penetration of India and is a long way behind more developed countries such as the US and UK.

16%

46%

24%

23%

Securities (excl equities)

Note 1) Total assets of the entire domestic the economy 2) China data combines equities and other categories 3) Other assets of the whole domestic economy (institutional units resident in domestic economic territory). Source: EIU

15% 24%

11% Currency and deposits

25%

Loans

Equities

Other

7 | Foreign sponsored RMB Funds - Still worth the effort?

2: Chinese LP classes, who they are and what they want position in developed markets, with substantial numbers of existing LPs being SOEs/POEs(privately-owned enterprises) and government guidance funds/asset management organisations. These are generally not inclined to invest with foreign managed funds in any case. The SOEs/POEs often link their investment approach to their business strategy, investing in captive funds or industrial funds set up with other enterprises and government bodies. Government funds/ asset management organisations also support broad-based industrial funds in pursuit of regional industrial and economic development strategies. Even where such LPs do invest with an eye to purely financial returns, their relationships to domestic fund managers are generally stronger, partly because the latter may be more ready to adapt to the more interventionist investment style adopted by such LPs.

The overarching narrative of any survey of the Chinese LP classes is that institutional LP money is progressively coming on tap as regulations restricting these investorsâ&#x20AC;&#x2122; investment in PE are relaxed. These institutional LPs will be looking for professional investment managers with robust corporate governance and track records.This presents a unique opportunity for experienced foreign fund managers. In addition, the rapid increase in the numbers of Chinese funds of funds (FOFs) promises to organise and channel funds from the individual Chinese LPs who have been enthusiastic about the promising returns from PE investment, but have generally been difficult to manage. However, as explained below, it may not be the foreign fund managers who benefit most from these developments. In particular, the regulatory restrictions on investment by foreign sponsored funds may dissuade LPs from investing with them as they are at a competitive disadvantage to the domestic manager sponsored RMB funds. In addition, the makeup of Chinese LP classes at present is somewhat different from the Investor classes

Institutional

Investor

A simplified overview of the various Chinese LP classes, with observations on their investing capacity, goals and behaviour, is set out in the table and commentary below.

Unsophisticated

Restricted from investing

Business strategy, Industrial policy driven

Preference to run GP

Optimal LP

NSSF

ď&#x192;ź

LSSF

Enterprise Annuity Funds

Insurance

Charities/ Foundations

Gov guided

CDB

FOF

Banks

SOE

POE

HNWI

Policy

Aggregators

Corp and indiv

ď&#x192;ź

Foreign sponsored RMB Funds - Still worth the effort? | 8

China’s National Social Security Funds (NSSF) and FOFs seek financial returns, are long-term focused and unrestricted by regulation, and accept the classic passive LP role There is currently much excitement about FOFs and the NSSF as these offer long-term LP capital contributions with minimal interference. The attraction of FOFs is that they can both aggregate the smaller investors, who may be unfamiliar with the operating manner of PE funds and may be too small to make a meaningful (or permissible) investment individually, while spreading the investment of big institutional investors, who do not want, or are not permitted to have, excessive exposure to one fund and who may not have professional investment teams. The public authorities are doing their bit to foster the growth of the FOF sector: CDB and Suzhou Investment Park established the consciously market-oriented Guochuang FOF in late 2010 (set to have raised RMB60 billion by end 2012) and the NSSF also sponsors the setup of FOFs. Encouraged by this, numerous fully private FOFs have also been established. Since April 2008, the NSSF has been permitted to invest 10% of its assets in market oriented PE funds and industrial investment funds, providing a potential USD10 billion (out of the NSSF’s total funds of in excess of USD100 billion). The NSSF is considered to bewell managed, to have a long-term investment horizon in line with the pension obligations it will ultimately meet, and to be willing to invest in a solely LP capacity. The assets of the NSSF are being swelled by numerous measures, not least an obligation for SOEs to transfer a proportion of their onshore listed shares to the NSSF, and is argued by many commentators to have the potential to become the largest institutional investor in the world. To have access to NSSF funds, funds must register with the NDRC and pass the NSSF’s very rigorous scrutiny process, but the NSSF has expressed a willingness to invest in foreign sponsored and managed funds in China and has already invested RMB 1.2 billion in an RMB fund sponsored by IDG, which in origin is a US VC firm. This being said, the NSSF’s onshore PE investments to-date have been primarily in domestically sponsored funds7, frequently in tandem with local government guidance funds, and this will likely continue to be the principal investing approach of the NSSF. Most PE investment money currently comes from SOEs and listed private companies, but the deployment of their monies is often guided by business strategy or industrial policy motives While the emergence of such ideal LPs as NSSF and FOFs is to be welcomed, the bulk of the funds flowing into PE in China still come from central and local SOEs and listed private companies. This contrasts with Western countries, where enterprises tend to contribute a small proportion of the total PE assets under management (AUM). This is in large part due to the restrictions on the institutional investors, which consequently represent a small amount of the AUM, but also reflects the fact that the

SOEs have had huge amounts of surplus cash from the conduct of their monopoly businesses. In the early to mid 2000’s many large enterprises set up ‘cash box’ captive funds as investment vehicles, generally as wholly-owned subsidiaries, which made investments broadly aligned with the business of the parent enterprise. However, progressively these enterprise have been directing their funds more towards the sponsoring of large ‘industrial funds’, collectively with local authorities and their guidance funds, the NSSF and other SOEs. Thus, frequently, business strategy or industrial policy motives have come to define investing by SOEs and large POEs, more than pure financial returns. While the sponsoring enterprises have thus far often been heavily involved in the management of the sponsored industrial funds, with their own staff constituting the management team. Professional domestic fund management outfits (e.g. Hony, SAIF, etc,) have not infrequently been invited to manage the funds, orienting them more towards financial return objectives. Foreign managers are admittedly less likely to be so invited, though local SOEs and their supporting regional governments have been willing to pair with foreign fund sponsors to attract expertise and investment to their regions, as evident in several deals done by the Blackstone, Carlyle and TPG funds with several local governments. Certain financial return focused investors, such as Chinese institutional investors, have a preference to act as general partners (GPs), requiring a nuanced take on the classic GPLP model to accommodate such investors In 2010 Chinese insurance companies were permitted to invest 5% of their assets in PE, and in July 2012 the CIRC raised this to 10%, potentially bringing USD71.0 billion to the table. In 2011, China Life became the first insurance company to obtain a private equity investment license under the 2010 regulation. Chinese insurance companies reputedly have a long-term preference to invest in self-managed funds, with only limited investment in third-party funds. China Life has spearheaded developments in this regard; for example, announcing the establishment of an urban infrastructure investment fund together with the Suzhou Municipal Government8. However, it is understood that they will invest primarily as LPs for the medium-term while building up PE experience and relationships. Notably, China Life has to date made substantial LP investments in both Hony and CITIC PE sponsored RMB funds. While under the PRC Commercial Banking Law commercial banks are restricted from making equity investments in domestic enterprises, these use offshore subsidiaries/ intermediaries to make indirect investments into domestic equity investment projects. A number of commercial banks have established controlled private equity funds under their Hong Kong subsidiaries to make such investments, and that they are considered unlikely, for the moment, to direct investment monies into third party funds9. 7 http://www.pedaily.cn/Item.aspx?id=219080 8 http://www.pedaily.cn/Item.aspx?id=219176 9 The large state owned banks have substantial capital allocated to securities and investment; in excess of USD1.5trn

9 | Foreign sponsored RMB Funds - Still worth the effort?

In 2012 the CSRC expanded a pilot scheme that had allowed certain securities companies to set up PE funds to all securities companies, and also permitted mutual fund managers registered with it to pursue PE investment strategies. Through their established customer networks and distribution channels, securities companies are able to bring PE funds to more investors. However, they are likely to play the role of a GP in relation to such funds that they do bring to the table. To date at least 20 funds have been established by securities companies, with over RMB60 billion raised by players such as CITIC and Haitong Securities. High net worth individuals (HNWIs) can be difficult to access and take a disproportionate amount of time to manage HNWIs are primarily of an entrepreneurial background and, as such, retain a desire to steer the use of their invested funds. In practice, much of the GPâ&#x20AC;&#x2122;s time can be consumed in liaison with them. Further, the underdeveloped state of intermediaries, such as banks and wealth management organisations which direct HNWIs towards funds, makes distribution complicated. In other markets these play an important amalgamation and gatekeeper role as they carry out due diligence and management of the fund s on behalf of their clients. As these new channels develop, HNWIs should become better disciplined into taking on a more passive role, making them a more attractive investor group.

Government bodies provide helpful financial support to PE/VC but the industrial/regional policy linked conditions for their investment may not always be acceptable Local government guidance funds, the CDB and state-owned asset management companies can be interventionist in pursuit of their policy goals, complicating the investment process for market-oriented fund managers. This being said, there is a great variability in approach between such bodies, and some seem more commercially oriented; for example, certain local government funds recently invested outside their own region in the latest IDG RMB fund10. Moreover, market-oriented PE funds may be happy to partner with a local government fund, where it is considered that the latter can assist with navigating approval process, business registration and, to a certain extent, investment restrictions. In addition, with the present drop in fundraising from private sources, public money is bridging the gap for many new funds. However, it still should be noted much of the government bodiesâ&#x20AC;&#x2122; money does seem to be drawn to the establishment of SOE-sponsored industrial funds, rather than the marketoriented funds.

Case Study: Difficulties faced by foreign managed private equity in China Foreign firms in China face difficulties raising funds with domestic LPs and often find themselves at a competitive disadvantage compared to local firms. In 2011, it took TPG more than 18 months to raise RMB4 billion for two RMB funds. In 2011 Blackstone was only halfway to its fund raising target after two years11. By contrast Hony Capital took 12 months to secure RMB10 billion for its HONY RMB Fund II, while CITIC Private Equity closed its Mianyang High Technology Industrial Investment Fund at RMB9 billion, 50% above the original target, after a year-and-a-half in the market.12 Time taken to close by four big name funds HONY

CITIC

TPG

Blackstone

24 0

RMB 9 billion rasied RMB 10 billion rasied (twice orignal target) RMB4 billion raised Undisclosed, halfway through fundraising RMB 5 billion 10

Months Source: Zero2IPO

10 http://www.pedaily.cn/Item.aspx?id=218491 11 http://blogs.wsj.com/privateequity/2011/09/27/blackstone-reaches-halfway-mark-foryuan-denominated-fund/ 12 http://www.avcj.com/avcj/analysis/2152525/foreign-rmb-funds-suffer-lp-access-troubles

Foreign sponsored RMB Funds - Still worth the effort? | 10

The greatest sources of institutional money are yet to come on tap There are still a number of large institutional investors which are still not permitted to invest in Private Equity in China, among these the local social security funds (LSSFs), regional state pension funds and enterprise annuity funds (EAFs). LSSFs and regional state pension funds are currently sitting on assets estimated at 1 and 2 trillion RMB, respectively. Most of their investment is uncoordinated and invested in a basket of low-yielding securities at a local level. EAFs, which provide complementary pensions co-funded by employers and staff and have USD35 billion under management, are currently experiencing slow growth and have strict limits on where money can be invested; however, greater government interest in the populationâ&#x20AC;&#x2122;s pension provision may see these expand substantially in future. Both EAFs and LSSFs would benefit from the returns PE can offer.

Whither the Chinese LP classes? As outlined above, while the NSSF and FOFs exhibit desirable LP characteristics, the real money is currently with the SOEs and POEs, who frequently let strategic objectives guide their PE/VC investment, and the medium term potential is with the institutional investors (such as insurance, which have already partly opened up) who may prefer the GP role.

Estimates of potential investor amount by LP in USD billion 80 70 60 50 40 30 20 10 0

Insurers

Listed Enterprise

NSSF

HNWI

Funds of funds

Trust Enterprise Pension funds companies Annuity managed by Funds local gov.

Assumed all assets permitted to invest are invested in PE funds Assets currently invested in funds Pension funds managed by local governments are not currently permitted, but this assumption is if permissions was granted in line with the NSSF Source: Zero2IPO, Merrill Lynch World Wealth Report, KPMG Trust Survey 2011, KPMG analysis

11 | Foreign sponsored RMB Funds - Still worth the effort?

