China’s non-bank private lending sector has been drawing foreign interest in recent years as sovereign wealth funds and the offshore wealthy have entered the fray via mezzanine financing.

Traditionally the sector has been served by Chinese trust companies and pawn shops. But Barry Lau, co-founder of fund-of-funds investment manager Gen2 Partners based in Hong Kong, notes its $100 million-plus China-focused mezzanine fund has pulled in 20 investors. These include a Middle East sovereign wealth fund, an insurance firm, offshore pension funds and HNWIs.

Its Asia Private Credit Fund provides mezz financing to Chinese real estate and SME mining operators, and Lau highlights internal rates of return of 33% in 2011 and 35% in 2010.

“We believe mezzanine financing is the way forward for anyone wishing to participate in SME financing in China,” says Lau, who prior to forming Gen2 in 2009 was head of collateralised lending for BNP Paribas Asia.

Fellow co-founder and Gen2 CEO is Paul Heffner, who was previously a partner in a multi-family office and responsible for a fund-of-funds business which Gen2 bought out in 2009.

Unlike private equity, Lau argues that mezz financing offers the potential for high returns, the option of equity participation, and downside protection in the form of a performance guarantee embedded in loans.

He points to equity conversion rights as one reason why the fund has achieved over 30% returns for the past two years. For a typical project Gen2 charges 20-25% interest per annum from a borrower.

“While private equity funds would focus heavily on an operational and strategic angle with their investments, we don’t seek to change the original management of the targeted companies and work with them as much as possible,” says Lau.

While holders of mezzanine debt are subordinated to senior creditors in the event of a default, Lau suggests many SMEs in China don't have senior creditors in their capital structure in the first place since they are unable to borrow from banks.

Unlike in mature economies, China’s 49 million SMEs are largely passed over by commercial banks, which prefer lending to low-risk state-owned enterprises. Such aversion stems from the country’s heavily regulated interest-rate regime, which sees banks profiting from a largely inelastic state-regulated net interest margin.

Amid a government drive to rein in asset prices, banks have seen their lending to the real estate sector restricted. Such background factors have spurred the proliferation of informal lending, referred to as China's shadow banking sector.

The People’s Bank of China (PBoC) estimates that over 40% of the nation's total social financing need of Rmb12.8 trillion ($2 trillion) in 2011 was accounted for by private lending, and this does not even include informal lending.

By channelling foreign investor capital into real estate and mining projects, mezzanine financing is providing another source of operating capital potentially to compete with local trust firms and real estate funds that have helped to plug the financing needs of developers and manufacturers.

Lau says he is getting ready to roadshow and raise funds for a new China-focused mezzanine closed-end fund called Gen2 Capital Partners Fund II, which will have a different model to the first which was open-ended.