New Ways Out for China’s PE Funds

New Ways Out for China’s PE Funds
2007-07-13   Caijing Magazine
Recently barred from the overseas initial public offerings that provided easy investment exits, China’s “homegrown” PE funds are ready to try IPOs on domestic exchanges.
By staff reporters Yu Ning and He Huafeng
China’s homegrown, private equity funds such as Hony Capital and D-Hui are abandoning overseas stock listings and turning to domestic markets for initial public offerings. The reason: Beijing regulators have effectively blocked their ability to exit investments through overseas IPOs.
Exiting a stock investment at the right time is a mainstay strategy for PE fund managers around the world, and China’s professional money movers are no exception.
Chinese funds have commonly used red chips – mainland enterprises whose shares trade on the Hong Kong exchange – to offload investments. Moreover, these PE funds are frequently registered in offshore centers such as Bermuda, Virgin Islands and the Caymans, making them “domestic” funds in name only.
But the red chip option ended, at least temporarily, last year when six government agencies, including the Ministry of Commerce and National Development and Reform Commission (NDRC), jointly issued a document restricting cross-border acquisitions. Since then, only one company out of dozens of applicants has been approved for an overseas listing through a cross-border deal.
A State Administration of Foreign Exchange (SAFE) official said the government intervened to stem tax losses connected to capital outflows. It also wanted to prevent shell companies registered outside China from buying the most valuable assets of companies at low prices.
Another factor influencing the decision is that China’s stock markets are thirsting for the IPOs that PE funds can generate.
Qi Bin, director of the China Securities Regulatory Commission (CSRC) research center, said the country’s lack of financial derivatives, such as real estate investment trusts, is pushing up demand for new IPOs. In addition, the tendency of large state-owned enterprises to hold a large portion of shares has led to a shortage of tradable stocks on domestic markets.
Regulators are currently eyeing changes to the country’s investment framework – changes that could make it easier for PE funds to offload assets through domestic stock deals.
“If China wants to establish a strong capital market, it has to enhance the comprehensive competitiveness of the market by further pushing ahead with mechanism and system reforms, and gradually loosening its policy,” Qi said.
In the eyes of regulators, PE-invested companies usually outperform other companies listed on mainland exchanges.
Wang Ou, a CSRC researcher, concluded that the domestic market’s main disadvantage is a shortage of listed companies with strong performance records. Therefore, policymakers are trying to persuade PEs to list their companies on domestic markets.
Nevertheless, many obstacles have stood in the way of PE funds’ efforts to exit investments listed on domestic markets. Their capital is both sourced and registered overseas, and regulators used to forbid trading in majority stakeholder shares before the 2005 market reform. PE managers preferred overseas IPOs to yield returns even higher than domestic listings.
In addition, Chinese rules are not foreign-investor friendly. For instance, the lock-up period in China is three years compared with an average six months required by mature, international markets.
Honey Chairman John Zhao does not consider the three-year lock-up period to be a serious issue. “We invest in good companies, and the longer we hold stocks, the more returns we will make,” he said. “However, it does not mean it’s unnecessary to shorten the lock-up period. It’s like building more exits along a highway: Drivers may choose to get off the highway whenever they want.”
Yet the three-year restriction prevents high-quality companies with strong potential from reaching domestic exchanges.
Sun said many private enterprises initially establish small affiliates for the sake of convenient business operations, and then consolidate before an IPO. But current laws regard a consolidation of affiliates as a merger and acquisition, which prevents individual companies from proving good performance for a three-year period.
Wu said the rule requiring three, continuous years of good business is a big challenge for PE funds, which specialize in accelerating enterprise growth.
For example, the Wuxi Suntech company would not have been allowed to launch its IPO if the current requirements were in place two years ago. Suntech lost money in 2002, posted a net profit of US＄ 18 million in 2004, and raised US＄ 400 million by listing on New York Stock Exchange in December 2005.
Taxation is another obstacle. According to Chinese tax law, a PE fund must pay a 20 percent tax on profits if it wants to exchange renminbis for dollars and wire the money abroad.
Some observers worry that international PE funds are discouraged by uncertain government policies and a lack of transparency in regulatory decision-making.
Nevertheless, homegrown PE investors are still itching to try listing companies on domestic markets.
Wu thinks PE’s hurdles are a normal part of the development process for an immature market. “PE funds should try as long as the framework of law allows,” he said. “Details could be resolved gradually.
“Enterprises need PE before going to IPOs because PE responds more quickly than the capital market,” Wu said. “If the market is really effective, PE will not have so many opportunities.”