Caution is needed with taking unsophisticated HNWIs as LPs, and the agenda of industrial development focussed government guidance funds must be borne in mind when choosing to accept their money. The real prize for RMB fund managers in the longer term, though, is the institutional money (such as pensions) still locked away by regulation. As the Chinese LP investor base matures, it may come to resemble that of more developed markets, such as Europe. The overwhelming predominance of institutions in Europe gives some indication as to how much money Chinese institutional LPs will ultimately bring to the table. The next section examines whether any of this will ultimately make its way to the coffers of the RMB funds sponsored by foreign fund managers.

USD billions

Investors in European private equity/VC funds by type 2002 - 2006

400 350 300 250 200 150 100 50 0

n sio

Pen

fun

ns als ies ent wn ate ets nds por utio l mark ot kno pan vernm dividu f fu r t i o o m t o C d In ns N ta Go Fun ance c ic i api m C r e u d s a In Ac

Ban

Source: EVCA/PWC/Thompson Financial

Foreign sponsored RMB Funds - Still worth the effort? | 12

13 | Foreign sponsored RMB Funds - Still worth the effort?

Foreign sponsored RMB funds â&#x20AC;&#x201C; can they compete?

Foreign sponsored RMB Funds - Still worth the effort? | 14

Part 1 has set out why foreign fund managers would want to have a presence in the RMB funds space, given that RMB funds progressively dominate China focussed PE and the domestic LPs coming on stream have deep pockets and an evident need for the services which international PE fund managers supply. A number of surveys show that many foreign sponsors now view an RMB fund as an indispensable part of their China investment strategy. One recent survey of leading PE/VC firms targeting China showed than more than 30% manage both USD and RMB funds. According to data from Zero2IPO, six of the top 10 biggest PE funds13 globally now have at least one RMB fund. Five-year fundraising Manager total (USD billion) 49.9 TPG

However, as emphasised in Part 1, foreign fund managers are minor players in the RMB funds space. For illustrative purposes, the table below shows the largest funds that had their final close in H1 2012 according to Zero2IPO and it can be seen that they are all domestic manager sponsored RMB funds.

RMB fund Yes

No. of funds 2

49.6

The Blackstone Group

Yes

47.7 43.5 30.7

KKR Goldman Sachs Carlyle

No Yes Yes

1 1

25.1 22.8

CVC Partners Apax Partners Apollo Global Management Bain Capital Oaktree Capital Management

Yes No

1 -

Yes

21 21 17.6

Comment Two funds, still fund raising One fund, Final close March 2011, raised RMB 5 billion Final close February 2012, raised RMB 5.5 billion One fund, still raising Final close July 2011, raised RMB 110 million

One final close July 2011, the remainder still raising

Note: List may not be exhaustive Source: Zero2IPO, PEI, KPMG analysis

VC/PE

Strategy

Value (RMBm)

Close date

Huatai Zijin Equity Investment Fund

Growth Fund

4000

April 2012

Shengda Culture Industry Investment Fund

Growth Fund

3000

June 2012

Venture Capital

3000

February 2012

Shanghai Sinopharm Fund

Growth Fund

1000

June 2012

Nanchang Low-Carbon Environment Protection Industry Fund

Growth Fund

1000

April 2012

Shengxin Runcheng Venture Capital

Source: Zero2IPO

13 Largest according to five year fund raising according to Private Equity International

15 | Foreign sponsored RMB Funds - Still worth the effort?

Since the time when RMB funds began to really take off in 2008 and 2009, the majority of domestic LP money has flowed to domestically sponsored funds. Much of the money from the state development banks, and the local government asset and finance companies has gone to industrial and regional development funds, set up mainly by local governments, which have also been supported strongly by various SOEs. The funds established by market-oriented professional domestic fund managers, such as Hony, CDH and CITIC PE, which replicated the business model of the foreign fund managers for the domestic market, also proved generally more successful at attracting LP money. This was partly due to regulatory factors. For example, the NSSF can only invest in funds registered with NDRC (see page 8); as most foreign sponsored funds were initially not so registered these could not be invested in by NSSF. As a further example, the terms of the CIRC measures permitting investment by insurers in PE funds, which required a proven track record, did not consider the overseas fund track record of the foreign managers and so left them at a disadvantage14.

2001-2006: SOE and enterprise captive funds Establishment of a number of captive RMB funds, managed and funded by listed private and state-owned enterprises Participation in Chinese market by foreign PE groups largely through offshore USD funds, with some experimental foreign invested RMB funds established

Thus, when it is said that RMB funds have outpaced offshore funds in terms of fund establishment, fundraising, investments and exits, it should be more accurately expressed that domestically-sponsored RMB funds have outpaced offshore funds. Statistically-speaking, the participation of the foreign sponsored RMB funds in this great shift has been negligible. It must be said, however, that when RMB funds were overtaking offshore funds in 2009/10, it did not appear that this would necessarily have to be the case. After all, the foreign fund managers had dominated the initial wave of China PE development, and a rash of innovations in 2010 seemed designed to draw foreign investors into participating in RMB funds. Notable among these was the Qualified Foreign Limited Partner (QFLP) programs originated by a number of municipalities (Shanghai, Beijing, Tianjin, Chongqing), which aimed to allow foreign invested funds compete on a level regulatory playing field with wholly-domestically invested RMB funds. Further, it was hoped that the ‘pure RMB funds’ (i.e. with solely domestic LPs) established and managed by foreign sponsors in China would be treated as domestically invested for regulatory purposes. However, measures taken by the NDRC in 2012 appear to have put a halt to this trend, taking away of the benefits of both the QFLP and ‘pure RMB fund’ structures.

2006-2010: Innovation and rapid growth Opening of local SME and growth stock exchanges, and introduction of partnership fund forms led to an explosion in RMB funds measured by numbers, fund raising and investments Some SOE and private enterprise established funds spawn professionally managed PE/VC investment companies Foreign sponsors primary focus remained on USD funds. In the RMB fund arena, foreign sponsors generally looked to establish ‘pure’ RMB funds, although with some further experimentation with foreign invested RMB funds

As of mid-2012 the competitive field appears increasingly open for the market-oriented professional domestic fund managers, such as Hony, CDH and CITIC PE, to dominate as they are unrestricted by foreign investment regulations, often receive the backing of local and central government funds, popular sponsorship from large SOEs and listed enterprises, and they are increasingly poised to sweep up the lion’s share of the huge amounts of institutional fund allocations and money about to come on tap due to progressive deregulation of investment by insurance and pension funds.

2011 onwards: The shape of the industry emerges USD funds subjected to tougher tax and regulatory requirements NDRC has increasingly imposed its will on the industry, clamping down on smaller funds. NDRC pronouncements result in liberalising regulations for foreign invested RMB funds giving way to restrictive treatment of foreign invested RMB funds and foreign sponsored ‘pure’ RMB funds Large professional domestic sponsors, with the backing of government agencies and SOE funding, set to seize the prize of increasingly liberalised institutional investment

By contrast, until such time as the NDRC position is reversed or workarounds are found, the establishment and operation of RMB funds by foreign sponsors is unlikely to flourish due to the lack of clear advantages for foreign fund sponsors, relative to offshore fund operation and establishment. This section looks at the different circumstances under which foreign sponsors and domestic sponsors establish and operate RMB funds, highlighting the relative competitive disadvantage at which foreign sponsors find themselves, and pinpointing what precisely needs to change in the regulatory environment for foreign fund managers to re-enter the fray as credible players in the RMB funds space. 14 For example, of the RMB80bn invested by NSSF to-date all of this has gone to funds sponsored by domestic managers (with the one exception of the China-Belgium Fund)

Foreign sponsored RMB Funds - Still worth the effort? | 16

17 | Foreign sponsored RMB Funds - Still worth the effort?

1: Who are the competitors to the foreign managed RMB funds? A wide variety of Chinese domestic investment enterprises are lumped together under the catch-all descriptor of ‘RMB funds’. In reality, only a certain number of these funds, which may be referred to as the ‘domestic fund manager sponsored market-oriented RMB funds’, are competitors of foreign sponsored RMB funds, as these similarly offer the professional investment expertise, coupled with high standards of corporate governance, which the institutional LPs coming on tap are seeking.

Standing in contrast to these funds, are the various investment enterprises established by SOEs and local governments which pursue investment strategies more closely linked to the business strategy of one or more SOEs, or the industrial development agendas of various governmental authorities. These are fundamentally ‘different animals’ pursuing a different agenda to the ‘financial-return’ focussed fund management groups (domestic and foreign), and are financed largely by the SOEs and guidance funds of the government authorities who establish them15.

Competitive overview for China PE industry Foreign managed Financial Business RMB funds return focused, strategy/ industrial and industrial policy focused industrial market oriented and captive funds funds • Professional • Professional • Entrepreneurial • Middle management management management team team of sponsoring enterprises seconded to manage fund • Financial returns • Policy/ business • Financial returns • Financial returns strategy Small unregistered firms

Management

Investment strategy Advantages

Disadvantages

• Expected to be regulated out of business

• Financial returns

• Harder to raise funds locally, particularly from state owned bodies

• Little outside investment

• Numerous smaller funds

• Professional management team

• Offshore • Experience • Advantaged in • Better at fundraising in complex domestic fund raising from transactions fund raising state owned than foreign organisations • Have existing sponsored funds offshore – particularly from funds which state backed may support organisations investments • Easier for these to invest in and list portfolio companies • Not focused on • Retaining talent • Regulatory limits pure financial on investment returns and exit • Slow decision making process

Examples

Foreign currency funds

• COFCO

• HONY Capital

• Retaining talent • Carlyle Group

• Bohai Industrial Fund

• CDH

• Blackrock

• SAIF

• TPG

15 However, this is not to say that ‘captive funds’ are never attractive investment prospects to third parties. The Flourish Libra FOF III, raised in May 2012, invested its capital in a fund directed solely at the upgrade of the Fosun group - http://www.pedaily. cn/Item.aspx?id=219090

Foreign sponsored RMB Funds - Still worth the effort? | 18

In passing, it is worth noting that such captive and industrial funds are often managed by existing staff of the sponsoring SOE/POE. As such these may replicate the somewhat bureaucratic management of the parent, with large, layered management teams resulting in long approval processes and relatively slow decision-making. Management pay can also be relatively flat with modest bonuses, and as management may not put any of their own money in the fund, they have no â&#x20AC;&#x2DC;skin in the gameâ&#x20AC;&#x2122;, lack incentive and are less aligned with the longterm success of investments. This contrasts with the small tightly knit team of investment professionals that is found in the classic PE model, who share in the gains of investment success as partners. This being said, some captive/industrial fund management teams have professionalised (e.g. Haiyue), or have appointed outside professionals and in doing so have become real rivals to the foreign sponsored market oriented funds.

A further grouping is the thousands of small limited partnership based funds (3000-10,000, according to the Economist), backed primarily by individuals and smaller POEs, and often managed as speculative enterprises. In 2011, the NDRC moved to clamp down on illegal fundraising by requiring all PE funds to register with it and introduced a recommended RMB10 million investment requirement for LPs16. Consequently, many of these funds are likely, in time, to be regulated out of existence.

16 Zero2IPO http://pe.pedaily.cn/201202/20120215293746.shtml

19 | Foreign sponsored RMB Funds - Still worth the effort?

The advantages of domestically sponsored marketoriented funds Domestic manager sponsored market-oriented funds exhibit significant advantages over foreign sponsored funds when raising capital, making investments and listing onshore. Domestic PE houses such as CDH, CITIC Capital, SAIF, New Horizon and Hony Capital, which are staffed to a large degree by alumni of Western banks and PE houses, are characterised by the same investment expertise and organisational structures as Western PE houses. However, given their local origins they may be better placed to service purely financial investors as well as enterprise and government LPs with somewhat different agendas. This is reflected in the fact that such firms have played a role in the establishment and management of regional industry focussed funds backed largely by enterprise and government LPs, as well as attracting most of the institutional money which has come to the table so far. The new PE management arms of the Chinese securities firms also have the added advantage of being able to draw on their existing brokerage and mutual fund client base.

foreign sponsored funds may be less of an asset than the connections of the domestic sponsored funds. Large SOEs may also be less willing to invest in the foreign managed funds.

Crucially, these funds face less regulatory obstacles, meaning that they can make investments in a broader range of industries more rapidly and also exit more easily. While some foreign sponsored RMB funds have succeeded in finding local governments to sponsor and assist their funds they have generally been slower in closing their funds than the domestic fund sponsors, and have not raised as much money. With awareness of PE as an asset class still in an emergent state, the established brands of the

Understanding the relative competitive disadvantage at which foreign sponsored RMB funds compete with domestic manager sponsored market-oriented funds requires a deeper consideration of the complications faced by foreign fund sponsors over RMB fund establishment, the onerous foreign ownership restrictions, pre-approvals and regulatory scrutiny which apply on investment, and the additional hurdles that arise on exit. These factors are considered below.

