Ask any offshore investor in China's private equity industry to name a key gripe and they are likely to say conflict of interest with RMB-denominated funds.
As China’s RMB-denominated private equity fund industry has grown, so too has the seriousness of the issue. Formerly an industry that largely consisted of USD-denominated funds managed by a few locally based GPs, the amendment of China’s Partnership Enterprise Law in 2007 to allow domestic investors to establish limited liability partnerships saw the creation of a local investor base.
The first port of call for China’s new breed of heavyweight LPs, like the country’s National Social Security Fund (NSSF), was those managers which already had a strong brand reputation based on their USD funds. But as they and other firms went about raising – and then starting to invest – RMB funds from this new pool of domestic money, existing offshore LPs began to feel increasingly marginalised.
In a country which has one (very strict) rule for the investment of foreign money, and another (much laxer) one for local money, it is not hard to see how conflict can arise. But the LP Association of China (LAPCN), which was formed three years ago by LPs such as Pantheon Ventures and Adam Street, with support from China-based private equity research organisation Zero2IPO, has identified four principle areas where conflicts of interest have arisen.
In a white paper written earlier this year for LPACN members, Vincent Huang, a Hong Kong-based partner at Pantheon, highlighted the first and foremost of these as deal allocation.
“GPs who manage both USD and RMB funds often claim that because RMB funds can invest in industries prohibited or restricted to foreign investors, there is little opportunity for conflict to arise,” he wrote. “However, in reality such investments only account for a small portion of total deal flow seen in the market.”
What does differ greatly though is the approval processes each fund must go through to close a deal: while the USD fund has to seek approval at various levels of government, often incurring lengthy delays, investments from RMB funds are generally waved through comparatively quickly. In practice, this has meant that foreign LPs have ended up watching parallel RMB-denominated vehicles make deal after attractive deal, while the sister USD-denominated fund they committed to lies largely idle.
Worse still, given the opacity of investment in China, LPs feel they have no way of really knowing how much manager discretion is playing a role in the allocation process.
“GPs say if it’s a restricted industry then we’ll use RMB – ok I’ll buy that. Or they’ll say the entrepreneur only wants RMB – but how do you know for sure? You have to take the GP’s word for it – it’s not practical for LPs to be checking up on every deal. So you always wonder… maybe that deal could have been done in USD?” explains Jason Zhang, a Beijing-based managing director at Morgan Creek Capital Management, which is also a member of the LPACN.
“Communications with offshore fund LPs can easily become more difficult when sponsors start exercising discretion, regardless of whether there is a seemingly bright-line rule for allocating investment opportunities,” adds John Fadely, a Hong Kong-based partner at law firm Weil, Gotshal & Manges. “For example, an RMB fund that has priority to invest in all deals below a certain value may sound like an objective standard, but often deal size can be influenced by the sponsor at the margins.”
With levels of trust between LP and GP already under strain a second – related – area of conflict arises in resource allocation.
“RMB deals are getting done for sure – and if there are a lot of RMB deals getting done then investment teams must be spending a lot of time on them,” states Zhang.
What foreign investors wonder, however, is how much time is being spent on the management of the USD vehicle. They also question how practical it is for the same small investment team, which used to focus solely on the management of sequential USD vehicles, to then take on a separate vehicle with a different portfolio and fundraising schedule.
The (mis-)timing of successor funds is a third area of conflict in itself, as Huang points out in the white paper: “To avoid the potential for conflict that arises when subsequent funds are raised during the investment period of a fund, GPs typically are required to deploy a substantial majority of committed capital in a fund. However, LP Agreements are often silent with regard to raising funds in a different currency.”
The fourth key area of conflict is that of economic incentives. One clash of interests here is caused simply by scale: as the pool of potential RMB LPs grows in China, so do the opportunities for RMB-denominated funds – and thus management fees – to outgrow their USD counterparts.
When you add to that the fact that, with the deal flow advantage the RMB funds have, it is more likely that those vehicles will generate higher and quicker returns – and therefore carry for the GPs – it is obvious the odds are stacked in favour of the RMB funds.
“If all of a sudden you are getting more management fees and potentially more carry from your RMB fund, then naturally you will want to spend more time on it – it’s a human alignment of interests,” states Zhang.
Given the discrepancies, it is not hard to see why foreign LP/GP relationships at some China-focused funds are under strain.
For those funds already raised and in the investment phase there is little that can be done and certainly no legal recourse that can be taken: the only big gun LPs can pull out is the threat not to re-up on the next fund.
However, that solution is unlikely to be satisfying to either party. The ultimate solution of course would be for the government to scrap Circular 142, a 2008 law from the State Administration of Foreign Exchange which restricts the conversion of foreign currency for the purposes of investment, allowing foreign and domestic LPs alike to invest into the same fund.
