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Renminbi Funds: Can They Rewrite the Rules of Profitable Investing?

May 23rd, 2012 No comments

Renminbi private equity funds are the world’s fastest-growing major pool of discretionary investment funds, with over $20 billion raised in 2011. These Renminbi funds also play an increasingly vital role in allocating capital to China’s best entrepreneurial companies. Despite their size and importance, these Renminbi funds often have a structural defect that may limit their future success.

Most Renminbi funds are managed by people whose pay is only loosely linked, if at all, to their performance. They are structured, typically, much like a Chinese state-owned enterprise (“SOE”),  with multiple managerial levels, slow and diffuse decision-making, rigid hierarchies and little individual responsibility or accountability. The resemblance to SOEs is not accidental. Renminbi funds raise a lot of their money from state-owned companies, and many fund managers come from SOE background.

Maximizing profits is generally not the prime goal of SOEs. They provide employment, steer resources to industries favored by government plans and policies. A similar mindset informs the way many Renminbi funds operate. Individual greed along with individual initiative are discouraged. There are no big pay-outs to partners. In fact, in most cases, there are no partners whatsoever.

This represents a significant departure from the ownership structure of private equity and venture capital firms elsewhere. Partnership matters because it efficiently harnesses the greed of the people doing the investing.  The General Partners (“GPs”) usually put a significant percentage of their own money into deals alongside that of the Limited Partners who capital they invest. GPs are also highly incentivized to earn profits for these LPs. The usual split is 1:4, meaning the GP keeps 20% of net profits earned investing LPs’ money.

Of course, partnership structure doesn’t guarantee GPs are going to do smart things with LPs’ money. There’s lot of examples to the contrary. But, the partnership structure does seem to work better for both sides than any other form of business combination. GPs and LPs both know that the more the GP makes for himself, the more he makes for investors.

Renminbi funds, in most all cases, are structured like ordinary companies, or as subsidiaries of larger state-owned financial holding companies. Instead of partners, they have large management teams with layer upon cumbersome layer. The top people at Renminbi funds are picked as much for their political connections, and ability to source investment capital from government bureaus and SOEs, as their investing acumen. They are wage slaves, albeit well-paid ones by Chinese standards. But, their compensation might not even be 5% of what a partner at a dollar-based private equity firm can earn in a good year. A Renminbi fund manager will rarely have his own capital locked up alongside investors, and even more rarely be awarded that handsome share of net profits.

Renminbi funds differ in other key ways from PE and VC partnerships. The Renminbi funds usually have relatively flat pay scales, modest bonuses and a consensus approach with often as many as 20 or more staff members deciding on which deals to do.  A typical dollar-based PE fund in China might have a total of 15 people, including secretaries. A Renminbi fund? Teams of over 100 are not all that uncommon. The investment committee of a dollar PE firm might have as few as five people. Partners decide which deals to do. A Renminbi firm often have ICs with dozens of members, and even then, their decisions are often not final. Often Renminbi funds need to get investors’ approval for each individual deal they seek to do. They don’t have discretionary power, as PE partnerships do, over their investors’ money.

Renminbi funds have abundant manpower to scout for deals across all of China, and can throw a lot of people into the deal-screening and due diligence process. This bulk approach has its advantages. It can sometimes take a few months of on-the-spot paper-pushing, coaching and reorganizing to get a Chinese private company into compliance with the legal and accounting rules required for outside investment. Dollar funds don’t have that capacity, in most cases.

Also, Renminbi fund managers often have similar backgrounds to the middle management teams at private companies. They are comfortable with all the dining, wining, smoking and karaoke-ing that play such a core part of Chinese business life. The dollar funds? From partners on down, they are staffed by Chinese with elite educations, often including stints in the US working or studying.  Usually they don’t drink or smoke, and prefer to get back to the hotel early at night to churn through the target company’s profit forecast.

Kill-joys though they may be, the PE dollar funds still have, in my experience, some large – and most likely decisive — advantages over the Renminbi funds. Decision-making is nimble, transparent and centralized in the hands of the firm’s few partners. If they like a deal, they can issue a term sheet the same day. At a Renminbi fund, it can take months of internal meetings, report-writing and committee assessments before any kind of term sheet is prepared. Internal back-stabbing, politicking and turf battles are also common.

We’ve also seen deals where the Renminbi fund’s staff demand kickbacks from companies in return for persuading their firms to invest. An executive at one of China’s largest, oldest Renminbi fund estimates 60% of all deals his firm does probably include such under-the-table payoffs.

It’s often futile to try to figure out who really calls the shots at a Renminbi fund. Private company bosses, including several of our clients, are often loath to work with organizations structured in this way. The boss at one of our clients recently chose to take money from two dollar PE firms because he couldn’t get a meeting with the boss of the well-known Renminbi fund that was courting him hard. That firm compounded things by explaining the fund’s boss was anyway not really involved in investment decision-making and would certainly not join our client’s board.

The message this sent: “nobody is really in charge, so if we invest, you are on your own”. For a lot of China’s self-made entrepreneurs, this isn’t the sort of message they want to hear from an investor. They like dealing with partners who have decision-making power, their own money at stake alongside the entrepreneurs. PE partners almost always take a personal role in an investment by joining the board. In short, the PE partner acts like a shareholder because he is one, directly and indirectly.