Domestically sponsored market-oriented funds may be better placed, in some instances, to lead co-investment by parallel USD funds17, as their domestically sponsored funds may be more nimble than the foreign sponsored funds in making the initial investments which USD funds can later support. Moreover, these domestic PE houses are now spearheading Chinese investment abroad, often in foreign industries whose success is linked to the China growth story18. Foreign investors have reacted enthusiastically to this development: CITIC Private Equity Funds Management Co closed its first USD fund in May 2011 having raised $1 billion. The fund was reportedly heavily oversubscribed, obtaining investment from 39 overseas institutions, including sovereign wealth funds, pension funds, endowments, family offices and insurers19.

Case Study: Hony Capital China has been actively trying to foster domestic PE firms as a challenge to foreign firms, and Hony Capital is a good example of the kind of firm being built up. Its development closely mirrors the development of the private equity industry in China as a whole. Hony Capital was founded in 2003as subsidiary of Legend Capital, a government-backed industrial development fund. Its first fund was a small USD fund, raising USD38 million. Over time it continued to raise incrementally larger dollar funds. In 2008 it established its first RMB fund, whilst continuing to raise larger dollar portfolios. Today Hony Capital is recognised as the largest PE firm in Asia by the PEI 30 rankings, with a five year fund raising of USD 6.1 billion. Last year the firm raised RMB10 billion for the firmâ&#x20AC;&#x2122;s second RMB fund. It has enjoyed strong support from domestic institutional investors, including RMB 1 billion in 2008 and RMB 3 billion in 2010 from the NSSF, and RMB 1.6 billion from China Life Insurance in 201120. Hony has begun making acquisitions beyond its borders, and at the time of writing has investments in Japan, Italy and Singapore21. It is attracting big name foreign investment houses such as Goldman Sachs, the Singaporean sovereign wealth fund, Temasek, and Stanford University.

17 In a recent survey 20% of domestic PE/VC funds reported that they were managing USD, or parallel USD/RMB, funds 18 Recent examples include CITIC Japan fund which has completed five deals in Japan and completing its seventh in the US - Reuters http://www.reuters.com/ article/2011/09/30/us-china-privateequity-idUSTRE78T09Z20110930 19 Reuters http://www.reuters.com/article/2011/09/30/us-china-privateequityidUSTRE78T09Z20110930 20 http://www.pedaily.cn/Item.aspx?id=218395 http://www.honycapital.com/hony_en/ news/28/one/191.html 21 HONY Capital website

Foreign sponsored RMB Funds - Still worth the effort? | 20

21 | Foreign sponsored RMB Funds - Still worth the effort?

2: What are the regulatory hurdles for foreign managed RMB funds? Mention has been made of the regulatory disadvantage at which foreign managed funds compete with domestic manager sponsored RMB funds. The problem is really twofold: (1) The permitted forms of RMB funds that facilitate coinvestment by foreign investors and domestic investors must comply with prescriptive criteria as to who their LPs may be and what they may invest in, labour under a range of tax and foreign exchange control ambiguities and, while being domestic Chinese entities, are treated for investment restriction purposes as foreigners (2) While foreign sponsors look to establish whollydomestically invested RMB funds (‘pure’ RMB funds) with a view to having these treated as domestic investors for the purposes of investment authorisation regulations, the latest NDRC pronouncements on this matter indicate a clear policy to treat these as foreign investors, putting the ‘pure’ RMB funds at a significant competitive disadvantage against domestic manager sponsored RMB funds In practice, the second of these issues has had far the greatest impact. While some minor amounts have been invested in the various fund types authorised for foreign investment, such as FIVCIEs, foreign investment programs (FIPs), qualified foreign limited partnerships (QFLPs), this has been largely on an experimental basis. Where foreign fund managers have raised RMB funds they have done so primarily as ‘pure’ RMB funds. It is for this reason that the NDRC ruling in April 2012, treating ‘pure’ RMB funds for investment restriction and approval purposes was such a setback. Given the significance of this development the details are outlined below. The sad fate of foreign sponsored ‘pure’ RMB funds Since the establishment of Chinese partnerships was permitted in 2007, and even though foreign invested partnerships became a possibility from 2010 onwards, foreign fund sponsors have principally looked to establish ‘pure’ domestic RMB funds under the 2007 partnership law. These were ‘pure’ in the sense that all of the partners, LPs and the GP, would be organised under Chinese law, although the GP itself may be foreign invested. While the relevant regulations are ambiguous22, the common view in the industry was that, if the GP limited its contribution to 1% of the partnership capital, then the Chinese regulatory authorities would treat the ‘pure’ RMB fund in the same way as a domestic investor. In consequence, a foreign sponsor, in establishing a ‘pure’ domestic RMB fund, would not only be best placed to compete with locally managed funds, but would also be better able to tee up co-investment opportunities for the foreign sponsors offshore USD funds.

For added protection from being regarded as foreign, some foreign fund sponsors went even further. The ownership of the GP or its contribution to the fund could be structured to mitigate the risk of the fund being viewed as FIE-invested. This could involve a PRC-resident nominee holding the equity in the GP, or could involve the GP’s contribution being funded out of pre-paid management fees to the GP, such that no ‘foreign money’ was contributed to the fund23. In pure RMB fund arrangements, the manager itself was simply established as a domestically incorporated WFOE or FIE, or as a partnership. However, it now appears this was all to no avail. In the Letter on Relevant Issues Relating to Foreign-Invested Equity Investment Enterprises of May 2011 to the Shanghai DRC, and DRCs and other regulatory bodies around China, the NDRC clarified that limited partnership form funds managed by a qualified foreign invested management company which also acts as, or is connected with, the general partner of the fund will be treated as a foreign investor for the purposes of investment authorisations. This means that that foreign-managed ‘pure’ RMB funds will be treated as FIEs for regulatory purposes. This has a number of potential ramifications (as explained in detail further below) the most significant of which are that: • The industrial sectors in which the fund may invest will be limited in accordance with Catalogue of Industry Guidelines for Foreign Investment. This involves prohibitions on investing in sectors such as media, education, telecommunications, Internet, and technology, and restrictions on the percentage ownership possible (and the form of fund through which the investment can be held) in many other industries • Investments may require pre-approval from the Ministry of Commerce (MOFCOM) (although this is still unclear), and for control transactions in strategic industries such as defence, energy and commodities, and oil and gas, may be subject to National Security Review • As the portfolio companies may consequently be FIEs, the process of listing the company for exit may be greatly complicated, and trade sales may also face hurdles. Potential investees may reject investment from ‘pure’ RMB funds on the grounds that they do not want to be subject to the business limitations which apply to FIEs

22 The 2006 M&A Law, which provides for a MOFCOM pre-approval process and adherence to the Catalogue for Guiding Foreign Investment for domestic equity acquisitions by foreigners and FIEs (explained further in section 3 below), made no reference to partnerships, per se. However, the FIP law specifically provides that investments by FIPs will subject to the same regulatory restrictions as investments by foreigners. As FIPs are defined to include foreign partners, the argument was that ‘pure’ domestic RMB funds (even though they might be considered to have foreigninvested partners) had no foreign partners, and therefore did not fall to be treated differently from domestic investors 23 This could also deal with the difficulties in getting SAFE approval to convert amounts, for investment in the GP, to RMB

Foreign sponsored RMB Funds - Still worth the effort? | 22

This is a serious blow to foreign sponsors and managers of wholly-domestically invested RMB funds, and may contribute to an accelerated dominance of the of the RMB funds market by domestic fund managers. In terms of total capital raised for RMB funds, domestic fund managers have completely outstripped foreign managers. In the current state of the regulatory environment for foreign sponsored ‘pure’ RMB funds, domestically sponsored funds are now likely to take the lion’s share of the new institutional LP money coming on-stream. There is also very little that foreign sponsors can do, as the very economics of the traditional private equity model require the GP to have some interest in the fund in order to align the interests of the GP and the LPs24, and the foreign sponsor must control the GP in order to direct the operations of the fund (i.e. it would not be possible to have zero investment by a foreign sponsor-controlled GP and for the foreign sponsor to solely control the manager). Offshore Investors

In this sense, the NDRC letter has placed foreign fund sponsors in a Catch-22 situation; while the only really workable model for the fund is to establish as a partnership with the foreign sponsor controlling the GP, this very control will put the ‘pure’ RMB fund in no better a position, from a regulatory perspective, than an offshore fund. While an onshore fund is more straightforward for local LPs to invest in than an offshore fund, they may be inclined to invest in a domestically sponsored/managed fund which is not hobbled competitively with regards to investments and exits.

Offshore Investors

Offshore PRC

Profit Distribution

Domestic Investors GP

Fund Manager (Limited Partnership)

Domestic Investors GP

Domestic Investors

GP LP

GP Management Fee

Portfolio company

Carried Interest LP

RMB Fund (Limited Partnership)

Portfolio company

24 Additionally, in many cases the foreign fund sponsor has created both RMB and USD funds focussed on the same segment of the China market. LPs in the offshore funds will have concerns that the RMB fund will engage in cherry picking when it comes to matters of co-investing with the offshore fund. To assuage these concerns it is usually necessary that the foreign sponsor maintains control of the China GP of the RMB fund.

23 | Foreign sponsored RMB Funds - Still worth the effort?

A number of foreign sponsors had managed to bring local governments and SOEs on board as LPs in their whollydomestically invested funds by sharing GP/manager ownership with the latter, such as the Carlyle Beijing RMB fund, which had involvement from the Beijing State Assets Bureau. This approach was designed to garner support when dealing with complex regulatory hurdles. However, this strategy may also be in danger under the new regulatory approach. Insofar as many foreign sponsors of RMB funds use coinvestment structures, with the less restricted RMB funds blazing a trail for parallel offshore USD funds of the same sponsor, the disadvantaged treatment of foreign sponsored RMB funds is likely to hobble this co-ordinated investment strategy. As the best domestic fund managers have also established USD offshore funds for investment into China, the greater nimbleness of their domestic funds is bound to also enhance the attractions for foreign investors of investing in their co-investing USD funds. However, as noted above, the regulatory environment for PE in China continues to evolve and foreign fund sponsors will look for a clarification in the treatment of ‘pure’ RMB funds going forward. Key issues affecting foreign invested funds As outlined above, by far the most significant issue for foreign fund managers looking to enter the RMB fund space is the treatment of the funds they establish as foreign invested. By putting the foreign sponsored funds at a competitive disadvantage against domestic manager sponsored funds when making investments, Chinese LPs are dissuaded from investing in the foreign sponsored funds. What precisely this means in practice, in terms of investment restrictions, approvals and scrutiny, is explored in Section 3 below. It should also be noted that treating foreign sponsored RMB funds as foreign invested may dissuade potential Targets from obtaining investment from the foreign sponsored RMB funds. This is because the Target may consequently be treated as foreign invested, potentially leading to restrictions on its licensing for conducting business. Beyond the investment restriction limitations to which the pure RMB funds are subject, certain particular issues arise additionally for the explicitly foreign invested RMB funds. In particular, taxation and foreign exchange settlement issues arise, as well as complexity in setting up the forms of RMB funds which cater to foreign LPs. Taxation As mentioned above, one of the key regulatory breakthroughs in allowing the RMB funds industry to take off was the issuance of the Partnership Enterprise Law 2007. This allowed for companies (including, from 2010, foreign companies) to be partners in Chinese partnerships, when formerly use of partnerships was restricted to individuals. This gave RMB

funds a vehicle through which to implement the GP-LP relationship which underpins the economics of the private equity model. Partnerships also have far greater commercial flexibility than a corporate fund as partnership law does not contain the many limitations of company law on the reduction of capital, the creation of statutory reserves and the distribution of profits. Importantly, use of partnerships allowed for flow-through taxation which in principle eliminated the potential double taxation arising where a corporate fund was used. The manifest advantages of partnerships as fund investment vehicles are reflected in the explosion in their use since 2007. However, the PRC taxation of partnerships is still an area of uncertainty and this gives rise to certain difficulties with their use. In summary the basic issue is that while the partners may be taxed on a look-through basis the ‘character of income’ may not flow through. While partners may hope to be taxed on the basis that the returns are investment income or capital gains (and so qualify for lower rates) the returns may be characterised as business income and subject to higher rates than expected25. Foreign fund managers will naturally compare RMB fund establishment to the alternative of establishing an offshore funds. They may conclude that, despite the removal of much of the tax advantages previously enjoyed by offshore funds in the past few years, these still enjoy preferential, and more certain, tax treatment than that which may be applied to whatever onshore RMB funds they choose to establish. Given that the regulatory advantages hoped for from RMB funds have not materialised, and foreign sponsored RMB funds are consequently in much the same position as offshore funds when making investments, the additional tax uncertainties of RMB funds may tip the balance in favour of going with the tried and tested offshore alternative. For domestic individual LPs with RMB funds the issue is whether the 20% rate for investment returns or the marginal 35% rate for business income will be applied. When it is considered that Chinese resident individuals are exempted from tax on returns from domestic mutual funds, the disadvantage faced by private equity RMB funds becomes clear. A parallel issue arises for domestic corporate investors which might normally benefit from a domestic inter-corporate dividend income exemption, but which could lose this and suffer tax at 25% if the returns were regarded as business income. RMB funds which involve foreign LPs may also face the income re-characterisation issues. Foreign investors would normally expect a withholding rate of 10% to apply on investment income or capital gains from China. If, however, the income is characterised as business income, arising from the partnership as a PRC permanent establishment of the foreign investor, then tax at 25% may be applied. 25 While these uncertainties also impact on wholly-domestically invested funds, the cross-border dimension of the foreign invested funds brings additional complexity

