How the Chinese government chooses to open up sectors of its financial industry will dictate the returns that investors may receive. Recent deregulation is beneficial because it affords Chinese investors an alternative avenue to invest savings, but significant hurdles remain before domestic private equity (PE) funds will be able to reinvest in domestic startups.
The Chinese government recently agreed to allow six United States and British hedge funds to raise $300 million in capital – $50 million each – from Chinese investors as part of a test “Qualified Domestic Limited Partner” (QDLP) program. ((Alexandra Stevenson, In Trial Program, Six Foreign Hedge Funds to Gain Foothold in China, N.Y. Times, Sept. 20, 2013, at B3.)) This represents another step in a broader movement towards deregulation and the opening of borders, which includes the much-anticipated announcement of a free-trade zone in the coming months. ((Id.)). QDLP is the last of four main cross-border investment programs that allow Chinese citizens to invest outside the country or foreigners to invest in domestic vehicles. ((Paul J Davies & Simon Rabinovitch, Shanghai Lines Up First Foreign Hedge Fund Entrants, Financial Times (Sept. 13, 2013, 6:00 AM), http://www.ft.com/cms/s/0/6848d56e-1c23-11e3-b678-00144feab7de.html#axzz2fxM7PqZ6.)) Allowing Chinese citizens to invest in foreign countries is expected to address several needs: 1) aging citizens, who are widely viewed as the “biggest population of savers,” are in need of varied wealth management products; 2) Chinese regulators are looking to encourage citizens to invest through regulated means rather than the estimated $6 trillion shadow banking industry; and 3) capital rich investors are looking for more lucrative investment opportunities than cash and bonds. ((See Stevenson, supra note 1.)) The new program will pave the way for Chinese cash to flow to abroad and “will give Chinese institutions access to alternative investment strategies, from short positions to arbitrage, which they have traditionally lacked.” ((Davies, supra note 3.))
Nevertheless, in the domestic sphere, Chinese venture capital (VC) and PE firms are experiencing difficulty in securing timely exits for their portfolio companies; standard investment norms dictate that money must be returned to investors within a five to seven year period. ((Richard Summerfield, Stagnant IPO Market Strangles Chinese Private Equity Exits, Financier Worldwide (Feb. 2013), http://www.financierworldwide.com/article.php?id=10245.)) But the Chinese government has frozen its IPO markets after discovering massive fraud within one IPO, Guangdong Xindadi Biotechnology. ((Peter Fuhrman, The China IPO Embargo: How and When IPOs May Resume, China First Capital (Sept. 13, 2013), http://www.chinafirstcapital.com/blog/archives/7339.)) The problem of limited exit opportunities is exacerbated because exits through trade sales or mergers and acquisitions are extremely rare in China and the market for secondary sales between PE firms has yet to develop. ((See Summerfield, supra note 6.)) The IPO closure has brought great stress to PE funds and their limited partners, resulting in over $130 billion of investor capital remaining locked in deals with little chance of exit before the PE funds hit their expiration date. ((Id.)) Approximately $22 billion of the locked-up capital is from 2200 deals that were completed before 2008. ((Id.)) Commentators have described the lack of IPO exit options as causing “a crisis within China’s PE industry,” causing over 7,500 PE-invested deals to wait for an exit. ((Fuhrman, supra note 7.))
It is not yet clear whether the government has intentionally chosen to open certain aspects of the industry while closely guarding others. Regardless of whether or not these two trends are orchestrated or accidental, all stakeholders – the government, fund managers, investors, and entrepreneurs – should take note of the impacts of pursuing the chosen path of deregulation. Ultimately, whether the chosen strategy is misguided or prudent depends upon the goals that the government hopes to achieve.
Allowing foreign hedge funds to raise capital from domestic citizens is a misguided strategy if the goal is to revitalize the internal PE markets. The $300 million that domestic investors can now commit to foreign hedge funds pales in comparison to the $130 billion that is currently inaccessible. On the other hand, however, the strategy is prudent if the goal is to placate internal investors, guiding them towards regulated investment vehicles, while the government takes a more deliberative approach to remodeling the regulatory infrastructure governing internal startups and PE funds. In either case, optimizing the startup financial industry will require a multifaceted solution that Chinese authorities have not publicized, or perhaps even drafted.
One industry member believes the current IPO crisis will abate within the next 12 months, which investors would of course welcome. ((See id.)) Nevertheless, the Chinese government and domestic PE funds may not be out of the water, especially if domestic investors are allowed to invest in overseas funds. Just because these investors can withdraw their money from existing deals does not mean that they will be eager to reinvest in domestic markets; they may remain fearful that another form of regulation or market closure will arise unexpectedly. That fear might prompt domestic investors to pursue investments with foreign funds that have access to reliable and active IPO markets. Absent regulatory compulsion, if the Chinese government is not careful when it allows investors to invest in foreign markets, they may not return.
There is an alternative story though. It may be the case that Chinese startups are too attractive to forgo. Despite the market closure, Chinese PE funds have raised over $30 billion in capital that they have yet to invest ((Id.)) This suggests that investors either have not been scared of the IPO market closure or that the risk of closure is a risk worth taking in light of the anticipated gains in open markets. The opportunity cost of forgoing domestic PE opportunities may be so high that it cannot be overcome by less risky international PE opportunities. This view is bolstered by the fact that China’s private companies continue to excel and outperform those everywhere else in the world. ((Id.)) Perhaps, however, domestic investors never had a choice with where to invest: the $30 billion was raised before investors were presented with the opportunity to move $300 million to foreign funds. Regardless, the allowable foreign investments would make up only 1% of the money that domestic funds raised. So even if Chinese investors wanted to invest overseas, they remain limited and will likely still invest comparable sums in the domestic market. The resolution to this question will take time. Those watching the market should ascertain the demand for the six chosen funds. If the waitlist is long, regulators might take longer to raise the existing cap.
Demand for QDLP will be a bellwether for how Chinese investors view foreign investment markets. In recent years, Chinese investors have shown a hesitancy to move their money abroad, which would speak to a probable limited involvement in QDLP. For example, analysts have suggested that many Chinese investors were burned during the implosion of overseas stock markets in 2008-2009, turning them off of foreign stocks. ((Man, Och-Ziff Among Hedge Funds to Get China Quota for Investment Overseas – Report, Reuters (Sept. 13, 2013), http://www.reuters.com/article/2013/09/13/china-qdlp-idUSL3N0H90W820130913.)) Notwithstanding investors’ prior disappointment, analysts suggest that investors have regained their confidence in foreign investments, becoming enthusiastic in overseas real estate. ((Id.)) Other indicators are less positive. For example, the Qualified Domestic Institutional Investor program (QDII), which gives local institutions quotas to invest outside of China in equities and fixed income products, has proven unpopular with Chinese investors, with much of the program’s existing quota going unused. ((See Davies, supra note 3; Man, Och-Ziff Among Hedge Funds to Get China Quota for Investment Overseas – Report, supra note 15.)) QDLP may be fundamentally different. Such is the view of hedge funds; a leading industry player indicated that everyone wanted to get in on QDLP. ((Stevenson, supra note 1.)) Are hedge funds misreading the demand or benefit of accessing Chinese investors? That is doubtful. Will Chinese investors treat QDLP differently than they did QDII? That is possible. How will QDLP interact with domestic IPO market reforms? That question remains open, but awareness of the potential impacts is likely to result in a well-tailored solution for all industry participants and stakeholders.