PRC: PRIVATE EQUITY NEEDS FOREIGN INPUT BUT

C O N F I D E N T I A L SECTION 01 OF 02 BEIJING 003254

SIPDIS

STATE FOR EAP/CM, EAP/TC, EAP/EP, EEB/TPP/BTA
STATE PASS USTR FOR STRATFORD AND ALTBACH
TREASURY FOR OASIA/WINSHIP AND PISA
COMMERCE FOR ITA/MAC/AP

E.O. 12958: DECL: 12/06/2019
TAGS: CH EFIN EINV
SUBJECT: PRC: PRIVATE EQUITY NEEDS FOREIGN INPUT BUT
REGULATIONS STYMIE GROWTH

REF: (A) BEIJING 002952 (B) SHANGHAI 000410 (C)
SHANGHAI 000191

Classified By: Econ Minister Counselor William Weinstein. Reasons: 1.5
(b) and (d).


1. (C) SUMMARY: According to a host of industry experts,
foreign PE firms looking to invest in China have two major
concerns: 1) how to convert foreign currency into renminbi
(RMB) in order to invest in Chinese firms; 2) how to exit
from their investments to realize profits either in RMB or in
foreign currency. The firms had various approaches to work
around the various regulations that made currency conversion
difficult, but were mostly in agreement that the current
situation impeded foreign PE business and gave an unfair
advantage to domestic PE. This is the second in a series of
cables regarding China's nascent domestic Private Equity (PE)
industry, the opportunities and challenges facing foreign PE
firms in China, and Beijing's actions to shape the regulatory
landscape. EconOffs in October and November met with a
series of industry experts from both U.S. and Chinese private
equity firms to gauge their sense of foreign PE firms' place
within China's market and the country's current regulatory
landscape. They agreed that Beijing wanted to foster the
domestic private equity industry by using foreign firms'
expertise while simultaneously protecting Chinese firms from
foreign competition. END SUMMARY.

PUTTING MONEY IN IS TOUGH...


2. (SBU) Foreign PE firms looking to invest in Chinese small
and medium-sized companies as of late 2009 faced a number of
problems exchanging currency, according to a host of industry
experts. First, converting foreign currency into RMB
required a difficult and opaque approval process. For
instance, one investor with a small U.S. PE firm told us he
could not compete with domestic funds, which could transfer
capital to a Chinese company "immediately." The U.S. firm,
on the other hand, was required to comply with Circular 142,
which requires foreign-funded firms to get approval from the
State Administration for Foreign Exchange (SAFE) for each
specific deal before converting any funds into RMB. This
regulation, although ostensibly designed to curb "hot money
inflows," in effect acted to protect China's domestic
industry from foreign competition.


3. (SBU) Chinese PE firm Hony Capital CEO John Zhao, on the
other hand, told Econoffs on November 4 that Circular 142 has
not affected his business at all, despite the fact that he
gets much of his funding from overseas. He said he simply
applies for, and receives, regulatory approval or waivers for
his currency conversions. (Comment: U.S. firms unanimously
put currency conversion on the top of their complaint list,
suggesting that the ease with which the Chinese firm Hony
Capital exchanged currency was unusual. The different
experiences may indicate favoritism toward Chinese firms on
the part of regulators. End Comment.)


4. (SBU) Carlyle's Hong Kong-based Director Eric Zhang on
November 10 told EconOffs he was concerned that the China
Partnership Law, which says that only domestic entities can
sponsor a partnership, would result in higher taxes for
Carlyle. Because foreign firms required a wholly
foreign-owned enterprise (WFOE) to be the General Partner
sponsor, they would be subject to the relatively high tax
regime imposed by WFOE regulations. Carlyle was also
concerned that the difficulty in converting foreign currency
into RMB would pose problems in making the standard one to
three percent of the fund available to the general partner as
a salary.


5. (SBU) Second, large foreign PE firms such as Carlyle, KKR,
and Blackstone increasingly sought to raise RMB funds within
China, which would allow them to access China's rising stocks
of wealth and circumvent Circular 142 restrictions. Beijing
historically has prevented foreign firms from raising RMB
funds, but the August 2009 draft foreign-invested partnership
(FIP) regulations could allow foreign investors to both raise
RMB funds and contribute RMB to Chinese funds, according to
industry experts. The new regulation, however, would still

BEIJING 00003254 002 OF 002


require foreign firms to obtain MOFCOM's approval for each
deal, and probably would not loosen sectorial investment
restrictions listed in the Foreign Investment Catalogue.
Moreover, Carlyle's Eric Zhang told EconOffs that allowing
foreign funds to contribute to a master RMB fund as a limited
partner was "a bit difficult," given the upward pressure on
the RMB in the last few months.

...AND SO IS GETTING IT OUT


6. (SBU) In the same vein, foreign firms increasingly sought
to exit from their investments by listing their companies in
Chinese securities markets. Some firms were attracted to the
relative regulatory ease of remaining in China for the last
phase of the business cycle, while others believed that
China's rising wealth would lead to better profit margins on
the Mainland than offshore, according to a contact working at
a small U.S. PE firm. This strategy, however, only delayed
the inevitable hassle of converting the RMB sale profits into
USD, which required SAFE's approval.


7. (SBU) A possible liberalization might come from the China
Securities Regulatory Commission (CSRC),which in mid-October
took comments on its draft Measures for the Administration of
Securities Registration and Clearing for comments. The new
regulations might allow PE firms to open securities accounts,
according to the U.S. Chamber of Commerce. This could ease
foreign firms' sale of stock in Chinese markets, but CSRC has
not yet indicated what any new draft might look like, and the
historical lack of transparency with which agencies have
applied regulations give us an unclear picture of how the new
rules might be interpreted.

OTHER REGULATIONS MUDDY THE WATERS


8. (SBU) The National Development and Reform Commission
(NDRC)'s draft PE Fund Regulations, which were submitted to
the State Council in August 2009, were likely to apply to
both foreign and domestic funds and could require all funds
formed within China--including foreign RMB funds--to file
with NDRC. Carlyle's Zhang said that one of his company's
biggest concerns was that the new regulations would give NDRC
increased regulatory power over foreign firms. However, NDRC
had not yet published its draft and would not meet with
EconOffs to discuss its proposal.

PE COPING MECHANISMS: GETTING ALONG BY HOOK OR BY CROOK


9. (C) PE funds have developed a number of methods to
decrease the time and money spent on seeking regulatory
approval to convert currency and invest in Chinese firms.
For instance, Hony Capital's John Zhao noted that his company
has conducted all of its business legally but that it often
had to receive exceptions to the rules on the books in order
to put together deals. Zhao appeared confident that his firm
would continue to prosper within the changing regulatory
environment because PRC regulators realize that the domestic
industry needs people who understand both the PE industry and
domestic Chinese businesses.


10. (C) Similarly, foreign PE firm Vice President Wang
Wenyong on November 27 told EconOffs that circumventing the
rules was easy. His PE firm would loan U.S. dollars to a
U.S. bank branch located outside China. In turn the bank's
mainland branch would loan his firm the RMB equivalent. When
applying to SAFE for approval to invest in a Chinese firm,
SAFE wanted to know where the firm had gotten its RMB funds.
The PE firm could then accurately tell SAFE it had received
its RMB from a bank loan rather than a currency exchange.


11. (C) Regarding anti-monopoly regulations, Carlyle's Zhang
said that his firm only files anti-monopoly paperwork when
specifically told to by Chinese regulators, despite being
encouraged to file for every investment. "It just causes too
many headaches and we'd never get anything approved,"
according to Zhang.
HUNTSMAN