Foreign sponsored RMB Funds - Still worth the effort? | 24

Re-characterisation could also frustrate efforts to lower applicable tax through use of tax treaty relief. At the fund manager level, the main tax concerns are to limit the tax arising on management fees and carried interest. In pure RMB fund arrangements, which as noted above have been the most popular to date for foreign fund managers, the manager and GP are typically established onshore. If these are PRC companies, then the manager will be subject to 25% CIT and 5% BT on his fee income and the GP to 25% CIT on the profit share/carried interest. Various structuring arrangements are in practice used to lessen this tax, including establishing the manager and GP as partnerships to access flow-through tax treatments, and establishing a separate carry vehicle (also as a local partnership). In doing this it is hoped to reduce the tax on the carry, which flows through to overseas fund entities, to the 10% withholding tax rate. Onshore fund management staff made partners in the GP may also look to obtain the 20% income tax rate on investment income. However, due to the income re-characterisation issue, the carry may end up taxed at 25% and the employees at the marginal 35% rate. There have been some efforts to address these issues. Certain local governments, looking to foster foreign investment in the local fund management industry, have rolled out incentives for qualifying funds26 and managers27. Such schemes provide tax incentives for fund managers but set down requirements concerning the minimum registered capital of the manager and the experience of the staff. In Shanghai, for example, Pudong registered fund managers of funds investing in encouraged industries within Pudong can obtain a 50% tax rebate from the local portion of income tax paid. In Tianjin and Chongqing, fund managers may qualify for a two-year exemption followed by three-year half-rate tax rebate for both BT and for the local portion of CIT. Financial subsidies may also be offered by local governments to fund managers. The terms of these arrangements are frequently a matter for negotiation between fund management and the local authorities. In addition, at the fund level, certain local governments have entered into memoranda of understanding with funds28 pledging to apply WHT treatment to offshore LPs, and apply the 20% investment income rate to local individual LPs. However, the precise basis upon which local governments provide these treatments is unclear, and such treatments could readily be overruled on the roll-out of the long awaited partnership taxation rules.

For the moment, the tax uncertainty surrounding partnerships gives further pause for foreign fund managers considering the establishment of RMB funds, and the issuance of a clarifying partnership tax circular is greatly anticipated29. As noted before though, this is a secondary issue when set aside the greater matter of the treatment of foreign sponsored funds as foreign invested for the purposes of investment authorisations and restrictions. Foreign exchange controls While more of an issue for foreign-invested RMB funds than for foreign-sponsored but wholly- domestically invested RMB funds, the foreign exchange regulations form a further hurdle to foreign involvement in RMB funds. Further to Circular 142, SAFE will generally deny approval for the conversion of borrowed amounts or increases in registered share capital of foreign invested enterprises where the amounts are to be used to invest in equity, on the basis that the making of equity investments is not within the business scope of the enterprise. Investments can of course be paid for in USD to a special domestic bank account of the vendor, though vendors may not wish to receive USD which they then have to convert themselves. Vendors can now find it harder to convert RMB to USD since Circular 142 was introduced, as they now have to justify why they wish to convert to RMB. While new Peoplesâ&#x20AC;&#x2122;s Bank of China (PBOC) rules (October 2011) do allow the use of RMB held offshore to increase the registered capital of FIEs and make loans to FIEs, they have replicated the Circular 142 restrictions on the usage of monies from overseas for local equity investment. There is a let-out in SAFE Circular 142 for enterprises which have been approved to make investments, such as the special forms of RMB fund which specifically are authorised to have foreign LPs, such as FIVCIEs. However, in practice these will generally be required to obtain SAFE approval for forex conversions on an investment-by-investment basis. The situation is even more ambiguous for foreign invested partnership form funds, as Circular 142 does not specifically deal with partnerships, and the FIP rules do not provide any further guidance. It is for this reason that a certain measure of enthusiasm greeted the QFLP rules, which provide that pilot PE Funds can obtain a quota to convert foreign currency capital (up to 5% of total funds) contributed by the GP and by qualifying LPs for the purpose of equity investment. However, the benefit of the scheme may be limited by the very high qualification requirements for the LPs.

26 Referred to variably as Equity Investment Enterprises (EIE) or Equity Investment Funds (EIF) 27 Qualifying as Equity Investment Enterprise Fund Managers (EIEFMs) 28 Including in the context of QFLP arrangements (detailed further below) 29 In addition to clarifying the income character flow-through matter, clarity is needed, inter alia, on (i) the use by partners of partnership losses against other taxable income, (ii) the taxation of gains on disposal of partnership interests, the taxation of carried interest payments, and stamp duty on partnership equity contributions.

25 | Foreign sponsored RMB Funds - Still worth the effort?

The special schemes for foreign invested RMB funds National and local schemes for facilitating foreign LP involvement in RMB funds have been developed since the FIVCIE scheme was first put into effect in 2003. The FIVCIE rules allowed for RMB funds taking the form of equity joint ventures (EJVs) and contractual joint ventures (CJVs), the latter of which can be either a legal person CJV or a non-legal person CJV. To the limited extent that the FIVCIE scheme was used, funds were established as non-legal person CJVs, as these could avail themselves of tax transparency (though tax law changes in the interim have muddied the waters on this) and the CJV agreement itself could be tailored, to a greater extent than with the EJV and non-legal person CJV, to accommodate the GP-LP relationship. By contrast, the EJV and non-legal person CJV gave rise to double taxation (once at the JV level and once at LP level) and the requirements to reserve part of profits to a non-distributable profit reserve30, the difficulties in redeeming share capital, and the general lack of legal flexibility made these unattractive fund vehicles. However, even non-legal person CJV form FIVCIEs had a number of drawbacks. As mentioned above, uncertainty exists about the applicability of the flow-through tax treatment31. While the JV agreement can be drafted with greater flexibility than the agreements for other JVs, many legal issues with the implementation of such agreements are untested in practice. Further, FIVCIEs may only invest in high-technology companies and are prohibited from investing in real estate, and MOFCOM approvals are required for investments in restricted sectors, as with all FIEs and foreign investors. FIVCIEs also need numerous clearances to be established in the first place, though they may invest in encouraged and permitted sectors under the Catalogue Guiding Foreign Investment without MOFCOM approval (more on this approval system in the next section). Certain requirements also apply to the size of the investors which must invest in the FIVCIE. All in all, the FIVCIE is a rather unwieldy beast. It was therefore with some enthusiasm that foreign fund managers greeting the 2007 Partnership Law, which enabled ‘pure’ RMB funds to be set up along the lines of the classic GP-LP partnership model used internationally, and the 2010 regulations which permitted the inclusion of foreign LPs. The introduction of FIPs was accompanied by a host of local schemes which enhanced the operation of the FIP in practice, most notably the QFLP schemes in Shanghai, Tianjin, Beijing and Chongqing.

Apart from the greater familiarity and flexibility of the partnership legal form when set against the non-legal person CJV, it was hoped that partnerships would have a more clearcut flow-through tax treatment (a matter, as noted above, which has yet to be fully resolved). The absence of a need for MOFCOM approval on the establishment of the FIP was seen as a plus, as was the lack of a requirement that the FIP invests in high technology firms, as with a FIVCIE. Obtaining QFLP status promised the crucial advantage that the FIP might also be treated as domestically invested for purposes of investment restrictions and approvals. The Shanghai rules, for example, provided that ‘pilot foreigninvested private equity management enterprises’ can use foreign currency to fund up to 5% of the aggregate capital commitment to a PE fund that it sponsors, without turning the PE Fund (or its portfolio companies) into an FIE. Tainting, however, would occur if foreign LPs contributed monies directly to the fund. This principal advantage of the QFLP was accompanied by the other advantages mentioned above, including a mechanism for settlement of foreign currency into RMB for investment in the fund, commitments from local authorities to tax the LPs on the preferred flow-through basis, and various incentives for locally based fund managers. However, FIP and QFLP did not turn out to be the panacea which foreign fund managers had sought. Despite the absence of a requirement for MOFCOM approval on the establishment of a FIP, as with FIVCIE, the establishment process is still cumbersome and protracted32. Investments by FIPs are complicated by the Catalogue of Industry Guidelines for Foreign Investment, which sets out numerous instances in which foreign investment in an industrial branch must be done in the form of an EJV or CJV, de facto excluding FIPs.

30 Chinese corporations must book 10% of their profits in each year to a statutory reserve (up to a maximum of 50% of total registered capital) and this limits the amount that may be distributed to investors 31 On the introduction of the new CIT Law in 2008, the old tax law governing foreigninvested enterprises ceased to be valid. As the 2003 Circular providing for FIVCIE look-through tax treatment related to that old law and was not fully grandfathered to the new CIT law, it would appear that 25% CIT should now apply at the level of the FIVCIE CJV 32 The Detailed Rules for the implementation of FIPs, contained in SAIC Order No 47, limit quite strictly the circumstances in which a local branch of SAIC may process the registration of a new FIP. SAIC branches are encouraged to confer with MOFCOM, SAFE, NDRC and other relevant government departments and regulators as necessary before registering FIPs, which may slow the registration process

Foreign sponsored RMB Funds - Still worth the effort? | 26

Entity form Establishment

FIVCIE

FIP

WFOE, EJV, CJV (legal person or contractual) MOFCOM approval

Partnership

MOST approval AIC registration

Minimum capital Permissible investments

Investment preapprovals

Non-legal person FIVCIE: US$10 million Non-listed high-tech enterprises only

No approval needed for investment in “permitted” or “encouraged” industries

MOFCOM approval for investing into “restricted” industry Leverage at fund level Excluded Cash trap

Not for non-legal person CJV

Shanghai QFLP scheme Partnership

AIC registration (AIC may refer to MOFCOM and NDRC re proposed investment sectors)

N/A Standard foreigninvestment Catalogue restrictions

FIPs are not allowed to make any investment unless the Foreign Investment Industry Guidance Catalogue permits 100 percent foreign ownership

Joint Working Committee of the Shanghai Financial Service Office, Shanghai MOFCOM and Shanghai AIC US$15 million In principle treated as domestic investor, but still restricted from real estate and secondary market None

Not excluded

Excluded

As highlighted above, the main attraction of QFLPs, that they would be treated as ‘domestic investors’ in certain instances, has been abrogated by the NDRC ruling in April 2012. In any case, QFLPs have their own structural issues: such as the very high capital requirements for LPs; the requirement under the schemes in some cities for investment to be directed into certain industries; they cannot invest in prohibited industries, secondary market stocks and bonds (so excluding private investment in public equity (PIPE) deal participation), real estate, or futures or other derivatives, nor lend/provide guarantees to third parties. Given that real estate and PIPE are among the most prevalent investment strategies for RMB funds, this is problematic. Even the ‘character preservation’ flow-through tax treatment for LPs, promised by the local authorities cannot be considered secure if the long awaited partnership tax circular takes a different tack. In summary, it should be noted that the forms which may be adopted by foreign invested RMB funds are very restrictive and limiting when compared to those used by wholly-domestically invested RMB funds. The latter may take the form of corporations, partnerships, trust and

FIE WFOE, EJV, CJV (legal person or contractual) MOFCOM approval AIC registration

RMB0.1 million Standard foreigninvestment Catalogue restrictions

No approval needed for investment in “permitted” or “encouraged” industries MOFCOM approval for investing into “restricted” industry Not excluded WFOE, EJV, legal person CJV are subject to statutory reserve fund under PRC Company Law

contractual arrangements. Partnerships and trusts are favoured significantly by their (in principle) tax transparency and for their operational flexibility compared to corporations. Trusts33, which cannot be foreign invested, also benefit from the confidence investors have in them as a business form regulated by the China Banking Regulatory Commission (CBRC). However, the complex rules on foreign-invested fund establishment, the foreign exchange and tax issues, while problematic, are secondary issues for foreign fund managers looking to enter the RMB fund space compared to the investment restrictions and approval requirements. As noted above, foreign fund managers set up RMB funds to tap the domestic LPs who will pay their fees, and the liquid RMB which can let them execute deals and generate carry. Facilitating the involvement of foreign LPs in the RMB fund space is a secondary consideration. Therefore, we now return to a focus on these investment restrictions and their impact.