At a Renminbi fund, the managers do not have skin in the game, nor a clear financial reward from making a successful investment. A Renminbi fund manager can be fired or marginalized by his bosses at any time during the long period (generally at least 3-5 years) from investment to exit. Private equity investing has long time horizon, and the partnership structure is probably the best way to keep everyone (GP, LP, entrepreneur) engaged, aligned and committed to the long-term success of a company.

It is possible for Renminbi funds to organize themselves as partnerships. But, few have done so, and it’s unlikely many will. The GP/LP structure is supremely hard to implement in China. Those with the money generally don’t accept the principle of giving managers discretionary power to invest, and also don’t like the idea of those managers making a significant sum from deals they do.

All signs are that Renminbi funds will continue to grow strongly in number and capital raised. This is, overall, highly positive for entrepreneurship in China. Hundreds of billions of Renminbi equity capital is now available to private companies. As recently as three years ago, there was hardly any. Less clear, however, is how efficiently that money will be invested. I know from experience that Renminbi funds find and invest in great companies. But, they also are prone to a range of inefficiencies, from bureaucratic decision-making to a lack of real accountability among those investing the money,  that can adversely impact their overall performance.

One way or the other, Renminbi funds will rewrite the rules for private equity investing, and eventually provide a huge amount of data on how well these managers can do compared to PE partners. My supposition is that Renminbi firms will not achieve as high a return as dollar-based PE firms investing in China. The reason is simple: investing absent of greed is often investing absent of profit.

Funny, You Don’t Look American

May 7th, 2012 3 comments

If I had one minute of national air time in China and could provide a single piece of information to correct a deep cultural misunderstanding, here’s what I would say, “You like to try, but it’s really hard, maybe impossible, to guess a white person’s nationality.”

Just about every Chinese I meet asks me where I’m from. My usual response is “Where do you think?”. What then follows, almost invariably, is “You look like you are from…” following by the name of various countries inhabited by large numbers of white people. Canada, France, Australia, Spain, Russia, Switzerland, Italy. I’ve heard them all.

There’s usually a note of certainty and keen deductive reasoning about it, for example, “people as tall as you are come from France, so you must be French”, or “people in America have big noses, and you do, so you are American, right?”, or “you are so friendly, you are English”, or “Canadians have blue eyes, so you should be Canadian”.

There is universal disbelief when I explain that white people pretty much all look the same, and that in most cases, I can’t tell by looking at Caucasians where they are from. The small clues I might use – differences in clothing, accent, hairstyles – are not perceived or understood by Chinese. They just look at the skin color and then form a conclusion.

About one-third of the time, someone guesses right. When I ask them why they think I’m American, I hear all kinds of things, some flattering, some not. Equally, when I correct a wrong guess, I’m then often lectured, in a friendly way, why I couldn’t possibly be American, because American men are all lighter-skinned than me, or have mustaches, or are balding. And so on.

I always enjoy these little exchanges. As far as I can tell, my Chinese interlocutors do as well. If I have the time, I’ll explain that white Americans are really deracinated Europeans, whose ancestors came from England, Germany, Ireland, Italy, Eastern Europe. We still look pretty much the same as people still living in those places.

This usually is news to Chinese. I suggest to them that just as lots, though not all,  Japanese and Koreans can pass for Chinese, and that large numbers of Thai, Indonesian and Filipino citizens have Chinese ancestry, so many white people look like they could come from any number of different countries.

From what I can tell,  many Chinese think there is a distinct American “race”, with unique appearance and physique. Sometimes I fit that “genotype” for them. Sometimes not.  Chinese are used to hearing over and over how their own country is made up of 55 different ethnic minorities, many of whom look rather similar to the Han people who make up 91%.5 of the country’s 1.3 billion peope.  Quite a few, therefore, surmise countries in Europe and North America are populated by unique “races” , all somewhat similar, but each with its own unique ethnic identity. Sometimes costumes as well.

The irony is that when pressed, most Chinese will admit that to them, all white people look pretty much the same. They are happy to guess a white person’s nationality, despite the fact that to them whites all look more or less alike. From what I can tell, Chinese don’t “see” a white face the way white people do. They don’t apprehend the big differences among whites in hair, eye and skin color.

If some of these more subtle differences don’t make of an impression, overall Chinese have gotten far more familiar seeing white faces, mainly on TV, but also in major cities like Shanghai and Beijing. Compare this to the situation 200 years ago when Europeans first began making their presence known, often forcefully, to the Chinese. Then, Chinese described foreigners mainly as peope in garish costumes, with long red beards, and an overall appearance not unlike either monkeys or the devil. (The porcelain plate displayed above is from that time, the Qing Dynasty, showing a Chinese official receiving a European envoy.)

Truth to tell, I don’t much like being mistaken for a Russian, the most common guess. But, I’m always greeted warmly and with genuine curiosity and goodwill. That’s something those earlier visitors of European ancestry rarely, if ever, experienced.