Cablegate: An Overview of Private Equity in China

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P 270339Z AUG 08
FM AMEMBASSY BEIJING
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E.O. 12958: N/A
TAGS: ECON PREL PGOV TNDG CH
SUBJECT: AN OVERVIEW OF PRIVATE EQUITY IN CHINA

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1. (SBU) SUMMARY: Private equity finance is a useful tool for
China's transforming
economy, as private entrepreneurs and small business continue to
have difficultly
accessing financing from the bank dominated financial sector and
capital markets.
Moreover, in a tightening credit market and a bear stock market,
Chinese businesses are
looking more to private equity firms to raise capital in 2008. A
survey of foreign firms
shows most are profitable, but they share concerns about
restrictions on equity
investment. END SUMMARY.

Government Mandated Funds -- "Private Equity" in Name Only
--------------------------------------------- ----------

2. (U) Previous Embassy reporting has addressed the Chinese
government's interest in
regulating private equity finance. The current policy environment
has an inhibitive
influence on any type of private equity involving foreign
transactions. Chinese laws,
regulations and procedures restrict mergers (M&A), offshore
enterprise formation and
stock listings and capital account transactions. In addition,
private investment is
restricted in some sectors, and foreign investment, including by PE
firms, is restricted in
other sectors. It was therefore a subject of some interest when the
National Development
and Reform Commission (NDRC) gave approval for the city of Tianjin
to introduce
special administrative policies on its own version of "private
equity," resulting in the
Bohai Industrial Development Fund in 2006.

3. (SBU) The Bohai fund was conceived as a government-sponsored
private equity fund,
and it was mandated to invest half of its funds in Tianjin's special
economic zone.
NDRC officials responsible for its creation noted that it was
different from traditional
private equity because it did not target a specific exit route or
term, whereas most private
equity funds have a lifecycle under 10 years. This appealed to
regulators, who favor
stability.

4. (SBU) Industry insiders revealed that at the end of July,
Bohai's CEO Ao Wei resigned
from his position due to his inability to work under government
constraints, a fact that
has not been made public. Bohai explicitly targets state-owned
enterprises, and much of
its capital is pension monies from China's Ministry of Civil Affairs
(MOCA).
COMMENT: The Bohai model is -- in effect -- only a few steps removed
from the
traditional channels used to finance state-owned enterprises. END
COMMENT.

Private Equity Firms with Close Government Partnerships
--------------------------------------------- ----------

5. (SBU) Nevertheless, many financially successful and
strategically competitive private
equity funds in China are ones that have formed close partnerships
with the Chinese
government. An example of this model is an American company,
International Data
Group Venture Capital (IDGVC). Founder of IDG, Patrick J. McGovern,
has 30 years of
experience in China and set up IDGVC in 1993. In 1998 he met with
President Jiang
Zemin after signing a special $1 billion investment deal with the
Ministry of Science and
Technology (MOST). Embassy Officers met Hugo Shong, the executive
vice president

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of IDG.

6. (SBU) IDGVC's venture capital strategy is to acquire and take
public small information
service companies that have a decent business concept and a superior
marketing team.
Examples of its portfolio include directory services, transaction
security, ticketing
services and digital mapping. Because IDGVC entered the market
early and with
government sanction, it was able to invest on the peripheries of
industries that are now
restricted, including telecom messaging.

7. (SBU) In IDGVC's business area, MOFCOM is the main regulator and
defines the
company's scope of business, but IDGVC does not need to obtain
approvals for
individual investments. IDGVC formed a special professional
association, the China
Venture Capital Association, as a platform to engage high level
Chinese government
officials. The association includes 130 financial executives and
hosts dialogues with the
government. Shong boasted that the platform was used to obtain
favorable revision of
SAFE Circular no. 11 (which was replaced by Circular 75). IDGVC
also has very close
relations to MOST and it has more experience than most companies
with regard to
government involvement in venture capital.

8. (SBU) According to Shong, MOST and the Ministry the Education
(MOE) control many
investment deals and have an interest in channeling money into
government projects.
Shong criticized MOST and MOE for corruption and opined that working
with them on
innovation policy is a waste of time. Shong added that China's many
?technology parks?
are vehicles for the government to exploit real-estate deals.
Second, the companies
attracted to technology parks often ride on the back of MOST
contracts and local
subsidies, without ever generating revenue. IDGVC has tried to
refocus on companies
not affiliated with government-sponsored technology projects. Even
in the absence of
corruption, a limited partnership (LP) with the government is
problematic because
changing government leadership results in re-interpretations of
contracts.