33 Trust company PE arrangements have proved popular with domestic investors and fund managers, particularly for investment in real estate. However, as portfolio companies invested by more than 5% by trusts are not permitted to IPO, trusts tend to be used in an FOF capacity rather than as principal PE fund investment vehicles

27 | Foreign sponsored RMB Funds - Still worth the effort?

3: What is the impact of PRC investment restrictions on foreign sponsored RMB funds? Until such time as NDRC changes its position, or a workaround is created, foreign sponsored RMB funds, whether foreign-invested or wholly-domestically invested â&#x20AC;&#x2DC;pureâ&#x20AC;&#x2122; RMB funds, must reckon with the following principal regulatory constraints on investment: (1) Restrictions in the Catalogue on Guiding Foreign Investment (2) Pre-approvals for investment to be obtained from MOFCOM/local commerce departments (3) Scrutiny under the national security review process What is important to realise is that wholly-domestically invested (and domestically sponsored) RMB funds generally face relatively few regulatory hurdles on investment. They do need to comply with the anti-monopoly law requirements set down by MOFCOM and special approvals may be required for investment in specific industries (e.g. China Securities Regulatory Commission approval if the Target is supervised by the former, State-owned Assets Supervision and Administration Commission if the investment is in an SOE, NDRC approval if the investment is in an automotive or oil extractive industry). Also, there are certain SOE monopoly industries which are off-limits to private investo rs, though the NDRC is progressively opening access to many of these, including railways, municipal administration, finance, energy, telecommunications, education and health care. However, subject to these restrictions, wholly-domestically invested (and domestically sponsored) funds may launch investment bids and, once consummated, simply register the change in equity holdings resulting from the acquisition with State Administration for Industry and Commerce (SAIC). By contrast, foreign invested (or sponsored) RMB funds may need individual approval for each investment made (depending on the status of the fund), will find themselves limited in terms of the sectors in which they can invest, and may find themselves subject to the national security review. Compared to wholly-domestically invested funds, investments by foreign invested funds will take far longer and face greater uncertainties, thus complicating co-investments with allied offshore funds.

This section paints a picture of the investment environment faced by RMB funds, highlighting the investment strategies pursued and the economic sectors into which money flows, and overlays this with a consideration of how the investment restrictions on foreign sponsored funds retards their ability to compete in this activity. As most RMB PE funds pursue growth strategies, the distinction between VC and PE in China can be superficial. While the PE model in other markets is defined by large leveraged buyout deals, the focus on minority stakes in Chinese PE transactions arises from continuing restrictions on private (foreign or domestic) investment in many economic sectors, difficulties in financing leveraged buyouts, and the difficulties in acquiring controlling stakes in the SOEs, which are still preponderant in many industries. The fact that most listed SOEs only have a minority stake listed on the market largely excludes the possibility of buyouts through domestic markets, though PIPE investment in minority stakes is very popular. The inability of RMB funds to pursue buyout strategies at present is unfortunate for the foreign sponsored RMB funds, as these could otherwise deploy their global expertise in taking underperforming companies and turning them around through strategic and operational improvements. In China, the minority ownership model denies them use of this model. However, as noted above, in implementing the Chinese governmentâ&#x20AC;&#x2122;s plan for re-invigorating the national economy, the NDRC have recently liberalised a number of key sectors into which private investment may now be made more readily. In addition, as the easy returns of prior years have diminished interest has grown in the more transformational forms of PE investment, such as buyouts. As government policy has moved towards industrial transformation, it may be just a matter of time before the limitations on financial institutions financing leveraged buyouts are relaxed. In principle, this development thus opens the way for foreign fund managers to play to their strengths in the RMB fund space and attract those newly liberalised institutional LPs who will look for this expertise.

Similarly, on exit, foreign invested funds may encounter a multitude of issues, both with trade sales and IPOs, with which domestically invested funds need not contend. In summary, foreign invested (or sponsored) RMB funds will find themselves severely hamstrung when compared with whollydomestically invested (and sponsored) funds. Venture capital

Growth

Buyout

Real Estate

PIPE

Resembles model in other markets

Bias towards pre-IPO funding

Minimal due to regulatory restrictions

Affected by efforts to limit property bubble

Limited to minority stakes

Foreign sponsored RMB Funds - Still worth the effort? | 28

However, while the prohibition on private investment in these sectors may have been lifted, this does not necessarily mean that foreign investors (including foreign sponsored RMB funds regarded as foreign investors) may participate. The foreign sponsored RMB funds may still be excluded from investment under the Catalogue Guiding Foreign Investment (discussed further below), and domestic financial institutions may still be reluctant to finance leveraged buyouts by such funds. If domestic manager sponsored RMB funds get a first-mover advantage on some of the interesting buyout options coming on stream, this will simply cement their current lead over the foreign fund managers.

Internet and media sectors attract a lot of RMB fund investment â&#x20AC;&#x201C; the elimination of foreign ownership restriction workarounds could be problematic for foreign sponsored funds According to Zero2IPO, in 2012 there were 1,151 deals, with a total value of USD 27 billion. Looking at the target sectors for PE investment in China, Internet was the largest investment category by both value and volume, with 12% of deal volume and 19% of value. From a deal value view, the next three largest are real estate, with 5% of deal volume and 12% of deal value; energy and minerals, with 4% and 10%; and financial service, with 0.1% and 9%, respectively. From a deal volume point of view the next three largest are bio/healthcare, with 11% of volume and 7% value; machinery manufacturing, 9% and 4% , and telecom & value added services, 8% and 4%, respectively.

Number of PE&VC investments, 2012 Internet Bio/Healthcare Machinery Manufacturing Telecom & Value-added Services Clean-tech Electronic & Opto-electronics Equipment IT Real Estate Chemical Raw Materials & Processing Agr/Forestry/Fishing Energy & Mineral Entertainment & Media Construction / Engineering Chain Retail Automobiles Others Food & Drinks Finance Textile & Clothing Undisclosed Logistics Education & Training IC Broadcasting & Digital TV

84 83 79

133 131

110 109

66 62 55 48 46 39 35 30 25 20 12 12 10 8 0 50 100

No. of Deals

Total: 1,151 Source: Zero2IPO

155

150

188

200

211

250

1217 1063 1056 1021 1018 898 705

1899

2631 2398

3337

5212

20 12 12 10 8

Undisclosed Logistics Education & Training IC 29 | Foreign sponsored RMB FundsBroadcasting - Still worth the&effort? Digital TV

Total: 1,151 Source: Zero2IPO

100

No. of Deals

150

200

250

Value of PE&VC investments, 2012 Internet Real Estate Energy & Mineral Finance Bio/Healthcare Chemical Raw Materials & Processing Telecom & Value added ServicesMachinery Manufacturing Chain Retail Clean - tech Others Electronic & Opto - electronics Equipment Agr/Forestry/Fishing Automobiles Entertainment & Media IT Food & Drinks Textile & Clothing Construction/Engineering IC Undiclosed Education & Training Logistics Broadcasting & Digital TV

1217 1063 1056 1021 1018 898 705 700 655 575 542 534 458 432 262 213 118 89 70 0

1000

1899

2000

2631 2398

5212

3337

3000

4000

5000

6000

USD million

Total: USD 27 billion Source: Zero2IPO

It should be noted that PE investment data in China tends to be skewed by a few large of mega-deals in a given sector, which can inflate the appearance of activity in that sector (notably financial services, as seen in the table below). Transaction date September 2012 August 2012

Amount (USD m) 3,900.0

Financial Services

March 2012

2,575.8

CIC; Boyu Capital; CDB Capital; CITIC Capital; DST Advisors; Silver Lake; Temasek Holdings The Carlyle Group; FountainVest Partnership; CITIC Capital; China Everbright; Fosun International CIC, NSSF

Financial Services

April 2012

2,306.3

Temasek

Financial Services

March 2012

1,643.2

CITIC Capital, NSSF, Standard Chartered; UBS

Financial Services

September 2012

1,337.3

HCP Holdings

Industrial Markets

July 2012

500

Abu Dhabi Investment Authority; Government of Singapore Investment Corporation (GIC); Norges Bank Investment TPG Capital

Haitong Securities

Financial Services

April 2012

460.0

360Buy.com

Internet

300.0

Shenzhen ZTE Netview Technology Li Ning

Technology, Media, Telecommunications Consumer Markets

November 2012 December 2012 Jan 2012

D. E. Shaw; Oman Investment Fund; PAG Capital; SBI Holdings Ontario Teachersâ&#x20AC;&#x2122; Pension Plan; Tiger Global

207.3

Unitas Capital

164.0

GIC Special Investments; TPG Capital

June 2012

94.4

CVC Asia Pacific; China Consumer Capital; Mousse Partners

Investee

Sector

Alibaba Group

Internet

Focus Media

Technology, Media, Telecommunications

Bank of Communications ICBC Cinda Asset Management Corp. China Pacific Insurance

C.Banner International Consumer Markets Holdings *Won board approval Source: AVCJ

3,700.0*

Investor

Foreign sponsored RMB Funds - Still worth the effort? | 30

clampdown on the use of VIE structures34 and the treatment of foreign sponsored ‘pure’ RMB funds as FIEs threaten to cut off access to investment into these highly lucrative sectors, excluding the foreign investors and making foreign sponsored RMB funds even less attractive as an investment prospect for domestic LPs.

Quite a lot of PE (and particularly VC) investment is directed into sectors, such as Internet related media and services, which are prohibited or restricted to foreign investors under the Catalogue Guiding Foreign Investment. As explained below, offshore funds have historically accessed these sectors using structures such as variable interest entities (VIEs), which transfer control and income participation rights to a WFOE but do not necessitate acquiring the equity of the domestic company conducting the business in the prohibited/restricted sector. The foreign sponsored ‘pure’ RMB funds wished to be treated as domestic investors, such that the Catalogue restrictions would have no relevance. The

Investment activity appears to mirror economic activity in the wider economy A majority of deals surround the tier one cities of Beijing, Shanghai, Shenzhen and Guangzhou, reflecting the locations of headquarters and principal operations of many acquisition targets.

Geographic Distribution of PE&VC Investments in 2012 360

Beijing Shanghai Jiangsu Shenzhen Zhejiang Guangdong (Exl. Shenzhen) Hubei Shandong Sichuan Anhui Henan Hunan

232 167 137 120 112 77 60 27 25 21 20

100

200

300

400

No. of Deals

Source: Zero2IPO

Geographic Distribution of PE&VC Investments in 2012 5,066 4,943

Zhejiang Beijing

3,315

Shanghai Guangdong (Exl. …

1,736 1,460

Jiangsu

949 818 622 590 548 426 205

Hubei Shandong Sichuan Henan Shenzhen Tianjin Anhui

2000

4000

6000

Investment Amount in USD million Source: Zero2IPO 34 In August last year, a MOFCOM national security review notice stated that foreign investors are not allowed to evade a national security review in M&A

31 | Foreign sponsored RMB Funds - Still worth the effort?

