China's Homegrown Private Equity

New tax laws and a little help from the government in Beijing are giving domestic private equity firms a big boost against foreign players

Ray Bartkus

By Frederik Balfour

Hong Kong - The barbarians, it seems, have arrived at the Great Wall—and now they're coming from both sides. In China the top players in private equity—the proverbial barbarians at the gate—have been Carlyle, TPG, Warburg Pincus, and other foreigners. But lately those global heavyweights have had to contend with increasing numbers of homegrown rivals. "Local competition is our biggest challenge," says Wayne Tsou, head of Carlyle Asia Growth Partners.

Last year, $4.3 billion worth of domestic private equity capital was raised in the mainland's currency, the yuan, nearly five times the 2006 level. This year that will likely reach $6 billion, and domestic cash now represents almost half of all private equity money in China, according to the Center for Asia Private Equity Research, a Hong Kong consultant.

The domestic industry has gotten a boost from a change in rules that had hobbled yuan private equity funds. Until late 2007 they were subject to double taxation: corporate taxes on the fund itself plus personal income taxes on investors. Today investors pay only the personal tax, in keeping with international practice. "Now there's a level playing field that has encouraged yuan funds," says Matthew Phillips, a partner at PricewaterhouseCoopers in Shanghai. Since the change, 19 funds denominated in yuan have opened.

In China the distinction between private equity and venture capital is blurry. Complete takeovers, where private equity firms strip and restructure companies, are rare. Instead they typically provide capital and expertise in advance of a listing and have shepherded several companies to successful public offerings. Beijing-based CDH Investments was an early investor in Mengniu Dairy and sportswear maker Li Ning, and crosstown rival Hony Capital backed New York-listed Simcere Pharmaceutical Group (SCR), a generic drugmaker based in Nanjing.

Beijing has long sought to foster a domestic private equity industry. The leadership hopes the firms will help boost returns at big money managers such as the national pension fund and state-backed insurance companies. These new players have an advantage over foreign predators when it comes to the sale of state assets. A year ago, for instance, Washington-based Carlyle Group abandoned an attempt to buy a stake in heavy-equipment maker Xugong Construction Machinery after a nationalist outcry and bureaucratic stalling. "Investee companies prefer dealing with local instead of foreign faces," says Richard Guo, a private equity specialist at Beijing law firm Fangda Partners.

In fact, the government often has a hand in the domestic funds. China Investment Corp., the mainland's sovereign wealth fund, is paying some $250 million for a 40% stake in Citic Capital, a financial powerhouse in Hong Kong with a big private equity arm. And the city of Tianjin sponsors the Bohai Fund, which has raised $880 million from local companies. Bohai's first investment: $200 million for 20% of Tianjin Pipe, a local state-owned manufacturer of steel tubing for pipelines. State-linked funds "come with strings attached," as backers meddle in investment decisions, says Stuart Schonberger, a managing director at CDH, which has both dollar- and yuan-denominated funds that invest exclusively in the mainland.

But China has also spawned independent funds that are run much like their international counterparts. These are often fronted by Chinese with close ties to both Wall Street and Beijing. Former Goldman Sachs (GS) rainmaker Fang Fenglei, for instance, in 2007 founded Hopu Investment Management. In May the firm led a group of investors who bought 5.8% of China Construction Bank from Bank of America (BAC) for $4.4 billion. And CDH Investments is headed by Jiao Zhen, a veteran of China International Capital Corp., a Morgan Stanley (MS) joint venture in Beijing.

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