AN OVERVIEW OF PRIVATE EQUITY IN CHINA

UNCLAS SECTION 01 OF 04 BEIJING 003307 STATE FOR EEB IFD AND EAP/CM STATE PASS USTR FOR STRATFORD/WINELAND/WINTERS STATE PASS DEPT OF THE TREASURY FOR ISA NSC FOR SHRIER/TONG SENSITIVE SIPDIS E.O. 12958: N/A TAGS: ECON PREL PGOV TNDG CH SUBJECT: AN OVERVIEW OF PRIVATE EQUITY IN CHINA (U)THIS MESSAGE IS SENSITIVE BUT UNCLASSIFIED. PLEASE HANDLE ACCORDINGLY. NOT FOR INTERNET DISTRIBUTION ¶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 BEIJING 00003307 002.2 OF 004 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 BEIJING 00003307 003 OF 004 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 BEIJING 00003307 004 OF 004 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