The relevance of the sectoral investment restrictions and approval process In light of the above-outlined complexion of the RMB fund investment landscape, the relevance of the sectoral investment restrictions and approval process for foreign sponsored RMB funds can be seen more clearly. Regulator MOFCOM

Investment approval requirements Domestic fund Foreign invested fund Anti-monopoly clearance (revenue threshold applies)

Investment pre-approval

NDRC

Anti-monopoly clearance (no revenue threshold) National security review (with other bodies) MOFCOM may consult NDRC

SAFE SASAC

Acquisition of SOE

Conversion and payments clearance Acquisition of SOE

Approval if target regulated/listed

CSRC/ CIRC/CBRC/ Gov dept

At every stage of the investment process, matters are more onerous for RMB funds treated as foreign invested than for those treated as domestic investors. To start with, while under the anti-monopoly law, acquisitions by purely domestically invested funds face a mandatory pre-merger approval process where the parties to the transaction have revenues in China of US$63 million and above, all mergers involving FIEs, such as foreign invested RMB funds, are reportable for the mandatory pre-merger approval process, regardless of the revenues of the parties. As noted above, Chinese equity acquisitions by foreign manager sponsored (or foreign invested) RMB funds also face the following hurdles: (1) Restrictions in the Catalogue on Guiding Foreign Investment (2) Pre approval for investment to be obtained from MOFCOM/local commerce departments (3) Scrutiny under the national security review process These matters, together with the greater difficulties for foreign managed RMB funds in conducting leveraged investments, are explored below. RESTRICTIONS: Catalogue of Industries for Guiding Foreign Investment Foreign investment in China is subject to the Catalogue of Industries for Guiding Foreign Investment, last updated in 2011. This is the core document to which central and local authorities refer when forming industrial policy, such as developing special tax and other financial incentives, and when granting approval for foreign investment projects. Central MOFCOM and the local commerce departments will refer to it when considering whether to pre-approve foreign investment applications (discussed below), the decision on which is at their complete discretion, with no formal system of appeal.

Industrial and economic sectors are classified into three categories which reflect the degree to which the government will support foreign investment in the industry in question: Encouraged, Restricted and Prohibited. Industry classes that are not included in the above three classes of the Catalogue fall into the â&#x20AC;&#x2DC;Permittedâ&#x20AC;&#x2122; class. Foreign investment in these sectors in not subject to restriction but is also unlikely to be afforded any specific incentives. The Encouraged class lists extensively various high-end industries, new technologies, new materials, new equipment, and environmentally-friendly industries. The Prohibited industries are broadly those which relate to key controlling parts of the national infrastructure35. No foreign investment whatsoever (directly or through FIEs) is formally permitted in these sectors. However, innovative structures such as VIEs have been used in the past and the authorities have implicitly acquiesced in their widespread use, until recently. The Restricted industries are those in which foreign investment is possible, but subject to restrictions as to the form in which the foreign investor (or FIE) may invest and their maximum holding percentage36. For a given industry, it may be required that: (i) the proportion of foreign investment does not exceed a given percentage, or (ii) the Chinese parties involved in the investment are the controlling shareholders, or (iii) the investment is limited to Chinese-foreign equity or contractual joint ventures. 35 The main listed sectors are media (radio and TV stations, publication of written and audio-visual media, internet media), transport (postal service, air traffic control) and power. Also included are certain valuable resources (rare earths), certain traditional Chinese craft products, and certain pollutants or undesired productions (e.g. genetically modified crops). 36 The list of restricted industries carves out certain parts of the prohibited industries in which investment may be possible (e.g. TV program production in the otherwise prohibited media sector). It also adds a large array of industries in the infrastructure sector (such as in transport, power, and communications) as well as most financial services fields, extensive parts of the real estate industry, wholesale/retail distribution, and certain areas of food production and mining.

Foreign sponsored RMB Funds - Still worth the effort? | 32

Limits on the percentage holding which an RMB fund which is treated as foreign invested may take in the Target can make transformational post-investment plans for the Target unworkable. The fact that a given industry is restricted may also make central MOFCOM and the local commerce departments more inclined to deny approval, or to consider whether the project must be referred to higher authorities for a national security review. It will certainly make the approval process much slower. Given the above, it would be unsurprising if domestic Chinese LPs found the possibility of investing with a completely domestically invested and managed fund far more appealing than investing with a foreign managed RMB fund, which is restricted in investing in such manner. The recent clampdown on some of the original workarounds has complicated matters. Given that some of the most popular industries for RMB fund investment in recent years are in the restricted and prohibited sectors (e.g. internet), the

invalidity of such structures, together with the treatment of foreign sponsored ‘pure’ RMB funds as foreign invested, is a significant setback for such funds. PRE-APPROVALs: MOFCOM investment authorisation RMB funds treated as foreign invested are required to make M&A investments in accordance with the Regulations on the Mergers and Acquisitions of Domestic Enterprises by Foreign Investors37(“the 2006 M&A Regulations”). This sets out a pre-approval process which must make reference to the Catalogue of Industries for Guiding Foreign Investment, which details the degree to which different economic sectors are open to foreign investment (details above). Under these rules, acquisitions by foreigners and foreign invested enterprises are subject to MOFCOM approval prior to registration of changes in ownership with SAIC. The level of approval from MOFCOM depends on the type of business and the size of the investment project: approval by higher level MOFCOM authorities implies greater scrutiny and potentially longer approval times.

Investment size Type of business

< USD 50 million

Encouraged or permitted industries Restricted industries

MOFCOM at the provincial/ municipality level MOFCOM at the provincial/ municipality level

As noted above, with ‘pure RMB funds’ and QFLPs now being treated by the NDRC as foreign invested, the understanding is that these will have to fully comply with the approval process for each individual investment. FIVCIEs, which require MOFCOM approval for their establishment, only need MOFCOM approval for investment in restricted sectors: investment in encouraged and permitted sectors requires only registration of the investment with MOFCOM. However, as noted, FIVCIEs are very much in the minority of the foreign managed RMB funds, with ‘pure RMB’ funds predominating, and they suffer from the other issues outlined above. As such, even where foreign sponsored RMB funds and domestic manager sponsored RMB funds in principle have the same investment access to a given economic sector, the foreign sponsored RMB fund may find itself slow off the mark in initiating and concluding investments. SCRUTINY: National security review In addition to the above, to the extent that foreign investors are considering acquiring effective control over certain enterprises deemed to be of strategic importance, a preapproval process under the new national security review procedures introduced in 201138 may be required. Usually it will be the central MOFCOM or the local commerce

USD 50million - USD 300 million MOFCOM at the provincial/ municipality level Central MOFCOM in Beijing

> USD300million Central MOFCOM in Beijing Central MOFCOM in Beijing

departments dealing with the pre-approval under the 2006 regulations, which decide whether to refer the planned acquisition for national security review. A joint committee led by the NDRC and MOFCOM, and potentially involving other government departments, will subject foreign inbound M&A in specified areas (e.g. national defence, key agricultural products, key energy, key natural resources, key infrastructure, transportation, key equipment manufacturing and technology) to an additional layer of review. Where such a process is initiated, it likely will lead to substantial further delays with the execution of fund investments39. Leveraged acquisitions Standard practice in the PE industry is to leverage up not at the level of the fund but at the level of the bidding co. used to acquire the target. However, borrowing to finance equity acquisition can be problematic in China, at least for foreignsponsored funds. 37 Issued by MOFCOM, SASAC, State Administration of Taxation, SAIC, CSRC and SAFE on 8 August 2006. 38 Notice on Establishing a Security Review System for Mergers and Acquisitions of Chinese Enterprises by Foreign Investors (“Notice”) issued by the State Council on 12 February 2011 39 A notable recent extension of the review was to acquisitions involving VIE structures, even though these do not involve equity control being taken of the Chinese company in question.

33 | Foreign sponsored RMB Funds - Still worth the effort?

Borrowing from abroad to finance equity purchases is effectively excluded by SAFE Circular 14240. Further, foreign invested real estate enterprises established after 2007 are not permitted to borrow offshore to finance construction of projects.

tax consolidation, so getting interest tax deductions may be complicated and require consideration of the possibilities of merging the bidding co. and the target co. Foreign sponsored or invested funds may continue to find themselves excluded in obtaining equity acquisition finance at the level of their bidding co’s. Where, subsequent to an acquisition transaction, leverage is injected at the level of the target companies (which might be done, say, to finance a distribution of profits to the fund), certain maximum debtequity ratios for FIEs must be respected. The difference between the total investment and minimum registered capital represents the foreign borrowing capacity. However, even this may run into difficulties, as SAFE may be unwilling to let the funds be converted for such a purpose43 and issues with the tax deductibility of the interest may be encountered. In short, even if regulatory limitations on leveraged financing of PE are relaxed, foreign sponsored funds may struggle to mirror leverage strategies adopted by domestically sponsored funds, so complicating their ability to compete on a buyout investment strategy.

As regards domestic borrowing, PBOC and CBRC rules prohibit Chinese banks from lending to finance “share equity investment”. While there is an exception, it is typically only invoked by the banks to lend to large domestic enterprises. This permits commercial banks to lend to finance M&A transactions, including share acquisitions, if they satisfy certain tests in relation to capital adequacy, and if it can be shown that there is an industrial or strategic relevance between the acquirer and the target enterprise41. A domestically sponsored fund might be in a position to secure such borrowing; in particular, SOE captive funds and industrial funds might be able to push for such loans on the basis of the linkage between their investment targets and the wider business of the SOE sponsoring the fund42. It should, however, be noted that as China has no system of Total investment amount in USD

Minimum registered capital in USD

$3 million or less

70% of the total investment amount

>$3 million but < $10 million

50% of the total investment amount, but no less than $2.1 million

>$10 million but < $30 million >$30 million

40% of the total investment amount, but no less than $5 million 33% of the total investment amount, but no less than $12 million

*Won board approval Source: AVCJ

Foreign sponsored RMB funds and investment Being treated as a foreign invested enterprise has significant ramifications for foreign sponsored RMB funds. When it is considered that the sectors into which PE/VC money is racing are in many cases those which are restricted from foreign investment (and that the popular work-arounds like VIE are being clamped down on) the significance of the sectoral investment restrictions in the Catalogue Guiding Investment can be understood. When it is considered that, insofar as every investment needs to go through a MOFCOM approval process that provides complete discretion to the authorities in approving investments, investment bids made by foreign sponsored RMB funds are always contingent on this unpredictable approval. Given this, targets may simply be happier to work with the domestic manager sponsored funds which can give them greater certainty of support. Further, as target enterprises may also be treated as ‘foreign invested’ themselves following investment by foreign sponsored RMB funds, with resultant complications in renewing business licenses and other issues, they may prefer to simply leave the money profferred by the foreign sponsored RMB funds on the table.

As noted above, the recent liberalisation of a number of key economic sectors into which private investment may now flow potentially opens a path for foreign fund managers to play to their strengths in the RMB fund space. This development may in time allow for stakes in underperforming SOEs to be acquired and for the buyout and turnaround expertise of the foreign fund managers to be applied. This move from growth strategy to buyout is likely to be driven by the growing maturity of the China PE market and the greater competition for returns. However, in addition to the investment restrictions and approvals process outlined above, as well as national security review scrutiny, foreign sponsored funds may face difficulty accessing the necessary leverage, whether from abroad or domestically, to execute the deals and may again find themselves outpaced by domestic fund managers.

40 An exception exists for China holding companies, but these are unlikely to be useful acquisition vehicles given the time required to set them up and the difficulty they will have in merging with the target co’s 41 Guidelines on the Risk Management of Merger and Acquisition Loan of Commercial Banks 42 A good recent example is the Bank of Ningbo’s recent lending arrangements with a CITIC fund, which involved the former receiving a type of equity participation in profits as part of its return on lending. 43 The PBOC have clarified that the SAFE Circular 142 restrictions will equally apply to offshore RMB used for the purpose, but the Qianhai scheme, discussed in Part 3, may provide for a new breakthrough treatment

Foreign sponsored RMB Funds - Still worth the effort? | 34

35 | Foreign sponsored RMB Funds - Still worth the effort?

4: Why do foreign sponsored RMB funds have a harder time exiting their investments? It has frequently been noted that RMB funds looking to exit investments face certain difficulties particular to the local market. These difficulties are, however, accentuated for foreign sponsored RMB funds and add to the overall competitive disadvantage at which the foreign sponsored RMB funds are placed. Exit is highly reliant on a tightly regulated IPO market Domestically invested and foreign invested RMB funds may exit their investments via IPO, M&A and trade sale, share placement, liquidation and buybacks. According to Zero2IPO, IPO exits are by far the preferred exit channel, making up 73% of exits from 2008 to 2012.