Expectations were raised that a partial solution of this kind was a step closer in March this year when sources close to the Shanghai government announced a pilot scheme to allow the conversion of up to 50 percent of an RMB fund's value from foreign currency. However, the announcement – which pre-empted central government approval for such a scheme – proved premature; no such approval was forthcoming and the scheme died a quiet death.
That is not to say hopes have been dashed that a Qualified Foreign Limited Partner (QFLP) scheme of some kind will one day prove the answer – in fact, this is one of the things the LPACN has been pushing for as it speaks with various government entities on the problems around conflict of interest.
The idea behind a QFLP programme would be similar to that behind the Qualified Foreign Institutional Investor scheme already in existence, which allows approved foreign investors access to Chinese equities. While it seems certain the government will one day introduce a QFLP scheme, it is impossible to even begin to predict when this might be. And with a government reshuffle coming in two years’ time, some voice skepticism that QFLP will be seen before that.
With concession at the government level unlikely for now, LPs and GPs are looking to other ways to fix the problem. For new funds being raised, the convertibility issue has become one of the key areas of focus in the drafting of Limited Partnership Agreements, as LPs, GPs and fund formation lawyers try to use fancy legal footwork to level the playing field as much as possible between parallel USD and RMB vehicles (see ‘Leveling the playing field at the fund formation stage’).
In February’s white paper, the LPACN also proposed several mitigating strategies that can be employed by GPs to ease (concerns of) conflict. These include ensuring investments are allocated to both funds on a pro-rata basis as far as possible; full disclosure to the advisory boards of both funds when this does not happen; independent investment teams for the two funds; matching time horizons for USD and RMB funds; and putting the same terms and conditions in place on both funds.
However, in pushing for greater accountability, LPs have to rely on the willingness of the GP in question to do this in the interests of maintaining a good, long-term relationship with foreign investors. This may not always be the case – after all, right now it is easy (much easier in fact) to raise money from local investors and they are typically more flexible on terms and conditions too.
However, most LPs remain confident the more established China-based GPs value the presence of a generally more sophisticated Western LP base.
“Having a diversified LP base is in the long-run good for their business. And the domestic LP community is still very new and doesn’t have a lot of experience. There is recognition they could learn something from USD investors,” says Morgan Creek’s Zhang.
In fact, this was one of the reasons behind the creation of the LPACN, which as Pantheon’s Huang notes was “designed to be a platform for communications among all the LPs which are investing in PE funds in China”.
For their part, USD investors acknowledge that the growth of China’s RMB industry is not only unstoppable, but natural.
“For all these years, private equity in China has meant Chinese GPs managing USD funds,” reflects Huang. “We have to wake up to the reality that the RMB funding source is the future in China and returns from RMB funds are likely to be better in the near future. We cannot change this; we can at best try to align interests with the GPs.”
Leveling the playing field at the fund formation stage
With conflict of interest such a prime concern for offshore LPs, it is no wonder it is uppermost in discussions between lawyers, LPs and GPs when new China-focused private equity funds are formed.
It is also where fund formation law is likely to see the greatest level of innovation in Asia as – rather than wait for the Chinese government to ease restrictions on foreign capital – it attempts to swerve and dodge its way through the uneven regulatory landscape and level the playing field for both domestic and offshore investors.
Step one for any China-based GP, says Dean Collins, a partner in the Singapore office of O’Melveny & Myers and head of its Asian funds practice, is to decide on the philosophical approach they want to take towards their USD and RMB pools.
“We are working with a couple of large Chinese funds involving significant RMB commitments. The main philosophical question facing those funds is: are we going to treat this as one fund?” he says.
For those clients that answer yes, the challenge then lies in structuring the Limited Partnership Agreement to best facilitate this given that the issue of conflict – and its prevention – is new and is only just beginning to manifest itself into fund terms.
In the absence of any set precedent, Collins says OMM for one has so far come up with a list of about 20 elements that could be applied to fund terms to reduce the scope for the offshore LPs to be mistreated. He predicts: “On a commercial level, the type of mechanisms being discussed will become market norms.”
Amongst these elements, one mitigating approach that can be taken is that in the event an onshore fund is drawn down by a particular percentage more than the offshore fund, investors are given the option to end the fund, says Collins. A second is that at the point at which the onshore fund is fully invested, the management fee on the offshore fund would also step down, creating an alignment of interest between the two vehicles.
“We have actually developed some practical technology to let both funds profit share. If you combine several of these together, the two funds start to become more like one fund,” adds Larry Sussman, OMM partner and head of the firm’s Beijing office.
Of course, all of this depends on the willingness of GPs and LPs to meet in the middle on some things, but as Collins puts it: “Conflict is there to be navigated and we’re having that conversation on both the GP and LP side of the divide.”