Firms eye U.S. IPOs for China-based companies

Several large U.S. private equity managers are hot on China, but getting money out of their investments is challenging.

That's why investment managers are predicting that private equity firms will increasingly return to issuing initial public offerings on China-based portfolio companies in the United States, an exit strategy popular a few years ago.

The number of China-based companies ready to go public in the U.S. is climbing. In the third quarter, 16 companies filed, compared with eight in the second quarter and 14 in the first three quarters of last year, according to an analysis for Pensions & Investments by Ernst & Young. Four that filed for IPOs in the third quarter were either private equity- or venture capital-backed companies, as were two of the eight that filed in the second quarter, according to Ernst & Young data.

Exits are key in China, where opportunity for private equity is tremendous but execution of the investment strategy can be tough, industry insiders say.

“China continues to be the market of great opportunity but difficult implementation,” Thomas K. Lynch, managing director in the New York office of Cliffwater LLC, said in an e-mailed response to questions.

At TPG Capital, spokesman Owen Blicksilver said: “As the Chinese economy continues to grow and Chinese companies become bigger and more internationalized, TPG does foresee more cross-boarder transactions taking place.

“Depending on the situation, TPG will help its portfolio companies expand overseas.”

TPG has two global funds that currently invest in China: TPG Partners VI LP and TPG Star LP, the TPG growth fund. The firm is currently raising two renminbi-denominated funds. Four earlier TPG funds focused on investing in emerging markets including Asia are all fully invested.

China's growth story — featuring its developing middle class and economy that's shifted to consumption from export — creates enormous prospects for private equity, Mr. Lynch said. However, getting money out of private equity investments in China is challenging, he added.

Unlike in the U.S., most China-based private equity investments represent only a minority stake in the portfolio companies. That's because the Chinese government requires that majority stakes be Chinese-owned. It's very difficult for a minority owner to a force the sale or IPO of a company, especially during the lifespan of a private equity fund.

Also, foreign investors have traditionally invested in Chinese companies through offshore holding companies that have limited exit alternatives. Plus, foreign investors are limited in the type and amount of shares they can trade on the Chinese stock exchanges.

Still, Mr. Lynch expects IPOs issued in the U.S. and China “will remain a significant source of exits.”

Chinese IPOs in general slowed greatly during the economic crisis and the two-year close of the global IPO window.

But these days, China is all the rage among U.S. stock investors. Mr. Lynch expects a new wave of private equity-backed China based portfolio companies to list in the U.S.

“IPOs are a function of demand and, specifically, the demand from mutual funds,” he said. “However, mutual funds and other institutional investors want more exposure to China, and a U.S. listing of a Chinese company fits that bill.”

Taking Chinese companies public in the U.S. is one of several exit strategies used by Washington-based Carlyle Group and other private equity firms that invest in China. In some instances, the company first goes public on an exchange in China and later launches an IPO in the U.S.

Carlyle, which has been investing in China for 10 years, recently held a first close of The RMB Fund, garnering nearly half of its targeted 5 billion RMB ($740 million), David Rubenstein, co-founder and managing director of Carlyle, said in a September panel discussion at a Private Equity Analyst Conference in New York.

Carlyle is not the only U.S. firm to begin raising a renminbi-denominated fund. They are doing so to get around the Chinese government's restrictions on investments by foreign companies, some industry insiders say.

“China is restricting many investment opportunities to local investors or RMB funds,” Mr. Lynch said. “While China recently announced a pilot program to allow certain foreign investors to participate in RMB funds, there is a clear policy to provide an advantage to local investors.”

In 2009, China introduced a growth enterprise board on the Shenzhen Stock Exchange, which made domestic IPOs easier, Ying Li, a Hong Kong-based partner in the law firm Proskauer Rose LLP, said in an e-mailed response to questions.

This makes first launching a domestic IPO an easier choice, then taking it public outside China for another listing, private equity firm executives say.

TPG is raising two renminbi-denominated funds. On Sept. 22, TPG announced that it had signed an agreement with the Shanghai municipal government to establish TPG China Partners I, which will invest in medium and large Chinese companies with a 5 billion RMB target. Fundraising will start in the next several months.

In August, TPG launched TPG Western China Growth Partners I, a 5 billion RMB fund. It's part of an agreement between TPG and the Chongqing Municipal Financial Services Office and Chongqing Liangjiang New Area Development & Investment Group Co. Ltd., the government company responsible for developing the municipality of Chongqing.

So far this year, 17 private equity funds aimed at investing in China raised $7 billion, compared to $7.8 billion raised by 23 funds last year. according to London-based alternative investment research firm Preqin.

Other private equity firms planning to raise renminbi-denominated funds are Blackstone and 3i Group, sources said.

There are several reasons for raising a renminbi-denominated fund, Christopher Ullman, Carlyle spokesman, said in an interview. There are certain sectors where the Chinese government is less inclined to have investors use capital from dollar-denominated funds, such as telecommunications, certain public utilities, insurance, securities, legal consultancy and market survey, explained Mr. Li.

Mr. Ullman said the Chinese government is encouraging and effectively starting renminbi-denominated private equity funds aimed at making domestic investments, and some Chinese investors prefer to keep their capital at home.

The new wave of larger Chinese portfolio companies is a twist on an earlier phenomenon, Mr. Li said.

“Offshore IPOs used to be a favorite exit approach of PE funds investing in China until two regulations, in 2005 and 2006, made it difficult to set up the offshore holding vehicles for domestic portfolio companies for the purpose of their IPOs outside China,” Mr. Li said.

But even private equity firms located in China are coming to the U.S. to launch their IPOs. For example, in September, Hong Kong-based SAIF Partners took portfolio company Global Education & Technology Group Ltd. public on the Nasdaq stock exchange.

SAIF raises money in the U.S to invest in companies based in China, and then takes its Chinese portfolio companies public in the U.S. following an IPO in China.

SAIF Partners is currently raising its fourth fund. So far, the $124.8 billion New York State Common Retirement Fund, $64.6 billion State of Wisconsin Investment Board and $14.2 billion Indiana Public Employees' Retirement Fund have committed capital to the fund.

Some institutional investors who declined to be identified said they invest in China through global and regional private equity funds that follow the China-to-U.S. IPO strategy.

For example, Blackstone's global funds have China exposure. Carlyle's Asia funds are regional private equity strategies aimed at U.S. and other non-Chinese investors that invest in Australia, Korea, Taiwan, Singapore, Southeast Asia and Hong Kong, Mr. Ullman said.

Oregon Investment Council, Tigard, which oversees the $51 billion Oregon Public Employees Retirement Fund, Salem, in July committed $200 million to Blackstone Capital Partners VI, a global fund that could include investments in China and $100 million to Angelo Gordon Asia Realty Fund II, which targets China among other countries.

Still, consultants and other investors are focused on getting returns on their China private equity commitments.

Mario Giannini, CEO of Hamilton Lane, Bala Cynwyd, Pa., an alternative investment consultant and fund-of-funds manager, said while investors are “hot” on China, they are aware that not much money has been returned to investors from these China-based investments.

There are a couple of theories, he said. One is that the investments are young and so investors don't expect much money back. The other is that managers would be reinvesting the money in the country, anyway, so it is would be all right if there are restrictions on capital repatriation, he said.

“Our view is that investors need to get cash back, and if that doesn't or can't happen, it's a problem for continued investment,” Mr. Giannini said.