The PE industry in China has exhibited two IPO booms: the surge (in both onshore and offshore listings) in 2005-07, which followed the first substantial investments being made by USD funds in the early 2000â&#x20AC;&#x2122;s; and what appeared to be a fairly robust recovery in 2010 from the global financial crisis, followed by quiescence in 2012. In the first IPO boom, exits were primarily on foreign stock exchanges (New York Stock Exchange, NASDAQ, HKSE, etc). In the 2010 upswing, a majority of exits were on the domestic exchanges (i.e. Shanghai and Shenzhen main boards, SME boards, and ChiNext GEM Board in Shenzhen) with 42% on foreign exchanges. The 2012 figures show a scene completely transformed, with 47 of 201 PE and VC listings being made on foreign exchanges.

VC/PE exits by type, 2008-2012 700 555 13 25 26

600 500

606 51 46 62

400

41 74

300 200 100 0

423

203 14 27 9

159 64 27 6 62

153

2008

2009

IPO

M&A

Source: Zero2IPO: Note: (1) Combines USD and RMB funds

491

40 447 268

2010 Trade Sales

2011

2012

Other & undisclosed

Foreign sponsored RMB Funds - Still worth the effort? | 36

IPO exits by location, 2007-2012 800 700 600 500 347

400 300 200

124 118

100 0

2007

76 37

2008

2009

281 154

129

2010

Domestic exchanges

2011

47 2012

Foreign exchanges

Financing amount of IPO exits by location, 2007 -2012 120

105.8

104.7

USD billion

100 80

33.3

39.7

54.6

27.1

17.8 65.0

20 0

61.5

21.8 6.9 14.9

2007

2008

72.50

27.5

2009

26.3 43.70

9.8 16.50

2010

2011

2012

Foreign exchanges Domestic exchanges Note: Domestic exchanges only includes mainland China and thus excludes Hong Kong Source: Zero2IPO

15 Capital IQ

37 | Foreign sponsored RMB Funds - Still worth the effort?

As the chart shows, the number of exits over foreign exchanges has fallen steeply in recent years. Part of the reason for this is the lower multiples available on foreign exchanges (relative to the PRC exchanges) in the wake of the financial crisis and the accounting scandals with overseas listed Chinese companies. However, a part of it is that the round-tripping transactions, which were used to place ownership of the Chinese company intended for listing under an offshore company (necessary for listing abroad), were severely constrained by a slew of regulatory changes in 2005/0644. With regards to PE IPOs on domestic exchanges, the ChiNext board on the Shenzhen stock exchange is favoured due to the (until recently) strong valuations and focus on smaller businesses compared with other exchanges. In 2012, 40% of IPO exits by PEs were through ChiNext. However, executing an IPO domestically remains difficult. Although 2012 saw a small increase in listings, the CSRC are generally understood to be fiercely prudent when vetting companies for listing45. The net result is that very few companies are listed each year (relative to the numbers applying) and funds, domestic and foreign, accumulate portfolios of companies waiting to be listed. The current IPO waiting list for IPO consists of over 800 companies. To further tighten up the vetting process of this back log the CSRC has recently asked all IPO sponsors to re-evaluate companies by the end of March 2013. According to media reports, 41 companies have withdrawn their applications in first two and a half months of 201346 Many commentators have argued that the better connected domestic fund managers do appear to have more success in getting their listings through the hoops – foreign managers often opt for M&A sales in lieu of waiting for investment approval.

The difficulty of IPO exit is anticipated to lead to a fundamental change of strategy as firms re-evaluate their legacy portfolios Conversely, this difficulty in exiting is changing the fund market in a way that may once again benefit foreign players. Legacy acquisitions over the last two to five years which at one time would have been easy to IPO are still lingering on firms’ books. PE firms will have to take a hard look at their portfolios and take difficult decisions about which investments to hold, which to look for a rapid (and potentially loss making) exit, and which investments to engage in fundamental restructuring of companies. Relevant experience in domestically managed funds is likely to be lower than in foreign firms, who tend to have global experience to leverage. Furthermore, restructuring of companies is unlikely to be easy because, as noted previously, a majority of investments are minority investments and firms will have to attempt such restructuring with a minority stake – not an easy prospect in any situation. Influencing previous congenial target management to make difficult restructuring decisions will be very different from influencing them for IPO listing, when objectives of both parties were more clearly aligned. This difficulty is compounded by the fact that many terms of investment were not set up with this in mind and therefore decision making power in company operations is often limited. This also creates opportunities for new funds, unburden by previous acquisitions, to enter the market and acquire stakes or engage in recapitalisation of companies at relatively good prices. Fundamentally, funds that are able to make difficult portfolio decisions and restructure underperforming companies from a minority position are likely to come out on top in the medium to long term, whereas others may not be able to survive the “hangover” from previous years buying sprees.

2012 Number of IPO exits in Chinese PE market by exchange 0 ChiNext SMEB Shanghai Stock Exchange HKMG 5 HKGEM 1 NYSE FWB 1

Note: PE only Source: Zero2IPO 44 The 2006 M&A Regulations (Circular 10) require an overseas listing to be approved by MOFCOM and CSRC. SAFE Circulars 75 (2005) and 106 (2006) created onerous filing requirements for overseas restructurings. The net result is a dwindling pool of potential ‘Red-chip’ listings 45 The Shanghai and Shenzhen main boards primarily list the shares of SOEs (80% by value) or of larger POEs (which make up the bulk of companies listed). The main boards have higher listing requirements which smaller POEs may not qualify, thus making the SME and GEM boards more attractive 46 http://news.chinaventure.com.cn/2/20130320/112133.shtml

Foreign sponsored RMB Funds - Still worth the effort? | 38

IPO Exit Regulator MOFCOM CSRC

Wholly-domestically invested fund Seller -

Foreign invested fund Seller FIJSC conversion

Listing approval

Listing exits by wholly-domestically invested funds vs foreign invested funds Wholly-domestically invested funds must convert the limited liability companies, in which they have invested, to joint stock limited companies. Listing will not be possible if trusts are invested in the portfolio companies – as discussed earlier, this sets an obstacle to the wider use of the trust form as a PE fund vehicle. In order to list on Chinese exchanges, foreign invested applicants must be organised in the form of a foreign invested joint stock limited company (FIJSLC). A company must go through onerous MOFCOM approval process to be converted into an FIJSLC, which include a requirement for three years of continuous profits. In view of the complications for exiting, companies receiving investment from RMB funds (and their controlling investors) may be wary of accepting investment from such funds unless they can be assured that there are no investments by foreigners in such funds (or that the funds will not be treated as foreign invested by regulators).

Listing approval Given recent developments, the position of QFLPs and any foreign managed ‘pure’ RMB funds may be looked upon with scepticism. Where a FIVCIE promotes a FIJSLC portfolio company, the FIVCIE is subject to a three-year lock-up period, limiting its ability to dispose of shares in the FIJSLC. The remaining shareholders are subject to a lock-up period of one year. These features naturally make domestic LPs reluctant to invest in foreign invested RMB funds, and portfolio companies reluctant to accept investment from them. With the above constraints, and with the CSRC rationing listing slots to domestic managers, the number of exits by foreign sponsored funds through listing on the domestic exchanges has not been large. It is to be hoped that this will be liberalised somewhat in future, and much store continues to be set on the long-awaited establishment of the International Board in Shanghai.

Top PE-backed IPOs VC/PE China Science & Merchants; -10 GF Xinde Investment Management; principle capital NewMargin; Shanghai Broad Resources; Zhejiang Sinowsisdom; Zheshang, venture capital Guosen Hongsheng Investment, principle capital BOCGI Direct Investment Management; Goldstone Investment GF Xinde, investment management Source: AVCJ

Investee Jiangsu Sunrain Solar Energy

Industry Energy

Date May 2012

Amount (USDm) 339.8

Ningbo Cixing

Manufacturing

March 2012

338.6

Xian LONGi Silicon Materials People.cn

Manufacturing

April 2012

249.7

Technology

April 2012

219.2

Services

March 2012

207.6

Pubang Landscape Architecture

39 | Foreign sponsored RMB Funds - Still worth the effort?

Due to IPO restrictions and a large exit backlog, M&A and trade sales47 may become an increasingly important exit option PE funds in China tend to prefer IPO exits over M&A as they offer a relatively structured way to dispose of assets. Consequently, in 2010 and 2011 M&A and trade sales combined accounted for 9% and 18% of exits by VCs/PEs, respectively. A higher percentage of M&A and trade sale exits were made by VC than for PE, with 21% of VC funds in 2011 and only 8% of PE funds exiting this way48. For foreign or foreign invested PE funds, disposals of Chinese portfolio companies to local investors need approval from a number of government agencies (explored further in Section 2). The minority stake model can make it hard to find a corporate strategic buyer. However, the huge waiting and approval list for IPOs means that M&A sales may well become a more common exit route in future. M&A exit by wholly-domestically invested funds vs foreign invested funds The sale by a wholly-domestically invested fund to a local investor will require the buyer to satisfy the various regulatory requirements for acquisition as highlighted above. These may include anti-monopoly rules, clearance by particular government departments and particular industry regulators if relevant, and SASAC if the acquirer is an SOE49. However, in

most cases, exiting by way of M&A transaction should not be overly complicated for wholly-domestically invested funds. Sales of portfolio company investments by foreign invested funds similarly require the buyer to clear the various hurdles outlined above50. However, a further layer of approvals is required for the foreign invested fund compared to the domestically invested fund, as the foreign invested fund, as seller, will also need disposal approval. When the foreign invested fund originally invested in the domestic Chinese enterprise, the Chinese company will have converted to an FIE and will have re-registered with the SAIC. Approval to dispose of the portfolio company will be needed from the relevant government authorities that approved the initial investment acquisition (MOFCOM, the National Security Review committee, etc). The discretionary nature of such decision-making by the regulator may complicate the exit transaction. It is partly for this reason that foreign funds have favoured the more structured IPO exit process (at least where overseas exit has been a possibility). However, M&A exits by foreign invested funds can be complicated by the fact that it is unlikely that the fund is selling a controlling stake in the target (this being difficult for FIEs to acquire in the first place). Strategic buyers, a key market for M&A exits, may therefore be uninterested.

VC/PE

Investee

Industry

Date

Amount (USDm)

Goldman Sachs Temasek

ICBC Bank of China

Financial Services Financial Services

April 2012 May 2012

2,306.3 1,239.8

Temasek

China Construction Bank China Kanghui Holdings

Financial Services

May 2012

1,232.9

Consumer Markets

September 2012

816.0

July 2012

726.4

CDH Investment; IDG Capital Partners; TDF Capital The Carlyle Group

China Pacific Insurance Financial Services

Source: AVCJ

M&A Exit Regulator

Wholly-domestically invested fund Seller

Foreign invested fund

SASAC

Buyer If buyer SOE

Seller If originally invested in SOE

Buyer If buyer SOE

Regulator/Gov dept

If buyer regulated

MOFCOM

If buyer foreign/FIE/monopoly

National Security review board

If buyer foreign/FIE

If originally invested in regulated target If MOFCOM pre-approval required at investment If NS pre-approval required at investment

If buyer monopoly If buyer foreign/FIE

47 A trade sale is typically defined as selling assets to a strategic buyer in a related industry rather than for financially motivated buyer 48 However, the examples of HOPU and MengNiu Dairy in the list of significant exits in the table below, show that even large deals can be exited via these routes. 49 Where they look to sell to a foreigner or FIE, the latter will have to satisfy the additional acquisition regulatory requirements and this may further slow the process 50 However, a sale by a foreign invested fund to another FIE does not actually require the acquiring FIE/foreigner to obtain any acquisition approvals as the target itself is already an FIE

Foreign sponsored RMB Funds - Still worth the effort? | 40

41 | Foreign sponsored RMB Funds - Still worth the effort?

