China takes on private equity at their own game

- Beijing is encouraging domestic equity funds to supplant global private equity titans such as Carlyle (CYL.UL: Quote, Profile, Research) on Chinese turf, but their small size and lack of experience mean it will be years before they threaten their international rivals.

The government has stepped up its efforts to bolster home-grown private equity by allowing yuan currency fund-raising, erecting hurdles for foreign rivals and encouraging IPOs on domestic markets.

Foreign private equity funds, while not quaking in their boots, see the writing on the wall.

"Our greatest competition will not be from one another but will be the indigenous Chinese private equity firms," David Rubenstein, co-founder and managing director of The Carlyle Group told a recent conference in Hong Kong.

A pilot for Beijing's private equity ambitions is Bohai Industrial Investment Fund, controlled by Bank of China (601988.SS: Quote, Profile, Research)(3988.HK: Quote, Profile, Research), which is amassing a war chest of 20 billion yuan ($2.7 billion).

Bohai is run by Au Ngai, a former dealmaker at U.S. fund TPG (TPG.UL: Quote, Profile, Research) which has $40 billion under management. His new fund recently bought a stake in Tianjin Pipe Group and is expected to buy 10 percent of Chengdu City Commercial Bank, sources have said.

Other funds will follow. Last month China gave the go ahead for five new Chinese industrial investment funds to raise 56 billion yuan ($7.5 billion).

There are already a proliferation of hybrid firms; founded by Chinese nationals, head-quartered in China but with foreign investors, such as the up and coming CDH China Management and Hony Capital.

Private equity firms founded by Chinese nationals signed about a fifth of all the deals done by funds in China so far this year, according to HK-based research house AVCJ based on data related to 68 local firms and 846 foreign private equity firms.

Total investment by funds in China has hit $9.7 billion in 2007 to date AVCJ said, a fraction of the volume seen in Europe and the United States but growing.

Keeping it Chinese will give the government more control over capital flows in and out of the country and spur the development of its financial markets.

China's belief in private equity was underscored this year when its new $200 billion sovereign wealth fund invested $3 billion in the initial public offering of U.S. buyout heavyweight Blackstone Group (BX.N: Quote, Profile, Research).

MADE IN CHINA

China has been looking for ways to divert cash away from its overheating real estate and stock markets, so this year Beijing made it easier for Chinese to invest in private equity.

Chinese yuan-based funds do not need central government approval for deals, a significant advantage when foreign funds such as Carlyle have seen purchases slowed or derailed during the approval process.

Global firms have shown interest in forming yuan funds. But difficulties ensuring equal tax treatment for investors across funds with different currencies means it may take some time before this becomes practical.

M&A is also becoming tricky. Traditionally, foreign funds and Chinese entrepreneurs have set up offshore investment vehicles to buy domestic companies and then floated them abroad.

But the Chinese government, keen for companies to list at home in order to add depth to its markets and plug the leak of tax dollars, has been slowly barring that route with regulations.

Entrepreneurs, fed up with waiting for foreign funds to gain regulatory approval and worried the investment cycle might turn, are talking more to home-grown teams in the hope of speedy deals.

"It may be more convenient for a company to accept investment from a local fund because the approval process is much, much simpler," said Maurice Hoo of law firm Paul Hastings, referring to yuan funds making investments in approved sectors.

Chinese funds have remained relatively small and had patchy success to date, limiting their global reach.

It was U.S. buyout firm Bain Capital, for example, that joined with China's Huawei Technologies (HWT.UL: Quote, Profile, Research) to bid $2.2 billion in September for U.S. network gear maker 3Com (COMS.O: Quote, Profile, Research).

"Not surprisingly, local funds' advantages are proprietary contacts, government relationships and the ability to value Chinese companies more accurately," said David Eich, a partner at law firm Kirkland & Ellis.

"However, the most complex transactions require lots and lots of experience and resources and the local funds aren't there yet."

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