9. (SBU) IDGVC cites SAFE Circular no. 75 as the largest regulatory
obstacle to its
operations. This regulation, which restricts Chinese businesses'
use of offshore foreign
equity, requires the disclosure of any offshore transaction details
at SAFE and also a
MOFCOM approval. In addition, Circular No. 10 (on Acquisition and
Merger of
Domestic Enterprises by Foreign Investors) has, since its
introduction, effectively frozen
approvals of off-shore special purpose vehicles that foreign private
equity firms have
used to exit their investment through IPOs in foreign stock markets.
[Comment: In
addition, the CSRC has exerted moral suasion on Chinese firms to
limit listings in
overseas markets. CSRC officials have indicated that this is likely
to intensify later this
year when China launches its Growth Enterprise Market for listings
of SMEs.] All of this
limits the strategic options of private equity firms and limits the
capital they can raise.

10. (SBU) A second problem is China's parochial approach to
creating the right policy
environment. Shong cited the NDRC's decision to designate Tianjin
as a special zone for
private equity. This was largely due to the influence of Dai
Xianglong, the former
governor of the People's Bank of China, who became the mayor of
Tianjin. Tianjin has

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never been a center for private equity, say insiders, and the
decision looks like
parochialism. Financial interest groups have been vocal in
demanding similar policies
for other regions in China.

Private Equity Firms with Arm's Length Government Partnerships
--------------------------------------------- ----------

11. (SBU) Among the private equity funds that operate at an arm's
length from government,
large ones are an exception. Embassy officers recently met with a
smaller firm more
representative of trends. Small companies are able to find a
comfortable arms-length
relationship with the government, because they deal in smaller sums
and with local
government.

12. (SBU) DT Capital informed Embassy officers that there are
challenges for small firms,
but also an equal potential for profit. Established in 2000, DT is
a recent entrant to
China's private equity market and was founded by an American
citizen. DT Capital is
closely affiliated with Madrone Capital in the US, an investment
entity for the Walton
family. The fund targets manufacturing, alternative energy,
commodities and retail, and
has both U.S. dollar and RMB-denominated funds with life cycles of
10 years. DT has
found a partner in the China Development Bank (CDB) and Suzhou city
government in
Jiangsu Province. It manages CDB money that was loaned to the local
commerce
department in Suzhou, and from this partnership DT gains leverage,
while Suzhou gains
expertise. Nevertheless, government fund represent only a fraction
of DT's portfolio, and
the company hopes to preserve this status quo in order to limit
government interference in
its business.

13. (SBU) DT Capital's strategy is to partner with local
governments and smaller provincial-
level companies. This enables the company to avoid the requirement
for approvals that
would be required in large transactions or in more regulated markets
such as Beijing or
Shanghai. The company's tactic is to hold an investment for 5
years, and preferably, to
take a company public. In the past, DT's preferred vehicle was to
set up an offshore
"BVI" company and then use it to buy a Chinese company under China's
"Wholly
Foreign-Owned Enterprise" (WFOE) law. The offshore BVI company
would then go
public on a foreign market. This practice was effectively banned by
SAFE Circulars no.
75 and 10. The procedures and approvals required under these
regulations are a long and
drawn out process even in the best circumstances.

14. (SBU) Under the new rules in Circular no. 75, it is no longer
practical to use the WFOE
vehicle for private equity investments and foreign IPOs. Instead,
private equity firms are
confined to joint venture partnerships, which have no stock options.
Under this
arrangement, under current practices, foreign listing is essentially
banned, while the
process for a domestic listing often takes a year. Foreign listings
that are occurring now
are mostly for companies that applied prior to the enactment of
Circulars 10 and 75. DT
Capital has not made any major transactions in 2008, due in part to
the domestic stock
market slump and the inability to list on foreign markets.

Private Equity -- Status in Summary
-----------------------------------
15. (SBU) COMMENT: The Chinese government has only started to focus
on private equity

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last few years, hence the introduction of the Bohai Fund, followed
by similar funds
created by China International Capital Corporation (CICC) and CITIC
bank. Restrictions
on foreign private equity have the effect of slowing foreign private
investment in China.
Industry insiders are most unhappy with the restrictions on foreign
stock listings and the
length of time required to obtain permission for a domestic listing.
They are unhappy
with central government (e.g. MOST) as an intermediary for brokering
or channeling
deals. They are also conflicted about parochial policies (e.g.
Tianjin), but happy to work
at the local level, so long as there are opportunities to be had.
As China's capital markets
develop and businesses depend less on foreign investment, fears
remain that more
restrictions could be applied at the local level. END COMMENT

RANDT

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