5: The regulatory web for whollydomestically invested and foreign sponsored funds in overview As outlined above, the legal and regulatory limitations on establishment and operation of RMB funds are relatively limited for wholly-domestically invested funds compared with foreign sponsored funds. While registration procedures with SAIC and NDRC51 on establishment of the funds must be followed, the only encounter with MOFCOM will be if antimonopoly clearance is required. Foreign sponsored RMB funds find themselves subject to many more layers of regulatory scrutiny and approval. As each regulator has very wide discretion in granting approvals, the necessity to obtain each additional approval is not just a matter of additional time and expense but, much more importantly, is also a hurdle which can potentially block the completion of the establishment/investment/exit process entirely. Most significant are the investment approvals required from MOFCOM, which must follow the Catalogue Guiding Foreign Investment. This is in addition to the acquisition clearance which wholly- domestically invested funds must also obtain (where relevant) from regulators and government departments responsible for certain regulated industries52. However, it is not just individual approvals that matter but the need for consensus to be reached between these bodies in the case of the foreign sponsored funds. The complexity is compounded by the fact that exit approval is needed from all the regulatory authorities which authorised the investment in the first place.

Regulator SAIC (and local branches) MOFCOM (and local commerce departments) NDRC SASAC CIRC/CBRC/Gov dept CSRC

While wholly-domestically invested funds also need to convert their portfolio companies to JSCs and obtain CSRC approval to list, the additional involvement of MOFCOM in the process for foreign sponsored funds substantially increases the complexity. Additionally, for the specific case of the foreign-invested funds (noted above to be in the minority compared to the foreign sponsored â&#x20AC;&#x2DC;pureâ&#x20AC;&#x2122; RMB funds, there is the additional battery of approvals needed for fund establishment (e.g. MOFCOM and the Ministry of Science and Technology in the FIVCIE case) and forex settlement and conversion on investment and repatriation (SAFE, State Administration of Tax (SAT)). In order for foreign sponsored funds to compete effectively with wholly-domestically invested, domestically managed funds, they would need to not be subject to foreign investment approvals or national security reviews, foreign ownership-linked limitations on the sectors in which the fund can invest, or to procedures more complex for exit than for wholly-domestically invested funds. Part 3 looks at what would need to change for this to come about.

Wholly-domestically invested, domestically managed fund Establishment Investment Exit Register

Target joint stock company (JSC) re-registration (listing) Anti-monopoly acquisition clearance

Listing approval

* Assumed to be investing in wholly-domestically owned enterprises and selling to local buyers

51 The NDRC maintain a register of all investment funds, and new funds are to register with it. Going forward, however, the CSRC may require all private equity fund managers to register with it. This would mean that the funds themselves would be registered with the NDRC and the managers with the CSRC. 52 CBRC, CSRC, CIRC for enterprises regulated by the latter; relevant government ministries (e.g. Information Ministry for electronics sector investments), and SASAC approval for acquiring interests in SOEs

Foreign sponsored RMB Funds - Still worth the effort? | 42

Foreign invested fund Investment Exit

Regulator

Establishment

SAIC (and local branches)

Register â&#x20AC;&#x201C; SAIC will Target re-registered as consult MOFCOM and FIE other bodies where FIP is registered Approval (FIVCIE) Investment pre-approval, antimonopoly clearance, national security review (with other bodies)

MOFCOM (and local commerce departments)

Target FIJSC conversion approval (listing) MOST

Approval (FIVCIE)

SAT

NDRC

SAFE

SASAC CIRC/CBRC/Gov dept CSRC

SAIC may consult these

Investee de-registered as FIE (sale) Target FIJSC re-registration (listing)

Disposal clearance needed by fund from same bodies as original investment approval obtained from (incl MOFCOM).

Clearance for repatriating sale proceeds out of China MOFCOM may consult NDRC Conversion and payments clearance Approval to acquire SOE Approval to acquire regulated target Approval to listed target

* Assumed to be investing in wholly-domestically owned enterprises and selling to local buyers

15 Capital IQ

Conversion and payments clearance Approval to sell SOE Approval to acquire regulated target Listing approval

43 | Foreign sponsored RMB Funds - Still worth the effort?

A way forward?

Foreign sponsored RMB Funds - Still worth the effort? | 44

Parts 1 and 2 have set out why foreign fund managers should want to be in the RMB fund space and what prevents them from participating effectively at the current time. At the present moment and with the regulations currently in place, foreign sponsored RMB funds are not in the running when compared to their domestic fund manager sponsored rivals. However, the regulatory environment is in flux and pathways for to re-enter the fray could emerge. Part 3 looks at the potential developments which might change position of foreign sponsored RMB funds and allow them to compete effectively in the China market. The emergence of a national regulator for PE There is currently no overarching regulator for the PE industry in China. This contrasts with the case of listed securities investment funds or asset management schemes, for which the CSRC acts as the ultimate regulator, or of trust companies or bank wealth management products which are subject to top level supervision from the CBRC. The lack of an ultimate national regulator for private equity appears to have made many investors cautious about putting money in RMB funds and limits the growth of the sector. The lack of a unified scheme of regulation also means that the uncoordinated approach of different regulators leads to complexity and uncertainty, as well as variance in local treatments on various aspects of regulation. In this regard many in the industry would welcome a unified system of national regulation for PE funds. Both the NDRC and CSRC have take steps to assume the mantle of national regulator; which of these prevails may well impact on the treatment of foreign sponsored RMB funds going forward. The NDRC has established systems for registering VC funds (2005) and all substantial PE funds (2011)53. It established a system of approval (2008) as well, but solely for so-called Industrial Investment Funds (IIF), a handful of which have been established by SOEs and local governments. The NDRC has long had a regulation in draft to govern the entire industry but, in part due to reservations expressed by the CSRC, this has still to be issued. More significant steps have been the introduction (2008) of a requirement that the NSSF is only permitted to invest in NDRC registered funds, and the ruling (2012) that foreign sponsored RMB funds were to be treated as foreign invested.

The CSRC has also taken significant steps towards an overall governance role. In 2011 it expanded a 2007 pilot scheme which permitted a number of securities companies to set up PE funds to all securities firms, over which it intends to be the principal regulator. As recently as June 2012 it authorised CITIC Buyout Fund Management Co., Ltd as the first buyout fund approved by the CSRC – as the buyout strategy may be set to develop rapidly among PE funds in China in the coming years, this put the CSRC in the vanguard of developments. Further, since September 2012 the CSRC has permitted mutual funds registered with it to pursue PE investment strategies. These funds can take on far more LPs than existing RMB funds, though the CSRC has limited, for the moment, the manner in which mutual funds can publicly promote their PE funds to potential clients. In addition to these particular fund managers and funds falling under the CSRC’s purview, the CSRC has crucial sway over all VC/PE funds insofar as it controls the principal exit route, through IPO, and can veto acquisitions of listed companies, thus controlling PIPE deals. While the new Securities Fund Law (2012) did not include the regulation by CSRC of all private equity fund managers in its final draft, earlier drafts of the law did, and it remains a stated goal of the CSRC to bring private equity funds managers further within their purview

53 Per Circular 2864, so-called ‘equity investment enterprises’ (EIEs) taking the form of a limited liability company, a company limited by shares or a partnership must register with central NDRC if capital commitments exceed RMB 500 million and the local NDRC if they fall below that level

45 | Foreign sponsored RMB Funds - Still worth the effort?

The CSRC is of crucial importance to the PE sector in numerous ways: The potential for overlapping oversight - the NDRC over funds and the CSRC over fund managers (if they eventually extend their purview to private equity fund managers) - raises the prospect of conflicts over jurisdiction, and the industry has sought for the NDRC and CSRC to agree on some degree of mutual exclusivity. This could, for example, involve the funds of CSRC fund managers being exempt from NDRC oversight. The industry has also proposed that the more onerous CSRC requirements governing mutual funds not be extended to private equity and that oversight be largely left in the hands of industry associations. Whether foreign sponsored funds might leverage the regulatory competition going forward to push for more equitable treatment might be one avenue open as matters develop. Special RMB fund regimes As noted above, the absence of a national level regulatory regime for private equity has left a space into which regional governments have moved, setting out tax, forex, and investment approval policies for funds establishing within their regions. However, flagship programs such as QFLP have run aground as a result of the NDRC ruling treating such funds as foreign invested. Nonetheless, this is not to say that other regional schemes will not emerge which may deal with some of the most pressing issues. Recently, much interest has been sparked by the RMB fund scheme planned as part of the new Qianhai Shenzhen-Hong Kong Modern Service Industry Cooperation Zone. This would allow for RMB raised in Hong Kong54 to be used to fund RMB funds in Qianhai for investment around China. While details of the scheme are emerging slowly, it is considered that if the scheme ultimately allows fund of funds to convert capital raised outside Hong Kong into RMB and invest into local funds then the scheme may have a significant impact. Some leading PE houses such as Blackstone and KKR have shown interest, and Hony Capital has indicated firm intentions to raise an RMB fund via the Qianhai programme. However, the impact of the scheme will depend to a great degree on whether the funds involved will be treated as foreign invested for sectoral restriction and investment approval purposes.

Chinese outbound investment Over the course of the last two years there has been an explosion in the number and size of outbound investments from China, in particular by the large SOEs in the energy and natural resources sectors. The latest figures from the first three quarters of 2012 alone show that the volume of outbound M&A surged to USD44.9 billion, up 73% from USD25.9 billion in the first three quarters of 2011. This trend is expected to strengthen significantly over coming years, and foreign PE fund managers may find a lucrative role in co-financing such investments. Given the accumulated experience and expertise of the international PE houses, they are well placed to assist Chinaâ&#x20AC;&#x2122;s outbound expansion. The success and expansion of the Qualified Domestic Institutional Investor programme shows the great demand that exists among Chinese investors for foreign securities market investments, and so there is clearly a deep seam of domestic LP money which foreign fund managers could tap in financing such outbound ventures. As noted above, however, domestic PE houses are quick to move into this space as well, for example the recently closed CITIC Private Equity USD fund, and will provide keen competition. The final word That foreign fund managers should want to be in the RMB fund space is clear from the progressive dominance of RMB funds over offshore funds and their potential for sustained future growth with the institutional LP money coming on stream. That the current regulatory environment stymies foreign sponsored funds at precisely the time that LPs are starting to look for more sophisticated investment strategies and higher levels of corporate governance is unfortunate to say the least. Whether national policy towards foreign sponsored funds is altered from the top, or whether the competition between rival national regulators will create an opportunity for foreign fund managers to have their case heard, or whether a regional incentive scheme for foreign sponsored RMB funds provides the in, it is hoped that foreign fund managers will be given the opportunity to re-enter the RMB fund space soon and make a mark at this crucial juncture in the development of the industry.

54 Per AVCJ, RMB deposits stood at RMB670 billion in May 2012 and are set to rise further

Foreign sponsored RMB Funds - Still worth the effort? | 46

Danny Le Partner in charge, IT Advisory Beijing Tel: +85 (10) 8508 7091 danny.le@kpmg.com

Thomas Chan Partner, Financial Services Beijing Tel: +86 (10) 8508 7014 thomas.chan@kpmg.com

Simon Gleave Regional Head, Financial Services KPMG Asia Pacific Tel: +86 (10) 8508 7007 simon.gleave@kpmg.com

Louis Ng Partner, Transaction services Beijing Tel: +85 (10) 8508 7090 louis.ng@kpmg.com

Edwina Li Partner, Financial Services Shanghai Tel: +86 (21) 2212 3806 edwina.li@kpmg.com

Egidio Zarrella Partner, Consulting KPMG China Tel: +852 2847 5197 Egidio.zarrella@kpmg.com

Theron Alldis Director, Transaction Services Hong Kong Tel: +852 2140 2270 Theron.alldis@kpmg.com

Eric Pang Partner, Financial Services Shanghai Tel: +86 (21) 2212 2480 eric.pang@kpmg.com

David Frey Partner, Consulting Beijing Tel: +86 (10) 8508 7039 david.frey@kpmg.com

Paul Ma Partner, Tax Beijing Tel: +86 (10) 8508 7076 paul.ma@kpmg.com

Ivan Li Partner, Financial Services Shenzhen Tel: +86 (755) 2547 1218 ivan.li@kpmg.com

Acknowledgements We would like to extend our appreciation to Danny Chung and Xinghua Fu of Zero2IPO, a leading Chinese VC/PE research organization, who provided much of the statistical information presented in this publication. We would also like to acknowledge the hard work of our key team members, in particular James Harte and for the guidance and comments from Jason Bedford. For any questions about the content of this report, please feel free to contact the authors of this report, John Gu, Paul Ma and Conrad Turley, at john.gu@kpmg.com, paul.ma@kpmg.com and conrad.turley@kpmg.com, respectively.

47 | Foreign sponsored RMB Funds - Still worth the effort?

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Foreign sponsored RMB Funds - Still worth the effort? | 48

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