The runaway train of PE investors in China

Investors continue to focus on Chinese industries that are expected to benefit from the country's drive to expand domestic consumption, accelerate urbanization, develop cutting-edge technologies and harness its natural resources.

Industry favorites include retail (virtual or brick and mortar), food and beverage, agriculture, telecommunications technologies, media, mining, and alternative and renewable energies.

International private equity funds, however, are not the only investors interested in these sectors. Over the last year, many domestic private equity investors have emerged and have become very effective competitors for deals.

Domestic funds enjoy the advantage of speed - their investments into domestic Chinese companies do not require any approval by the Ministry of Commerce or its provincial or local offices.

Furthermore, they raise and deploy capital in yuan and therefore their investments do not raise any issue with the State Administration of Foreign Exchange (SAFE) or any need to convert foreign currency into yuan.

The intense competition has prompted international fund managers to continue to explore setting up their own renminbi funds. Every few weeks the market hears another report that yet another Chinese city is issuing rules to promote the establishment of foreign-invested private equity funds or foreign-invested private equity fund managers, or yet another international private equity fund is raising its own renminbi fund.

Another by-product of competition is higher valuation. Deals have become larger: According to an industry publication, for deals below $29.9 million, compared the first half of 2011 to the first half of 2010, total investments amount fell by 21.8 percent and the total number of deals fell by 22.5 percent. Chinese fund managers are getting increasingly comfortable doing deals in the $30 million to $50 million range and have amassed impressive coffers to write large checks.

In the meantime, international investors seem to be shifting their focus from onshore investments to offshore investments in the so-called little red chip structure.

For a few years after 2006, with the strength of the renminbi and robustness of the A-share market, many international investors considered the A-share market an increasingly attractive exit possibility and invested directly in China's incorporated companies to form joint ventures or joint stock companies with the goal of an A-share initial public offering (IPO). In the last few years, however, while the renminbi has remained strong, the A-share market has not been able to escape volatility that has spread throughout the world. Coupled with the market uncertainty over when and how quickly the China Securities Regulatory Commission approves IPOs and the competition they face when investing onshore, international investors are once again turning to Chinese companies that have restructured their ownership.

To further exploit their competitive advantages (compared to renminbi funds that operate onshore), many global private equity players are investing in Chinese businesses via Hong Kong or United States markets. With stock prices for Chinese businesses listed in the US at alarmingly low prices, many private equity funds are working on taking some US public companies private and then listing them in Hong Kong. There is a general perception that other than certain companies engaged in high technologies, the Hong Kong market will be in a better position to appreciate the true value of these Chinese businesses, and the improved stock price under the new listing venue will improve these companies' access to capital in the long run.

It has been reported that during the first half of this year, international investors invested a total of $2.6 billion into 13 Chinese businesses that are domiciled outside China.

Especially with the recent scandal and allegations of fraud hounding Chinese companies listed in the US, while trade sale always remains an option, the Hong Kong public market, in addition to being a venue for investments, has increasingly become a major focus for international private equity investors as the principal target exit from investments.

Successfully raising capital offshore, however, does not automatically translate into additional renminbi onshore. In recent months, some companies experienced delays when trying to convert foreign currency investments into renminbi until the specific need for the renminbi arose and could be explained to the State Administration of Foreign Exchange. Therefore, as the new capital in foreign currency was waiting to be converted, the amount of renminbi into which it would convert continued to diminish.

Despite the many challenges, uncertainties and competitive pressures, China remains a major focus for international investors. Deals still focus on growth rather than financial engineering or restructures after buyouts, and the use of leverage is still uncommon when compared to the Europe or the US.

The author is one of the global co-heads of private equity at Orrick, Herrington & Sutcliffe LLP.