China Rolls out Red Carpet for Private Equity

When Carlyle Group, the US private equity firm, unveiled what would have been the first direct foreign buy-out of a state-owned Chinese enterprise the reaction in Beijing was not quite what they had hoped.

Whispers that the government was selling state assets on the cheap to rapacious foreigners started immediately.

The transaction was compared with controversial Asian private equity deals, like the JC Flowers buy-out of Shinsei Bank in Japan and Lone Star's purchase of Korea Exchange Bank.

As in many other Asian markets, China viewed large international private equity firms with deep suspicion and blamed them for all sorts of evil deeds in the global economy.

So after three years of tortuous negotiations and stalling by the government, Carlyle's attempt to buy state-owned Xugong Construction Machinery, one of the world's largest makers of cranes, finally fell apart in mid-2008.

Fast-forward two years and private equity has become the darling of the Chinese government with funds like Carlyle, Blackstone and TPG ushered into the market to set up local currency funds and rapidly expand their investments.

In the coming months the government is set to hand the cities of Beijing and Shanghai quotas of up to $3bn each to allow private equity firms to bypass the country's strict currency and investment controls and put offshore money into their new renminbi-denominated funds.

More importantly, the quotas will allow them to put global investors' money to work in a wider range of domestic industries and to repatriate their profits when they finally exit their investments.

Some in the industry say the more welcoming attitude towards foreign private equity funds is part of a shift in China's macroeconomic policy priorities.

Just a few years ago, Beijing was most interested in attracting foreign industrial companies to set up joint ventures that created jobs and accelerated the country's industrialisation, and it shunned purely "financial investors" like private equity funds.

But in the past year or so, industrial giants like Siemens, BASF and General Electric have publicly complained of feeling much less welcome in the country, while investment firms including Carlyle have seen the red carpet rolled out.

Policymakers appear to feel the country no longer needs so much new foreign capital investment and would prefer its pillars of industry to be controlled by domestic enterprises instead of multinationals headquartered elsewhere.

Meanwhile, the traditional private equity model of investing in a company, improving its management, introducing new technologies and then selling at a profit for others to run has become much more attractive to Beijing.[Page]

"A three-to-five-year investment is relatively long in the private equity world so we're quite transitory," says David Rubenstein, Carlyle co-founder. "The Chinese government also recognizes how we can help local companies acquire western competitors and technologies and that's something they're very interested in. GE is not teaching people in China to buy companies in the west like we are."

Analysts and industry participants say the about-face has also been driven by the desire to develop a domestic private equity industry to promote better allocation of capital.

By allowing the big international players into the market, Beijing hopes to introduce international best practices and develop tougher local competitors.

So far it appears to be working, with as many as 400 domestic funds set up in the past three years, according to Ying White, head of the China investment funds practice at law firm Akin Gump.

China Venture, the consultancy, estimated China-focused private equity funds raised more than $15bn in the first three quarters this year. That figure is expected to increase rapidly as more funds are set up and new sources of capital come online.

The government is drafting regulations that will allow China's large insurance companies to invest up to 5 per cent of their assets in private equity, potentially adding more than Rmb220bn ($33bn) to the funds available to private equity managers.

But in spite of the rush of new fundraisings from domestic and international players, the Chinese private equity industry remains in its infancy. By the end of last year private equity investment as a percentage of gross domestic product in China was 0.27 per cent, compared with 0.61 per cent in India, 1.42 per cent in the US and 1.06 per cent in the UK, according to Carlyle.

That is partly why the Chinese market today "is more favourable for private equity capital than most other markets," Mr Rubenstein says. "More favourable even than the US."