Although China private equity funds are drawing increasing interest from domestic and also overseas institutional investors, several increasingly appear to be vehicles for shadow banking.
A phenomenon of what is called “fake private equity” funds have gradually become more evident in the country. While these vehicles can take many forms, Yan Qingmin, vice chairman of the China Securities and Regulatory Commission (CSRC), described many of them as “fake funds, real debt” at a private equity summit late last month.
Some are related-party transactions conducted through multiple fund products, while in other cases investment salespeople have raised funds illegally and defraud investors in the name of private equity funds, Yan said.
He did not mention how much has been invested in these “fake private equity” funds so far, or how many such funds are believed to exist.
A standard private equity fund should be one in which capital is raised to enhance the value of portfolio companies. Eventually, investors can make a profit when the fund exits these investments.
But in the case of fake private equity funds, the capital is used for high-risk investments or loans, Barry Tong, joint Asia Pacific head of transaction advisory services at Grant Thornton Hong Kong, told AsianInvestor.
Zhang Wei, chief macro strategist at Kunlun Health Insurance, said the fake funds resemble unregulated peer-to-peer lending.
The funds are seeking to benefit from an array of local Chinese asset owners and international players looking for private equity opportunities in the country.
CPIC Life, the third-largest life insurer in China, intends to increase its private equity allocation to a mid-single-digit percentage of its Rmb1 trillion ($144 billion) investment portfolio, while other Chinese insurers are expanding their teams for private equity investments as interest in the asset class grows.
Meanwhile, Queensland Investment Corporation’s (QIC) has said that it is building its private equity portfolio in China as the Australian market slows down. And in March last year, Australia’s Future Fund also said that it plans to increase investment in Chinese technology start-ups, although heightened trade tensions between China and the US are raising complications in the process.
In China, private equity and venture capital funds have swelled 4.5 times in three years to Rmb8.7 trillion as of end-2018, up from Rmb1.9 trillion at the end of 2015. But in addition to “fake private equity”, the asset class has other flaws which regulators are seeking to address.
The first is its small scale. At the end of 2018, the average assets under management (AUM) for private equity and venture capital funds in China stood at Rmb240 million and Rmb590 million respectively. The corresponding AUM in the US are 128 times and 28 times larger, Yan said.
More to the point, the top 10% of private equity fund managers manage more than 80% of those assets, while 37% of the private fund managers’ AUM stands at less than Rmb10 million.
The quality of internal control among private fund managers is low too. Over the past three years, the CSRC has conducted on-site inspections of some 1,200 private fund managers. Of those, more than a third (36%) have faced administrative measures or a penalty, Yan added.
Short investment horizons are another headache. By their nature, private equity investments should be long-term and illiquid. But as of the third quarter of last year, almost three-quarters (74.6%) of the investment projects exited by private equity and venture capital funds had a duration of fewer than four years. The exits represent 81.5% of the funds’ principals.
Yan also said that private equity funds have found it hard to raise capital, a situation that Tong believes will continue into 2020. It is hard for private equity funds to raise capital in mainland China, a contrast to the US where it's easy to do so, courtesy of far higher returns.
Thanks to its bull-run public equity market, limited partners in the US have been making good returns from private equity investments, which are often around 20%, more than double the amount offered by many mainland China funds, he said.