Over a period of only a few short years, a very significant private equity industry has developed in China.
However, since around 2005, when the Chinese government started to restrict the offshoring of Chinese companies and their financings, the private equity market started a process of moving onshore.
With the development of this market, many foreign private equity investors are now looking for ways to structure at least some of their investments into China in the form of direct onshore investments — with the intention of an eventual onshore exit — instead of investing in an offshore holding company owned by founders or management.
To succeed, investors will need to make many difficult choices, and the best decisions will depend on a combination of factors and will change over time as the Chinese regulatory regime evolves. Despite the uncertainties, several clear trends are emerging.
First, large Chinese LPs are becoming important sources of funding. International PE sponsors need to decide whether such LPs can or should become part of their investor base, and if so, how to work them into their overall fund structure.
Second, China’s domestic financial infrastructure, including PE activity, is growing both in terms of size and sophistication. Onshore investors are playing an increasingly important role in China’s PE marketplace, and international PE funds may need to become as “domestic” as possible, and quickly. However, not all investment opportunities will take the form of onshore investment in domestic companies. Some Chinese companies are already structured in such a way, or they are in such sectors, that the natural exit is an offshore listing or sale.
Third, the domestic capital markets are becoming a viable exit option, despite their less transparent regulatory regime, the uncertainties of the listing process and the volatility of the market. Even if international investors do not prefer a domestic exit, they need to address the reality that many Chinese companies do.
All of this argues for flexibility in how an investor structures its China investment vehicles and makes it investments in China to preserve the maximum optionality in raising funds, making investments and achieving exits. For larger investors, this means establishing both offshore and onshore vehicles and learning how to structure deals in a manner adapted to the peculiarities of Chinese law. And in many cases it will be necessary to make a call early on as to whether the exit will be offshore and onshore, since that will determine the investment structure. And as Chinese law and the marketplace change in the coming years, and as the control over renminbi conversion is further liberalised, some of these structures will need to change, again.